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Why Markets Might Turn Next Week

Written By Briton Ryle

Posted October 21, 2014

What a month it’s been. For the past several weeks everything seems to have turned negative.

Reports out of Europe projecting slowing growth and possibly shrinkage into recession have pushed investors out of European equities and into government bonds. Since the markets peaked intra-day on September 19th, the U.K.’s FTSE 100 stock index (beige in the graph below) had plunged more than 9% by last Thursday, France’s CAC 40 index (purple) had fallen more than 10%, Japan’s Nikkei index (orange) had fallen 11%, and Germany’s DAX index (blue) had plunged more than 12%.

Tuesday Image 1


The lower GDP forecasts for not just Europe but also China and the rest of Asia pushed oil — which had already been falling since reaching a high of $104.44 on June 25th — down even further to a low of $79.78 by last Thursday, representing a total drop of 23.6% since late June on the fear that slower European and Asia growth will mean lower oil demand.

Yet the flight from stocks, oil, gold, copper, and other commodities as of late is only half of the so-called “fear trade.” The other half is where all those investments go, namely into bonds. As massive amounts of investment capital shifted out of equities and commodities into bonds, traders were astonished at how high bond prices rose and how low their yields fell — with the U.K. 10-year yield falling to as low as 1.92%, the German 10-year to 0.67%, and the Japanese 10-year yield to 0.47%.

In the U.S. the situation was just as bad. Even though the American economy is not at risk of recession but is projected to grow at an annualized rate of 1.80%, 2.31%, 2.29% and 2.30% over the next four quarters, U.S. stocks at all-time highs last month after more than three full years without a sizable correction left them ripe for the picking. The fear of a slowing global economy was all it took to bring U.S. indices down, plunging the Dow Jones Industrial Average more than 6.5% from September 19th to last Thursday (beige below), the S&P more than 7.3% (black), and the NASDAQ nearly 8% (blue). Black and blue were indeed the colors for the month.

Tuesday Image 2


Of course, just as occurred in Europe and Japan where money sought refuge in bonds, so too in America, where the U.S. 10-year bond yield fell to 1.864% last Wednesday — its lowest level in over a year since May of 2013.

But in all of these plunges, do you notice one very striking common element? All corrections from Asia, to Europe, to the U.S. had stopped at around the same time — last Wednesday/Thursday.

Two important signals were received at that time — one from the charts, the other from Federal Reserve bank presidents.

The Technical Case for a Bottom

The technical signal that a bottom may have been seen in equities, and conversely a top in Treasuries, can be clearly seen in the last graph above. Of the major U.S. indices, the Russell 2000 (purple) comprised of small caps fell the most, some 8.5% at its worst point.

Yet the drop in the small caps dates back much farther than the other indices, as noted in the graph below. Where the Dow, S&P, and NASDAQ indices had been falling since reaching their highs on September 19th, the Russell 2000 had actually reached its peak back on March 4th, and has been falling for seven months compared to the other indices’ one-month declines. Since March 4th, while the other three indices are still near their break-even zero-line, the Russell 2000 is down 9.5%, having reached as much as 13% down by last week.

Tuesday Image 3


Due to their smaller structures and fragility, small caps tend to fall first during a rout. The recent correction in the broader market, therefore, had been foreshadowed six months earlier when the small caps began their rout.

Yet by those same properties of being smaller and more nimble, small caps are also the first to rise during a recovery. And this is precisely what happened last week, as noted in the second graph above. Where the major indices reached their bottoms on Wednesday the 15th / Thursday the 16th, the Russell 2000 reached its bottom two days earlier, on Monday the 13th.

Since then the small cap index has risen some 4.30%, where the NASDAQ has risen 2.45%, the S&P 1.55%, and the Dow Jones 0.50%, as noted below.

Tuesday Image 4


Could this be the turn-around we’ve been waiting for? It’s hard to say. After all, one week does not a trend make. But it is a pattern that regularly appears at the start of a market recovery.

