Written by Lance Roberts, Clarity Financial
“If you wonder why we’re seeing such a HUGE divergence the past 3 weeks between the economy and where investor psychology has taken the market…just remember…it’s all about the Fed.
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Market psychology is having a ‘V’ shaped recovery from total panic while the economy still looks horrible. S&P futures implied volatility is down 50% from the ‘max panic’ level it hit mid-March.
Can the ‘psychological rally’ be sustained? Is this just a vicious ‘Bear Market Rally?’ Will the ‘reality’ of a devastated global economy pull the market back down? And if market price action shows us that investors are growing fearful again will the Fed just throw up their hands and say, ‘Sorry, we gave it our best shot and that’s all we could do?’ I don’t think so. In for a penny…in for a pound.” – Victor Adair, PI Financial
Victor is correct.
As I noted in Friday’s #MacroView:
“In the short-term, the Fed is massively increasing the liquidity of banks (excess reserves) through the various ‘Q.E’ facilities to stave off a second ‘financial crisis.’ Given the banks do NOT want to loan out any funds not guaranteed by the Federal Reserve, the excess liquidity flows into asset markets.”
Not surprisingly, as discussed previously:
“From a purely technical basis, the extreme downside extension, and potential selling exhaustion, has set the markets up for a fairly strong reflexive bounce. This is where fun with math comes in.
As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance.
Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”
Over the last couple of weeks, we have indeed had an extremely strong “oversold,” reflexive rally, that has now reversed the conditions that “fueled” the advance.
As shown above, all previous short-term oversold conditions have been fully reversed, with the market completing a typical 50% retracement of the previous decline. This was also a point made by my colleague Jeffery Marcus of TP Analytics this past week for our RIAPro Subscribers (30-day Risk Free Trial)
“The S&P500 has now rallied 19% off of its low close of 2237.40 on 3/23 and 21% from its intraday low of 2191.86 on 3/23. The benchmark is now within sight of its 50% retracement.
By definition, a 50% retracement of the S&P500 would be a rally that retraced 50% (+574) of the net loss (-1148) from 2/19 to 3/23. The chart below shows that the 50% retracement level is approximately S&P500 2811 (the low of 2237 + 574 = 2811).
It is very hard in the volatile environment to be too exact, but at the S&P 500 2800 – 2830 level, the risk/return trade-off becomes bad for the market.”
On Friday, the market hit an intraday high of…2818.57 before selling off into the close.
Could the market rally more next week? Absolutely, given any good news on the virus, additional stimulus, and just general short-term market optimism. A 62.8% retracement is entirely possible.
However, history suggests that whatever rally still remains is likely a “gift” to sell into.
A Look Back
Here, let me save you the trouble of emailing me.
“But Lance, like Victor says, the Fed is pumping the markets full of liquidity. So, ‘Don’t Fight The Fed.'”
Or, even tweeting me:
As noted above, excess liquidity WILL flow into markets short-term; however, eventually, the markets will reflect the underlying economic destruction.
While 2008 was bad, the impact from the “economic shutdown” due to the virus will be substantially worse for several reasons:
- In 2008, the economy was already slowing down, unemployment was already on the rise, and businesses were adjusting for the related impact to earnings. Also, despite the “crisis” caused in the mortgage market, businesses and consumer activity remained “open.” Outside of the real estate and finance industries, many other sectors were only marginally affected.
- In 2020, the shuttering of the economy caught many businesses “flat-footed” and ill-prepared for an involuntary “shuttering” of business.
- In 2020, the surge in unemployment, combined with a shuttering of business, will have a substantially deeper impact on gross consumption in the economy than in 2008.
- As opposed to 2008, there are many businesses that will not ever reopen, many more will be very slow to recover, with the rest very slow to rehire until demand returns.
The markets are currently rallying on a flush of liquidity, and a massive short-covering rally, which is likely reaching its “exhaustion” stage. Over the next few months, stocks will begin to price in the severity of the economic damage, a substantial decline in earnings, and the realization that hopes for a “V-Shaped” recovery are not likely.
While there are lots of market analogs making the rounds comparing the current crash to 1929, 1987, and a host of other periods, it is 2008, which has the most similarities. (I am not a fan of analogs, but if you want one, this is the most logical.)
In 2008, the Fed had already started bailing out banks in early March as Bear Stearns failed. The Fed was also aggressively lowering interest rates to Zero. In 2008, the Fed lowered rates by 5.25% versus just 1.5% currently. While the market initially rallied after the Bear Stearns bailout, and even set new highs shortly thereafter, the economic crisis was still revving up.
The depth of the crash came in September 2008. Importantly, after the failure of Lehman Brothers, the market rallied nearly 20% from its lows in late October as the Federal Reserve, and the Government through fiscal policy, and an alphabet of bank support programs, began to intervene aggressively. That rally took markets back to a short-term overbought condition.
Following that rally, the reality of the economic devastation began to set in as unemployment skyrocketed, consumption and investment contracted, and earnings fell nearly 100% from their previous peak. The market declined 26% into late November until the Federal Reserve launched the first round of Quantitative Easing.
With liquidity flooding into the system, stocks once again staged an impressive rally of almost 25% from the lows.
Yes, the bull market was back!
Except that it wasn’t.
Over the next few months, the market once again sold off, falling 28.5% from the prior “bear market rally” high.
By the time the end of February 2009 came, it was widely believed that “NOTHING” would save the markets. Headlines from the media were filled with stories that the Dow would fall to zero.
Most importantly, there was NO ONE that wanted to “Buy The Market.”
That all happened despite the Federal Reserve’s, and Government’s, intervention programs. As noted in our #MacroView:
“The problem with monetary policy, in all of its forms, is that it disincentivizes capitalism.
Zero-interest rates, excess liquidity, and a closed-loop between the banks and the Fed, removed all incentives to “take risks” of lending money to businesses and individuals to create economic growth. Instead, that liquidity, fueled asset prices, stock buybacks, and corporate debt which engendered a wealth gap never before seen in history. In fact, there is no evidence QE leads to increased monetary velocity, or rather the transfer of liquidity into the economic system, at any level.”
