How Far Will the Bounce Take US Stocks?

US stocks - how far will they bounce?

Let’s start the week with a little humour, courtesy of a confused Bloomberg columnist.

What’s supposed to be the most volatile asset in the universe is proving to be a bastion of stability compared with wild swings and carnage in global equities this week.

Bitcoin clawed its way back from the four-month low of $5,922 it touched on Tuesday, rebounding 53 percent to $9,069. The S&P 500 Index and the Dow Jones Industrial Average both fell more than 5 percent this week, wiping out gains for the year.

Since the drop below $6,000, Bitcoin has been on a steady climb, causing volatility measures on the digital asset to stabilize while the sell-off in the S&P 500 triggered the biggest jump on the Chicago Board Options Exchange Volatility Index ever.

Hang on, a 53% surge in less than a week results in a stabilising of volatility? Really?

Just in case you think the surge in bitcoin was an opposite response to last week’s global equity market sell-off, have a look at the following chart. It shows the price of bitcoin in US dollars, with the ‘relative strength index’ (RSI) at the bottom.

Bitcoin in US dollars, with the ‘relative strength index’ (RSI) - 12-02-2018


Source: Optuma
[Click to enlarge]

The RSI is a momentum indicator. At the low point early last week, the RSI was in hugely ‘oversold’ territory. That means the selling had become so extreme that the market was way out of balance. A bounce back was a very high probability.

The question is, how far will the bounce back go?

I don’t know. But I believe there is a high probability that the bubble in bitcoin has now popped. The big falls are a psychological blow to the whole crypto market. There are not enough new buyers to come in and renew the bull run.

Is it the same scenario with US stocks?

At this stage it’s too early to tell.

The US market rebounded on Friday, but intra-day trading is very volatile. There isn’t a great deal of conviction either way.

From a purely technical (charting) perspective, US stocks are due for a bounce. Like the price of bitcoin early last week, the S&P500 is now ‘oversold’, as you can see from the RSI measure in the chart below:

The S&P500 is now ‘oversold’ - 12-02-2018


Source: Optuma
[Click to enlarge]

The important thing to watch here is how far the bounce takes stocks. If, for example, you see the market rally back to around 2,700 points and then run out of steam, I think you’ll see stocks subsequently fall to new lows.

It will tell you that there isn’t enough buying enthusiasm to push stocks back to (or beyond) the recent highs.

Given the speed of the recent falls, my feeling is that a decent amount of psychological damage has been inflicted. Investors are no longer reckless and confident. Certainty any confidence has given way to a big increase in uncertainty.

There is a well-worn phrase, ‘Market’s hate uncertainty.’ I would add a slight adjustment to that phrase to make it even more accurate: ‘Market’s hate the perception of uncertainty.’ 

The thing is, we operate in an uncertain world every day. No one knows what will happen from one day to the next. But often, the market will enjoy the perception of things being predicable and stable.

That becomes the narrative, and more people are lured into the perception of calm. That’s what this market has been all about.

And Wall Street is always ready to sell something based on the prevailing narrative. In the past few years, ‘low volatility’ strategies have been an easy sell…and passive ETFs.

But last week, a number of low volatility strategies blew up, losing 90%-plus of their value in a matter of days. And the inflow of funds into US stocks looked to have reversed sharply. As the Wall Street Journal reports:

The sharp swings appear to have especially spooked investors in funds tied to U.S. stocks, which have soared for the past nine years and blown through a series of record highs. Investors pulled a net $33 billion out of North American equity funds in the week through Wednesday, the biggest weekly outflow based on data going back to 2015, according to EPFR.

$33 billion in a week is a decent outflow. In the December issue of Crisis & Opportunity, I highlighted the extreme equity market inflows (see chart below) as a driving force behind the market’s extreme valuations. I argued that money was blindly flowing into stocks with little concern for risk. I wrote:

When things look good, investors gain more confidence and buy stocks without worrying too much about valuations.

Either that, or they just buy an exchange traded fund (ETF) and not worry about anything…

I then showed the following chart:

Investors pulled a net $33 billion out of North American equity funds in the week through Wednesday. 12-02-2018


Source: Yardeni Investment Research
[Click to enlarge]

If massive equity market inflows pushed the market higher, it makes sense that capital is now fleeing.

The big question for longer term investors is whether this is just a ‘hot money’ exodus that will quickly run its course, or something deeper.

You’ll know more when you see how this bounce plays out…

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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