If you are not that reliant on technical signals to guide your trading decisions, perhaps some reassuring words from policy makers might be enough to entice you back into the markets.

Central Banker Bullard Soothes Market Jitters

Remember that key turn-around date for the major indices last Thursday? It was likely triggered by comments from James Bullard, President of the Federal Reserve Bank of St. Louis, who suggested that the Federal Reserve could continue its third Quantitative Easing program of monthly bond purchases if the correction worsens.

It should come as no surprise that the markets have been falling over the past few weeks, since we are rapidly approaching the final monthly purchase of QE3, which is scheduled to be completely terminated after this month. With the end of QE stimulus and the subsequent raising of interest rates down the road, markets would have to adjust lower to account for the higher cost of money, which is already here in a more expensive dollar.

While Bullard did not promise an extension to the QE3 bond buying program, his comments remind the markets of what the Federal Reserve has long stated: that the winding down of QE3’s “asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation.” The Fed is leaving itself free to play-it-by-ear.

And this is precisely what St. Louis bank president Bullard reiterated last week. “We have to make sure inflation and inflation expectations remain near our target. And for that reason, a reasonable response of the Fed in this situation [is] we could go on pause on the taper at this juncture and wait until we see how the data shakes out into December.”

“If the economy is still as robust as I am describing it,” he added, “then I think we could just end the program in December. But if the market is right, and this is portending something more serious for the U.S. economy, than the committee would have an option of ramping up QE at that point.”

Ramping up? Does that mean increasing the monthly bond purchases back up again? If the economy warrants it, yes, that’s what it means.

Yet even if the Fed commits itself to the final taper at the end of its two-day meeting next Wednesday the 29th, the value of Bullard’s comments must not be lost, as they are intended to reassure the markets that come what may, the Fed will still be there to catch them if they fall.

“It is possible that Bullard is hoping that simply talking about more QE will be enough to raise inflation expectations,” economist Thomas Simons explained Bullard’s tactic. The rising USD is threatening to introduce deflation, which is not what the Fed wants. The Fed wants to see inflation at a normal annual 2 to 2.5% range. Talk of continued QE would thus remind the markets of just how much the Fed wants inflation and a weaker dollar, which should go a long way to easing the markets’ jitters over any increase to the cost of money.

Central Banker Fisher Soothes Market Jitters Some More

Just one week after Bullard reminded the markets that the Fed is still promoting an inflationary policy which is great for stocks, another Federal Reserve bank president — Richard Fisher of the Dallas branch — stressed in a CNBC interview yesterday that the Fed is in no hurry to raise interest rates once the QE3 monthly bond purchases are terminated.

Fisher made clear that the conditions for raising interest rates are present. “We’ve had a sharp drop in national unemployment; we have price stability,” he stressed, with inflation running at the desired 2 to 2.5% annual rate. “The underlying economy is doing well,” he added. This would seem to indicate the all-clear signal to begin raising interest rates soon, perhaps as early as next summer as many are expected.

But when pressed for a timeline, Fisher replied that “it depends on how the economy progresses from here.”

The markets will likely get some more reminders of just these very conditions at the end of next week’s FOMC meeting. The decision to raise interest rates is dependent not solely on the presence of inflation but also on “longer-term inflation expectations.” Only when the Fed is convinced that inflation expectations are “well anchored,” as its last press release stated, will it proceed with rate hikes.

Time to Get Back In?

Thus, the markets may have two good reasons to be looking up at this point. On the technical side, the small caps seem to have started to turn, rising more than the other major indices as of late. On the fundamental side, even though the last QE stimulus arrangement is on its way out, it can be brought back if needed.

And if inflation remains weak, the Fed will be in no hurry to begin raising interest rates, reminding us that it is still able and willing “to maintain the current target range for the federal funds [interest] rate [at near-zero] for a considerable time after the asset purchase program ends”, as its last press release reaffirmed.

Investors should tread carefully in these still turbulent waters. Yet they should not be fearful of picking up some bargain stocks at these rare 10% discount prices. Remember that the Fed has our back.

Joseph Cafariello