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Two Signs the Pullback Will Continue

Written By Briton Ryle

Posted December 11, 2014

If slower growth expectations for China’s economy tripped up U.S. markets on Tuesday, then what could have caused yesterday’s steeper declines?

In a repeat performance of Tuesday’s opening hour plunge, yesterday’s first hour started with a bust of some 17.5 points or 0.85% on the broader market S&P 500 index. The only difference this time was that where Tuesday saw a rebound back up to opening levels, yesterday’s plunge decided to just keep going.

After a couple of hours of flatlining in the late morning yesterday did not turn into a rebound like we saw on Tuesday, traders realized the market was tired and did not have enough strength to pick itself up. Traders gave the market until 1:30 pm to mount a comeback, and when it failed to do so, they simply gave up and pulled their buy orders, letting the market fall another 0.8% to close the day with a drop of 1.6% overall.

So what’s the story with the market now? The slower growth expectations for China is old news already. This time the market might be looking at two key events which could mean a little more downside movement before this pullback stops.

Political Wrangling

One of these two events is something we’ve been dealing with for years, and will likely never stop grappling with: the U.S. government is about to run out of money again, and could face another government shutdown.

“Congressional Democrats balked Wednesday at a provision rolling back part of the 2010 Dodd-Frank financial overhaul embedded in the $1.1 trillion spending bill, casting some doubt over whether Congress will be able to pass a long-term bill to avoid a government shutdown before this week’s deadline,” reported the Wall Street Journal. There’s a lot of info in that small paragraph, so let’s dissect it into its main pieces.

First up, a new spending bill needed to be passed before Monday [the 8th] at midnight to fund the government’s operations for another year. And as always, even though everyone in Washington knew months ago when the deadline was coming, they naturally managed to leave it until the very last day.

A $1.1 trillion spending plan was considered on Monday, but ultimately failed to find approval. “Top leaders spent most of Monday reviewing the final details of the massive spending bill, but hopes of unveiling the legislation by midnight [that night] were dashed amid last minute disagreements over the renewal of a terrorism insurance program… which provides for a government-backed program to protect against catastrophic terrorist attacks,” reported the Washington Post.

While Democrats and Republicans finally agreed on that part of the bill by late Monday evening, wouldn’t you know it… another disagreement arose “regarding proposed changes to 2010 financial regulatory reforms”, known as the Dodd-Frank reform act which includes numerous reforms to the financial system from banking to markets and much more in between.

“News that [Tuesday’s] spending bill included a GOP effort to dismantle part of the Dodd-Frank law provoked a liberal backlash Wednesday,” reported WSJ. “Democrats pushed to restart negotiations on the spending bill released late Tuesday after weeks of bipartisan talks.”

So back to the negotiating table they went, but not without calls from democrats to vote the bill down. “Sen. Elizabeth Warren urged Democrats Wednesday to withhold support for a massive government funding bill, as opposition on the political left mounted over a set of changes to the Dodd-Frank Wall Street reform law buried in the legislation,” informed The Hill. “The last minute inclusion, hammered out by party negotiators, is outraging several Democrats who have spent years fighting back against GOP efforts to reduce the impact of the 2010 law.”

“With the government’s funding slated to run out at midnight Thursday [today], it wasn’t clear if enough Democrats would withhold their support for the spending bill to imperil its passage,” the WSJ raised doubts.

The last time politicians failed to come to an agreement late 2013 saw the government shutdown for some 17 days, costing the economy an estimated $20 billion in lost productivity as contractors were not paid, wages were deferred and revenue generating public services were shut down.

We can understand, therefore, how all this drama would add to the markets’ jitters. If nothing is passed by tonight, look for more market turbulence ahead.

Year-End Rebalancing

Another factor weighing on the markets is year-end profit taking and position rebalancing by hedge funds, banks, and institutional investors. 2014 has seen the major indices hit one new all-time record after another. In fact, the S&P 500 index just hit another all-time high last Friday.

“Swelling risk appetite – embodied by a relentless push upward by the S&P 500 – and a firming US Dollar have been the defining market themes in 2014,” explains Ilya Spivak of DailyFX. “Profit-taking on these trades ahead of the calendar turn to 2015 would imply a parallel downturn in the greenback and the benchmark stock index. Indeed, the two now have a positive correlation of 0.74 on rolling 20-day studies.”

And sure enough, there it is in the graph below, that increasing correlation between the U.S. dollar and U.S. stock markets, which has grown more correlated over the past two months.

Correlation between US Dollar and Stock Market


It is both understandable and to be expected that positions would be sold to lock in gains to make the fourth quarter and the entire year look as great as it can for portfolio managers. Weakness could continue through to next week’s option expiration day on the 19th, the third Friday of the month.

The question now it, is this 5.75-year bull exhausted, or does it still have power to run in 2015?

Expect Correlation to Continue

That strengthening correlation between the USD and stock market is a pretty significant development that bodes very well for the market in 2015. Why? Because we all know the USD can only grow stronger, as interest rates in the U.S. are set to begin rising soon, even if it does take another year until early 2016.

We also know that central banks around the world are going to continue debasing their own currencies, ultimately making the USD even stronger. Plus, America’s GDP is still projected to grow at 3% annually over the next year according to the World Bank. If the correlation between the dollar and equities continues, then equities should enjoy a very nice 2015 as the USD continues to strengthen.

Rather than panic sell, investors should learn from the recent pullback just experienced from mid-September to mid-October, where a 9% drop in the S&P from September 19th to October 15th was quickly followed by a 13.7% rise from October 15th to December 5th, lifting the broader market index to a new all-time high.

Buying opportunities never look like opportunities at the time, since they arrive in the thick of the rout when it’s the most painful. But if we discipline ourselves to buy a little every 1 or 2% down or so, we will be glad we did when the rout turns into a victory lap in very quick order.

Look for this pullback to continue until early next week, with the FOMC’s two day meeting on the 16th and 17th delivering an assurance from that the Fed remains staunchly dovish, with its customary bullish expectation that the economy’s recent progress in job creation will continue.

A combination of the government avoiding a shutdown, more positive comments from the FOMC, and an end to profit-taking as option expiration approaches should see the current pullback end by next week, giving it fresh legs from which to take its next leap upward into next year.

Joseph Cafariello