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The Fed is blinking at taper, the bulls are buying the dip again

Cops buy the dip … again.

, we discussed that further upward moves would remain difficult. As noted:

“Unsurprisingly, given the current extended and overbought conditions, the market has not made much progress over the past week. For now, the “buy signals” remain intact, which is likely to limit the downside for the next week. Another test of the 50-dma is certainly not ruled out. “

That was the case again this week as concerns about the Fed’s reduction in its balance sheet startled investors. However, the Fed trained investors to “buy the dip”. Unsurprisingly, they jumped into the 40-dma to buy instead of waiting for a test of the 50-dma. (Though it was on lower volume and weaker latitude.)

The “buying frenzy” came after a “crash” of almost 2% in the financial markets, forcing the Fed to “blink” while tapering. :

“Dallas Federal Reserve President Robert Kaplan said Friday he was waiting carefully for the economic impact of the delta variant of the coronavirus and may need to adjust his views on politics” slightly “if it slows economic growth significantly.”

We discuss below why we think the Fed will still announce plans for a taper as early as September.

Nevertheless, the bullish tendency remains. Since the “shutdown” lows in March, the rally fueled by QE has led to heightened complacency. With the assumption of “no risk”, investors buy more and more flat.

S&P 500 drawdowns

We did the long stretch of the current advance without a 5% correction, a Test of the 200-dma, and 6 consecutive positive months.

While this does NOT mean that a major correction is imminent, there is no question that such a correction will occur. It’s just a function of catalyst and time.

One warning sign is the decline in speculative interest.

Speculative zeal is waning

Last week we made some specific comments about the deterioration in internal market data. Namely:

“As already mentioned, the market recovered well to marginal new highs last week, but the market internals remain relatively weak.”

Our sentiment is primarily based on declining volumes, a narrowing range and a decline in speculative activity.

As shown, the speculative surge in markets, particularly in “meme” stocks, has faded as market moves have become more subdued.

Volume of trade in retail

A look at some of the “meme” stock favorites is illuminating.

AMC entertainment (NYSE 🙂

AMC 5 minute chart

GameStop (NYSE 🙂

GME 5 minute diagram

Robinhood Markets (NASDAQ 🙂

HOOD 5 minute diagram

Last week we also found that the number of stocks trading above the 50-dma was weak despite a market trade at all-time highs. We are also seeing this on the NYSE advance decline line, which broke the 50-dma this week.

NYAD Adv-Decline-50-DMA

One of the market drivers last year was the constant “bidding” by private investors in both the equity and options markets.

Much of this speculation was due to the relocation of athletes to financial markets. In sports betting, however, the more subdued returns on stocks are less exciting. As shown, the put / call ratios have decreased significantly in recent months.

CPC chart

The decline in speculative sentiment is also reflected in the collapse, which historically has been closely correlated with the markets. However, confidence recovered despite the .

Composition of Consumer Confidence (2009-present)Composition of Consumer Confidence (2009-present)

Investor risk remains high, but there is little concern as long as the Fed continues to inject $ 120 billion a month into the markets.

However, that could change.

Fed adjusting the table for taper

As in ours Daily market commentary:

“The Fed shed little light on the timetable for the Fed rejuvenation in the July FOMC minutes. While some Fed members seem eager to start as early as September, others expressed concern about downward inflationary pressures and market perception. We look to the Jackson Hole Fed conference late next week for further guidance.

Highlights from the Fed minutes of the FOMC meeting on July 28th. “

  • “Most of the participants found that they felt like this, assuming that the economy performs broadly as expected It might be appropriate to slow down the pace of asset purchases this year.
  • “They are concerned that plans to accelerate asset purchases are accelerating” Investors may wonder if the Fed is in a hurry to hike rates or less committed to lower unemployment. “
  • “However, several others said slowing the pace of asset purchases early next year would be more appropriate.”
  • “Most of the participants noticed that they had seen Advantages of proportionally reducing the pace of net purchases of Treasury and Agency MBS to complete both purchases at the same time. “
  • “The staff updated their assessment of the stability of the financial system and described the overall financial vulnerability of the US financial system as remarkable. The staff believed that asset valuation pressures had increased. In particular, the forward price / earnings ratio for the S&P 500 index was at the high end of its historical distribution; high yield corporate spreads tightened further and were near the lower end of their historical range; and real estate prices continued to rise rapidly, which prolonged the valuation measures. “

Why taper is important

We believe the Fed is laying the table to begin the tapering process sooner rather than later. improves, decreases and inflationary pressures rise, especially apartment rents. Given their perceived mandates, we suspect that they will talk about the reduction as early as September.

