Overnight we saw the biggest sell-off in the US markets in over two months. US Federal Reserve Bank of Philadelphia President Charles Plosser made the grave mistake of telling the truth. He said that ‘we are unlikely to see much benefit to growth or to employment from further asset purchases.’
Plosser opposed QE3, so it shouldn’t be a surprise to hear him say this. But most market participants have been waiting with baited breath since the QE3 announcement to see whether the sharp rally of the last few months would continue.
The trading over the past week has been decidedly sluggish and after last night’s sell-off we have now retraced most of the rally since the QE3 announcement…
Last week I wrote about the technical set up in the S+P 500 and said that, ‘From where I sit, if the market fails to hold these levels and sells off to a level below the previous high of 1422 made in April this year, then there’s a high chance that we’ll see a sharp correction back towards the 200 day moving average at 1350.’
The intermediate trend is still up in US markets so you have to expect the buying pressure to remain for the moment. But last night’s price action sends an ominous warning that the emperor (US Federal Reserve Chairman, Ben Bernanke) may soon be shown to be wearing no clothes.
Unlike QE1, QE2 and Operation Twist, market participants have been front running the announcement of QE3 for the past three months. There will be plenty of traders scrambling to hit the sell button if the market continues to fall over from here.
Macroeconomic figures worldwide have weakened over the last few quarters so the strong rally is looking more and more like hot air.
Bernanke’s greatest power was in promising to do something in the future. The uncertainty and expectation that this created was enough to keep short sellers at bay while buyers attempted to front run the money printing.
But now that Bernanke has turned expectation into fact the market will focus on whether or not the money printing will actually achieve anything.
That is why Plosser’s comments last night created such a strong reaction. If printing all this money achieves nothing other than keeping mortgage rates close to their all-time historical lows and economic figures continue to worsen, you have to ask yourself why you would buy the US stock market at a yield of 1.8% or so.
Bernanke the Witch Doctor
If the spell is broken on the money printing voodoo there is a long way for the market to fall and I think the announcement of ‘QEternity’, as it’s becoming known, at multi-year highs for the stock market smacks of desperation.
If the market continues to fall from here there isn’t much Bernanke can do, because he has already shown his hand.
As always market tops take time to form and some buying pressure always remains while we are in intermediate uptrend (10-day moving average above the 35-day moving average) so it’s still too early to come out all guns blazing on the short side.
But I think last night’s price action is the first sign of cracks appearing since the announcement of QE3. That means you need to closely watch the trading over the next few weeks.
Another sign that we may be close to a market top is the extremely low volatility of the past few weeks…
Market Warning Signs
I look at the 10 day average true range of the index I’m analysing as a percentage of its price and then I invert the indicator and lay it over the index.
I’ve found this method can give you great early warning signs when the market is ready to turn.
S+P 500 Daily Chart and Average True Range
(As always it’s advisable to open the above chart in another browser window so you can follow along with my reasoning.)
The blue line chart below the S+P 500 is the ATR indicator. It’s inverted, so a rising line means falling volatility and a falling line means rising volatility. The scale for the ATR indicator is on the left hand side of the chart and you can see that when the ATR indicator hits a level of around 0.8 (meaning the average true range over the past 10 days has been around 0.8% a day) the stock market has been very close to a multi-month top.
The vertical lines show you each time the ATR indicator has come close to that level (I’m not including the Christmas trading period in 2010, which I consider an outlier).
Follow the vertical lines up to the actual S+P 500 chart and you can see quite clearly that the market was very close to a major sell-off each time the volatility fell below the 0.8 level.
Obviously nothing is ever 100% certain in the markets and this may be the one time in the past three years where this indicator gets it wrong. But after explaining the waning post QE3 excitement above I would start to tread very carefully going forward.
An article in the Age yesterday said that:
‘Regulators have vowed to impose a fresh ban on short-selling in shares if markets descended into the kind of chaos seen around the time of the global financial crisis.‘The Australian Securities and Investments Commission has pledged to impose a ban on the practice should market conditions require it.
I’m sure you remember the last time ASIC banned short selling. It was in 2008 just prior to one of the biggest sell-offs in the market history. I love the way regulators are happy for short sellers to lose money while the market goes up but then when short selling is profitable they decide it’s an evil practice that must be stamped out.
The only outcome from banning short selling last time was that it took away buying volume as the market fell because there were no short sellers covering their positions. Yes they created an initial spike, but when the music stopped the bottom fell out from under the market.
We can always rely on regulators to do the dumbest thing at exactly the wrong moment and to ignore history. So when you see them acting on short selling you should start to get very worried indeed.
I want to make one other quick observation about the ASX 200 before I sign off.
ASX 200 Daily Chart
The ASX 200 has been in a very clear range between 4100-4300 for over a year now. Whenever the ASX 200 has closed above the 4300 level during this time (the ellipses in the chart) the market has created a high and subsequently sold off sharply to below 4100.
The actual high of the range is 4324 so keep your eye on that level and if it closes below that level this week the chances of another drop to below 4100 increases dramatically.
Murray Dawes
Editor, Slipstream Trader
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