Things were not looking good on Friday afternoon. At 3:00 pm eastern, the major stock market indices were at the lows of the day and falling fast. The yield on the 10-year, which is viewed by many as a proxy for the economic outlook, had plunged again, this time closing the day at 0.706% – a move of 23.76% in one day. The headlines kept coming, and they weren’t painting a pretty picture. In short, it looked like the DJIA was about to get rocked for another 1,000+ point decline.
But then it happened. A furious rally from the low, that is. A searing, eye-popping move that pushed the Dow up 731 points – or 2.9% – in just 49 minutes. Yowza.
The action meant it wound up being a fairly busy afternoon talking to folks who wanted to know what the heck was going on. My first point on these calls was that the relentless rally could have been expected, as the same trend played out last Thursday/Friday. And given that Wall Street traders love them a good pattern to follow, I was actually looking for a “face ripper” Friday into the close.
My thinking was that the big boys with the really big computers make big money trading millisecond trend-following strategies in this type of environment. So, once one of these relentless trends take hold, the algos tend to simply chase their tail until the closing bell rings.
I opined that it is in everybody’s best interest not to panic the masses, whose monthly 401K contributions keep money flowing into the game, too badly. My thinking was that if you can create a positive spin to end the week – you know, headlines such as, “Dow Surges 750 Points In Last Half Hour” – you keep investors in their seats and the game alive.
My admitted conspiracy theory was that by running the indices higher into the close, traders create a “feel good” situation out of a -1.7% decline in the S&P 500. Oh, and the big boys trading at the speed of light make a good buck along the way. Everybody wins, right?
Great Action, Right!
Less cynical analysts could be heard falling all over themselves on TV Friday, espousing the “great action” seen into the close. We were told that the rally was encouraging as the market “held” above last week’s low. The indices had advanced on the week. Valuations were improving. And bargain hunters were stepping in.
It turns out that there was something else at play on Friday afternoon. A little thing called “forced liquidation.” In the VIX complex. In a BIG way.
The concept here is straightforward. Something called a “short squeeze” apparently caught a very large player (rumored to be the 4th largest clearing firm in Chicago) on the wrong side of a short gamma trade. And without getting too geeky, the bottom line is when you are short and then a margin call that you can’t meet occurs, your short positions get liquidated. This produces buying to cover the shorts.
In this case, the VIX was sold and stock futures were bought. Rinse and repeat until the position is liquidated. Apparently, it took 49 minutes to liquidate the position.
Below is a chart from ZeroHedge.com illustrating the action.
According to ZeroHedge, “what happened is that the VIX ramped as a major Chicago market maker was caught in the infamous gamma short squeeze, which forced them to keep buying the VIX as the VIX soared, in the process ending the VIX even higher, only to get margin called out of their position by their clearing firm, puking their entire position while liquidating anything they could, and unleashing the VIX selling avalanche and the 700 Dow point rally.”
To be sure, this kind of thing happens often during market crises. Big moves occur that are not “sending a message.” No, some big moves are just trades being closed out, whether the trader wanted them closed or not.
I’m of the mind that this and other types of computerized trading is one of the reasons why technical analysis and chart reading are not as valuable today as they once were. In short, what difference does a closing price make if that price was the result of a clearing firm liquidating positions to close out a big trade gone bad?
The answer is, in my humble opinion, next to none. As such, I’d be VERY careful in trying to read too much into the action, especially when it gets wild and woolly.
Remember What’s Driving The Action
Finally, let’s remember, that it is the COVID-19 news and the economic uncertainty resulting from a hunkered down consumer that is driving the primary trend right now – not technical levels.
Yes, at some point, “enough will be enough” – meaning that market prices will have discounted the appropriate impact to the economy, and in turn, earnings. But in reality, it will likely take time for this to occur. And while I’m a card-carrying member of “the glass is at least half-full” club, I can’t help but believe the news from the virus front is going to get worse before it gets better (or in this case, stops getting worse). Therefore, we need to stay patient and keep our eye on the end game here – I.E. How the economy is going to fare.
From my seat, this means keeping some powder dry and managing the risk of the environment. Personally, I don’t think we should expect to see a quick, V-bottom turnaround as the Fed can’t really save the day here. And while both monetary and fiscal stimulus can help reduce the economic impact, the bottom line is that unless cases stop spreading pronto, this is gonna take a while.
Turning to This Morning’s Debacle
This morning’s action in the markets is once again, nothing short of wild. Bond yields are plunging (the 10-year has traded at 0.398% – are you kidding me!?!). Oil is crashing. And stocks are diving around the world. The reason, you ask? Besides the increasingly bad news on the virus front in places other than China, we have a new negative input into the game.