As noted in, There is a not-quite-as-subtle impact on asset prices as the Fed begins to depreciate assets. While market participants ignore the Fed in the short term, the risk of a “taper” increases. The gray shaded bars in the graph below show when the balance is either flat or shrinking.

Fed balance sheet expansion / contraction vs. S&P 500Fed balance sheet expansion / contraction vs. S&P 500

This volatility will increase significantly if the Fed also raises interest rates.

Balance sheet shrinkage + Fed Funds vs. S&P 500Balance sheet shrinkage + Fed Funds vs. S&P 500

There is a reasonable likelihood that if inflationary pressures are above target and employment improves, sooner or later the Fed will begin tightening.

The bond market is already forecasting that.

The 30 year old death cross

As Michael Lebowitz stated on Thursday:

“The diagram below shows the UST yields with its 50 and 200 dma. The vertical lines highlight the last five times that 30 year returns fell the dma of 50 below the dma of 200, also known as the ‘death cross’. In 3 of the last 4 Death Cross instances, yields fell noticeably and hit record lows. The only time they didn’t was in 2017 (red vertical line). At that time, earnings consolidated to negate the death cross. As shown, 30-year-old crops witnessed a death cross on Monday. “

TYX daily chart

As discussed in “”, Returns are a leading indicator of economic growth.

“Bond yields are sending an economic warning as government bond yields fell to 1.3% last week. As the dollar rallies at the same time, there are increasing signs that the economic “reflation” trade is unwinding. This is despite the overly exuberant expectations of strong economic growth from the mainstream media. As we suggested in 2019, bonds are generally more likely to have the correct outlook than stocks.

10-year government bonds versus GDP10-year government bonds versus GDP

Interestingly, BofA, Goldman Sachs and other mainstream firms are rapidly downgrading projections for year-end economic growth.

FMS diagram

FMS diagram

Increased inflation and declining economic growth are not a good story for corporate margins or profits. We therefore continue to advise investors to pay close attention to the message of bonds.

As Michael notes, history suggests that bond yields are likely to be lower than higher. It usually coincides with a “risk-off” rotation in the equity markets when it occurs.

Portfolio update

Due to the low volatility, the allocation models for the customer portfolios have hardly changed. After previously increasing cash and increasing the duration of the bond portfolio, the portfolios continue to outperform their relative benchmarks.

At the “death cross” of 30-year yields, we again increased the duration in our bond portfolios, as we did at the beginning of the year. As a result, our weighted average duration is now 4.5 years versus 5.9 years for our benchmark.

Allocation model

Our main focus remains on mitigating portfolio risk in a market that remains elongated in terms of price and duration over the longer term. However, as mentioned earlier, there are a few key factors to consider:

  1. All periods of successive performance eventually end. (Investors tend to forget about this during long bullish periods.)
  2. Since 1900, upward trends with bullish performance have been rare for such a long time.
  3. Such service periods are often, but not always, precede fairly decent market corrections or bear markets.

The table shows that in almost 40% of the cases two months of positive performance are followed by at least one month of negative performance. Conversely, three consecutive positive months occur in 23% of the cases, and only 14% of the incidents extend over 4 months.

Since 1871, there have only been 12 occurrences of 6 month or longer periods with positive returns before a negative month occurred. In total, there are only 40 occurrences; Out of 245 periods of 2 months or more, the market ran for 6 months or more without a correction. “

Table of positive elongation monthsTable of positive elongation months

Given the risk of monetary policy change, high levels of complacency and prolonged advancement, it is probably advisable to consider rebalancing the portfolios.

As Todd Harrison previously quipped:

Opportunities are made up much more easily than lost capital. “

Have a nice weekend.

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