After several weeks of rallying, the S&P500 finally stalled and actually reversed. The index dropped about 0.7% on light volume due to holiday shortened trading hours. Volatility, while not changing very much, did edge higher which adds to the importance of the price drop.
US macro reports were mostly weak. The Chicago Fed National Activity Index fell into negative territory again; it was expected to climb a bit. Existing home sales rose, but less than predicted. The PMI manufacturing flash index came in weaker than expected. While headline durable goods orders just about met expectations, the core (ex-autos) figure cam in well below consensus estimates. On the positive side, initial jobless claims were slightly better than estimated and new home sales beat expectations ever so slightly.
After highlighting how the most recent multi-week bounce in the S&P was closely echoing the big bounce that also occurred in October last year, we went on to ask if the same final outcome would also occur—namely, that the bounce would end without setting new highs and then the index would turn down to set new post-peak lows.
Well last week’s price drop suggests—at a critically important technical level—suggests that the bounce could be finally coming to an end. Supporting the argument that the bounce may be ending were several reports suggesting that big money funds were net sellers into the recent rally. In other words, professional or “smart” money investors were selling because they were betting that the recent rally was going to reverse itself.
So who was buying on the upside in this rally? The same huge buyer that’s been buying massive amounts of stocks over the last couple of years—corporations were buying back their stocks, by using cash from reduced capital expenditures or from increased borrowings.
The problem with this strategy is that it means that corporations have been buying assets (their shares) at high prices (during the rally) and leaving themselves with less in terms of productive investment (bad for future sales and profit growth) or with much more highly leveraged balance sheets (bad for financial risk especially when a recession finally arrives).
Something very similar happened during the run up to the 2008 financial crisis. And the worst part of that story was that after the crisis hit, many of the same companies who were buying their shares at high prices suddenly were forced to de-lever and sell their shares at low prices.
The result—they bought high and sold low, which clearly destroys value for shareholders. And now, sadly, history seems to be repeating itself.