Keeping it brief, the fact that oil is crashing again brings another negative component into the mix. Before the latest plunge in crude prices, we only had to deal with the economic impact from COVID-19. Now we have to deal with the potential fallout from crude’s rude move.
The problem is basically a replay of 2015/16. Oil in the $30’s means shale producers are not profitable. And since the bonds of these companies are typically in the lower end of the scale (think BBB – or the lowest level of investment grade) and highly leveraged, risk of default increases when oil falls. This puts the nightmare scenario of a potential “downgrade cycle” in play.
This is where BBB debt gets downgraded to junk. Which, in turn, causes FORCED SELLING of the new junk debt. And with everyone in the space trying to make the same trade at the same time, market dislocations occur (which is a kinder, gentler term for the word collapse). Rinse and repeat and welcome to the next credit crisis.
To be sure, this is NOT occurring at the present time. But it is uber important to recognize the risk of such an event playing out – globally.
So, my primary point to close this morning’s meandering market missive is there is now more to worry about than washing your hands, canceling your business trips, and calculating how far GDP will fall. No, we now have to watch the oil patch and the derivative problems created. Joy.
Weekly Market Model Review
Each week we do a disciplined, deep dive into our key market indicators and models. The overall goal of this exercise is to (a) remove emotion from the investment process, (b) stay “in tune” with the primary market cycles, and (c) remain cognizant of the risk/reward environment.
The Major Market Models
We start with six of our favorite long-term market models. These models are designed to help determine the “state” of the overall market.
There are two changes to report on the Primary Cycle board this week. First, the Risk/Reward model moved back to neutral from positive. Then my “Desert Island” model (so named because if I were stranded on a desert island with only one model available, this would be the one I choose) moved from neutral to negative. And with the average historical return for the board now well below average, I have no choice but to downgrade the rating of the board to neutral.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View My Favorite Market Models Online
The State of the Fundamental Backdrop
Next, we review the market’s fundamental factors in the areas of interest rates, the economy, inflation, and valuations.
The good news is that there are no changes to report on the Fundamental Factors board this week. However, it is worth noting that one the component indicators in the Valuation Model continues to improve as valuations on the Value Line index are now back to where they stood at the bottoms seen in 2019 and August of last year (but still far from the levels seen at the bottom of January 2019.) In short, I consider the status of the Fundamental board as Exhibit A in the argument that the bull market remains intact and the uptrend will resume once the market sorts through/comes to grips with how much the U.S. economy will slow in response to consumers “hunkering down.”
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Fundamental Indicator Board Online
The State of the Trend
After looking at the big-picture models and the fundamental backdrop, I like to look at the state of the trend. This board of indicators is designed to tell us about the overall technical health of the current trend.
While I may be accused of looking on the bright side, I think it’s a modest positive that the Price Trend board actually improved a bit last week. The reason for the uptick was the buy signal flashed by our Short-Term Channel System. And as long as the market does not exceed the Feb 28 low, this indicator will remain positive. Speaking of the 2/28 low, this remains a critical technical area on both a closing and intraday basis.
Next, we analyze the “oomph” behind the current trend via our group of market momentum indicators/models.
The bad news is there is no longer anything positive on the Momentum Board. And in the category of full and fair disclosure, the L.T. Volume Relationship Model is within a whisker of moving to a sell signal. As such, the bears can claim that they’ve got market momentum (not to be confused with “Jomentum” of course – LOL) on their side. However, given the veracity of the current dance to the downside, the current state of the momentum board is to be expected.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Momentum Indicator Board Online
Early Warning Signals
Once we have identified the current environment, the state of the trend, and the degree of momentum behind the move, we then review the potential for a counter-trend move to begin. This batch of indicators is designed to suggest when the table is set for the trend to “go the other way.”
The really good news this week is the Early Warning board is now screaming for attention. This suggests that a tradable bounce may be close at hand. However, my take on the situation is that a series of tests to the downside is likely. I say this because the news of the novel coronavirus is just getting started in the U.S. and is likely to get nasty before it improves.
* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability – NOT INDIVIDUAL INVESTMENT ADVICE. View Early Warning Indicator Board Online
Thought For The Day:
The only thing that interferes with my learning is my education. – Albert Einstein
All the best, David D. Moenning Investment Strategist
At the time of publication, Mr. Moenning and/or Redwood Wealth Management, LLC held long positions in the following securities mentioned: None
Note that positions may change at any time.
NOT INVESTMENT ADVICE. The opinions and forecasts expressed herein are those of Mr. David Moenning and Redwood Wealth and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as investment recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.
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Mr. Moenning and Redwood Wealth may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.
The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.