Sunday, August 23, 2015

Mix of Aug 2007, Aug 2011, and Oct 2014

This market has entered an altered state.  A higher volatility period that likely plays out in one of 3 different ways.  This is based on past history, market conditions, sentiment, and market positioning.

1. The August 2007 scenario where you are in the heart of the topping phase of a long bull market, with weakening credit conditions, overvaluation, and a potential bear catalyst for a big drop.  Even in the worst of the 3 likely scenarios, you get a market that makes a flush out bottom, and rallies over the next 2 months towards the previous all time highs.  The current market is definitely much more bullish than August 2007, even if you can state without much doubt that the market is more overvalued now than back then.  But market positioning is more conservative now among fast money fund managers and there are much larger corporate buybacks now with fewer secondaries and IPOs.

The current market is definitely not like 2007, or even anything similar to 1998, which many seem to point out on CNBC.  In 1998 you had immense enthusiasm among the general public for stocks, with massive inflows into mutual funds at the time, not outflows as you have now.  Also with stock buybacks a much smaller part of the demand picture than it is in 2015.

2.  The August 2011 scenario when you have a financial panic.  It was building for several months, and it exploded into a final panic over European sovereign credit.  August 2011 was much scarier than August 2007, just by the magnitude of the drop, and the persistence of the weakness which lasted for a few months.  You didn't make the final bottom until October, and the coast wasn't clear until January.

This is the least like the current market situation from a fundamental standpoint.  In 2011, you didn't have the corporate buyback train at full steam, the market wasn't overvalued, but there was a risk of a financial crisis if the ECB didn't bring out the LTROs, and Europe is a much bigger part of the global financial system than China.   This is the short term worst case scenario, but the long term best case scenario.

3.  The October 2014 scenario where the market just got too bullish and complacent over the endless uptrend, you had a meaningless Ebola scare, and oil prices started its big drop.  This is the most bullish short term scenario but not bullish for the long term as the market is still overvalued and you never truly flush out the hard core bulls.  Since the cause of the drop is not fundamentally driven (oil was still around $80 in October 2014), but fear driven (Ebola), you a V bottom and the selloff ends as quickly as it starts.

Based on the amount of time (over 6 months) you spent building overhead resistance at higher levels (SPX 2040 to 2120), and the fact that you are now 80 points below those levels, the technical damage is much greater than October 2014, a bit greater than August 2007, but less than August 2011.

China is a convenient excuse for the selling, but the US stock market historically only enters a bear market when the US economy enters a recession (1981-1982, 1990, 2001, 2008), not when a foreign economy enters a recession (1997-1998, 2011).

Three scenarios is a small sample size, but it does give you a general guideline into how to trade the next couple of months.  I expect a flush out low this week that forms the initial bottom, upon which we should rally back up about 80-100 points over the next few weeks into the Fed meeting in September, where they will likely be more dovish than the market expects.  That should form a short term top, which will lead to renewed selling as investors fearing October and a shutdown of the corporate buyback window gives us a retest of the August low.  After that retest, I expect the market to bottom and rally into year end.  While the market is overvalued, the drivers for a continued rise are still there:  massive corporate buybacks, hedge funds still underweight US equity exposure, and a Fed that will be extremely slow in raising rates.


shzhning said...

first time to witness limit down for ES

Market Owl said...

Last time I remember was in October 2008, around 850. This is looking like August 2011. Way more damage done than either Aug 2007 or Oct 2014.

Anonymous said...

If fed doesn't hike rates, what do you think are chances we get back to/exceed old highs?

Market Owl said...

It doesn't matter. No one expects the Fed to raise rates now and the market is still getting killed. Bond traders are not dumb. They have been pricing in a much lower probability of a rate hike than the pundits all year long.