Reflex Bounce?

To nobody’s great surprise, the S&P500 paused from its multi-week slide and bounced just under 0.90% last week. Volume was low to moderate, and volatility fell back 10%, as one would expect in a week where prices generally rose.

Technically, the pullback—as seen from the weekly charts—is still in effect. The daily charts highlight the bounce as being a natural reaction to a short-term oversold condition. The breadth indices are still not very bullish. These market internals show that the rebound wasn’t  driven by a wide range of companies. Instead, it was fairly narrow. The percent of stocks above the 50 day moving average, for example, still displays a severe breakdown in breadth, a breakdown that began several weeks ago.

The US economy is still struggling, as it has for the past four years, to reach ‘escape velocity’, which means that the economy has not been able to grow at a healthy rate on its own. Instead, it’s still dependent on massive fiscal stimulus (eg. federal government deficit spending to make up for lowered private sector spending) and massive monetary stimulus (eg. the emergency near-zero interest rates and quantitative easing programs are still very much in place) to prevent a depression-like collapse. And now, many are beginning to question whether the monetary stimulus is even doing anything positive; it could be that this medicine is actually poisoning the patient.

Economic reports continue to disappoint. The Chicago Fed national activity index missed expectations. Durable goods orders, on the other hand, beat. New home sales also beat expectations, but this measure is very much backward looking. Since interest rates have surged higher over the last four weeks, upcoming home sales will become stressed due to the much higher mortgage rates. The latest report for quarterly US GDP growth was much lower than expected. Initial jobless claims disappointed. Personal spending also missed; but personal income was higher than estimated. The Dallas Fed beat; the Kansas City Fed missed. Finally, Chicago PMI—one of the most important leading indicators of US economic activity—missed badly.

And for equity markets, this presents a problem. If US economic news were to disappoint badly, across the board, then the Fed would have a harder time considering any reduction, or tapering, to its ‘QE Forever’ program. It could conveniently continue to ignore the huge distortions this program has been creating in the financial markets (ie. blowing big bubbles in equities and fixed income and real estate….again), and focus on the ‘bad news’ to keep on printing at the rate expected by markets.

But that’s not happening. Instead, the economic reports are somewhat mixed, leaving the Fed to suffer from criticism focused on market distortions, distortions which we know by now could lead to financial distress and dislocations (also known as financial crises and crashes).

And that’s where we are left today, wondering whether or not the Fed will taper the rate of QE. If markets believe that the economy is too weak, and distortions are not too great, then tapering might be put off, and equity markets can rally further.

If markets believe that the economy is not so weak, and that the market distortions are becoming too great, then tapering will happen and sooner than later. This will cause the markets to sell off further.

And after last week’s bounce, we are technically at a crossroads. If the rally continues then the markets could be buying into the first scenario and technical support for more price gains would build.

But if the rally falters, then the markets could be buying into the second scenario, and last week’s bounce would be seen as just that, a reflex bounce that is followed by continued price declines.



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