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Will This Bloodbath Continue?

Market Tumble Signals Impending Change

Written by Briton Ryle
Posted September 26, 2014

Yesterday’s rout of 1.54% on the Dow Jones Industrial Average of 30 large caps, 1.62% on the S&P 500 broader index, and 1.94% on the mostly tech NASDAQ marked the fifth mini-pullback of the past 12 months. Yet as nerve-wracking as it may have seemed while it was unfolding, it was actually pretty mild compared to the previous four.

In each of the previous four pullbacks, the S&P 500 lost 4.35%, 5.95%, 4.22% and 3.79%, while the current retreat which started last Friday the 19th has been about half to two-thirds as long – just 2.67% as of yesterday’s close.

Today is going to be a very important day on Wall Street, for today will tell if the recent sell-off is a normal short-lived, end-of-quarter portfolio squaring, or if it will spill over into a frightful October of corrective proportions.

Luckily, most of the evidence supports the former, indicating that the pullback will likely be short-lived if not over already – some evidence technical, some fundamental.

Technical Evidence that the Worst is Behind Us

As noted in the graph below, each of the previous four tumbles (marked in red) had breeched well past the S&P 500’s 100-day moving average, with the second one back in February touching the 150-day average.

Five Consecutive Drops in S%26P

Source: BigCharts.com

Yesterday’s pullback, however, stopped before reaching the 100-day M.A. While this does not by itself indicate the selling has stopped, the way yesterday’s session started and finished might prove so.

As noted below, nearly all of yesterday’s losses (red) were borne during the first 90 minutes, while the rest of the session saw a trend reversal where small caps (beige) edged up (green), while the S&P (black) fell just a tiny bit more (blue). Let’s consider the two time periods separately.

short-term market tumble sept 2014

Source: BigCharts.com

• First, yesterday’s open. This pattern fits the scenario of end-of quarter rebalancing very nicely. Since it takes 3 business days to settle trades, trades placed today will settle the first of October, the beginning of the next quarter.

A major concentration of sell orders by institutional traders at yesterday’s open triggered a cascading effect where markets panicked for a sharp and immediate selloff. This set the stage for a nice buying opportunity the next day – today - at cheaper prices, locking in some profits at the end of Q3 and starting Q4 on the right foot when today’s trades settle October 1st.

Thus, if we see a good deal of buying today with markets ending higher, then we’ll know that this is what yesterday’s sell-off was all about, just your typical end-of-quarter squaring of accounts.

• As for yesterday’s close, that the small caps (represented by the Russell 2000 index in beige above) ended the day higher than their early morning lows might be showing that the small cap bear of the past several months is finally dead. The small caps started to diverge from the rest of the market at the beginning of March, falling some 5.5% while the broader market S&P 500 is up 6% since then – a bearish signal, as small caps generally lead the way.

If today’s trading sees the small caps rise by a larger percentage than the broader market, it could mark the end of that bearish trend, with small caps now leading the rest of the market higher into year’s end.

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Fundamental Evidence that the Worst is Behind Us

Apart from these two technical indications that the recent sell-off will be very short-lived - if it isn’t over already – are a slew of disappointing economic reports over the past two weeks.

Normally, bad reports would further exacerbate a pullback into a full-blown correction. But not in our current economic environment. The “bad news is good news” rule we have all come to know and love over the past five years since still applies, since bad news means the Federal Reserve is more likely than not to keep monetary policy loose and expansionary.

Here are just some of the reports over the past two weeks that give us very good reason to expect the Fed to keep interest rates lower for longer, and that the current sell-off in equities will be minor:

• September 15: The nation’s industrial production contracted by 0.1% from an expansion of 0.2% the previous month, with a series of downward revisions to several previous months.

• September 16 & 17: Producer price index changed by 0% after it had risen 0.1% the month before. Consumer price index fell 0.2% after it had risen 0.1% the month before. Core consumer price index changed by 0% after it had risen 0.1% the month before.

All three of these price indicators are showing no inflation growth to slight deflation. Since the Federal Reserve has long stated it fears deflation while desiring inflation, these reports keep the Fed leaning decidedly toward continuing monetary accommodation.

• September 18 & 22: The Federal Reserve Bank of Philadelphia General Business Conditions Index measuring business growth slowed to 22.5 from 28.0 the month before. The Federal Reserve Bank of Chicago national activity index comprised of 85 economic indicators fell to -0.21 in August from +0.26 in July with negative readings indicating slowing economic growth. This dropped the three-month averaged to +0.07 from +0.25 in July.

Note that these are both Federal Reserve indices, meaning that the very institution that decides interest rates has some really bad data right at its fingertips. This is a strong indication that the central bank will remain highly accommodative for a while longer.

• September 25: Durable goods orders shrank by a record 18.2% in August after expanding by a record 22.5% in July, which couples with the slowing industrial production report of the prior week to show continuing slowing productivity, strengthening the case for a continuation of the Fed’s easy money policies.

Taken together, then, the fundamentals are pointing to no change in the central bank’s dovish leaning over the near term. The explanation by commentators that yesterday’s pullback comes over the fear of interest rates rising earlier than anticipated simply does not match with the recent economic data - data which the Federal Reserve has long stated it is heavily reliant upon in its decision-making.

Investors Get Ready to Buy

Rather than panic into selling their holdings, investors should at the very least simply ride this pullback through to its end, which should come soon if it isn’t upon us already. Better still, investors should prepare to add to their holdings, especially with stocks that have been beaten down the most - such as the small caps, technology, energy, discretionaries and industrials.

The case for industrials is a tough one, since global economic estimates have been slashed yet again, with demand for American made aircraft, tractors, and other machinery expected to remain muted. In fact, the slowing demand for aircraft contributed significantly to the recent record drop in durable goods orders.

However, with the Fed expected to remain highly accommodative for a while yet - (even after interest rates begin rising, they will do so ever so slowly) - there will be enough demand within the U.S. over the next 3 to 5 years to prop industrials back up, with global demand ready to flourish itself by then.

Energy is another sector that is a tough sell these days, with a recent glut in crude oil and natural gas supplies putting downward pressure on the prices of energy commodities and energy company stocks. Yet we mustn’t forget the ongoing row between Russia and the European Union – the largest buyer of Russian oil and gas.

While there currently exists an excess supply of fuels on the markets, if Russia follows through on its threat to cut-off oil and gas supplies to Europe and diverts those supplies to China instead, then the European continent of over two dozen nations will be drawing down on global stockpiles at a very rapid pace.

With winter just round the corner, the current excess supply shouldn’t last long, making the beaten down stocks of energy producers like Exxon Mobile (NYSE: XOM) and Chevron (NYSE: CVX) very attractive right about now. Over the past several months, these energy giants have fallen more than even the small caps, with both XOM and CVX falling 9.5% the last two months, as compared to the Russell 2000’s 2.5% retreat. Over the past one month, all three have posted much the same drops between 5.5% and 6%.

Hence, we have ample reasons to expect the market pullback of the past week to be very short-lived if not over already. It all hinges on today’s performance. If we close flat to up, the tumbling will likely be over, or perhaps fall no more than another 2% or so to bring it inline with the previous four pullbacks which ranged from 4% to 6%.

But if today closes down decidedly, then all bets are off, as the pullback will turn into a full-blown correction that could reach 10% or more before it’s all over. Today should decide things one way or the other.

Joseph Cafariello

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