We are not surprised that Federal Reserve Chairman Jerome Powell changed his view that inflation is transitory or that monetary policy would not change dramatically in the foreseeable future. However, we are surprised that he would make an abrupt about-face in his views less than two weeks after being reappointed as Chair of the Federal Reserve!
This week the Fed chief told members of the Senate Banking Committee that the word “transitory” should be retired when describing inflation. In terms of monetary policy, he added that the Federal Reserve “at our next meeting in a couple of weeks (is) going to have a discussion about accelerating that taper by a few months.” The fact that monetary policy may be changing more quickly than popularly expected spooked the market. But in our view, what is more disturbing is that the FOMC waited too long to address inflation and as a result, its delay in reducing monetary ease earlier this year means it will be forced to raise interest rates more often and higher in 2022 than if they had started a shift months ago. This is the crux of the issue, and it is what has investors worried.
Unfortunately, Powell’s comments came on the heels of another troubling event. On Thanksgiving Day, reports surfaced from South Africa indicating a new COVID strain known as Omicron had emerged in a number of southern African countries. The World Health Organization warned it was a “variant of concern” and European countries banned travelers from eight African countries. President Joseph Biden announced similar restrictions on Friday. The thought of another bout of restrictions compounded the list of unknowns facing the financial markets and this combination triggered a sell-off.
As we noted last week, we put little value on the market’s performance on the Friday after Thanksgiving Day. It is usually the lowest volume day of the year; many traders are on vacation and investors are also distracted. This combination can create a lot of volatility, but nothing meaningful in the longer run. In other words, the 905-point decline in the DJIA on November 26 was dramatic but did not carry great weight in our view, even though declining volume rose to 89% of total volume. But the rebound on November 29 which boosted the DJIA 236.6 points was indeed a concern. Volume rose in the session and was well above the previous 10-day average, yet despite the gain in the index, volume in advancing stocks was only 50% of the day’s volume while volume in declining shares represented 48% of the total. This was not impressive. However, volume on the 652-point decline in the DJIA on November 30 was more than twice the 10-day average. See page 12. In short, although the S&P 500 is less than 3% from its record high of 4704.54 made on November 19th there are a number of changes in the landscape in the last three trading sessions. Several technical indicators are on the verge of turning negative.
One of the signs that the market is at risk in the intermediate term is seen in the chart of the Russell 2000 index. We have focused on this chart for months since it is broader than the SPX or DJIA and less influenced by the action of large cap technology stocks. The RUT underperformed for most of 2021 but broke out of an 8-month trading range in early November creating a very bullish chart pattern. However, in the last four trading sessions this breakout has reversed into what appears to be a breakdown. The RUT (2198.91) is now trading in the middle of its 8-month trading range, but it has dropped below its 200-day moving average of 2260.12. In short, it appears the early November rally in the RUT was a rare, but troubling, false breakout. See page 10.
Another technical indicator showing erratic behavior is the 10-day average of daily new highs and lows. The new high list has been consistently bullish in 2021 and the 10-day average reached a high of 368 in early November. Nonetheless, the average number of NYSE new highs in the last three trading sessions fell to 45 and the 10-day average dropped to 144. This is still above 100 and positive. But the number of new lows rose to 390 on November 30 and the 10-day average is now 206. This is well above 100. Since 100 new highs or lows defines the major trend, one can see that even with highs and lows currently averaging more than 100, the action of last few trading sessions is suggesting a major shift may be taking place. One should observe, not predict, the indicators, but the underlying trend is beginning to favor the pessimists.
Technical analysts take note of 90% volume days because these extremes tend to represent investor panic. Panic selling tends to start slowly, accelerate, trigger margin calls, and then turn into a short, but painful liquidity crisis. This multi-stage pattern often characterizes a major market trough. Panic buying has less predictive value, but 90% up days following a major sell-off frequently marks the end of a bear cycle. In recent days we have recorded an 89% down day on November 26 and an 88% down day on November 30. Neither quite met the criteria for a panic day; however, the combination did result in the 25-day up/down volume oscillator tumbling to negative 2.62 this week. It is close to recording an oversold reading of negative 3.0 or less. An oversold reading that follows a series of record highs in the indices that failed to record significant overbought readings, would be a sign of a major shift in trend. We will be monitoring this indicator closely in coming sessions. See page 11.
Given the weakness in the market this week we reviewed margin debt data, since sharp price declines can trigger margin calls and intensify selling pressure. Margin debt totaled $935.9 billion in October, up 4% for the month and up almost 42% YOY. As a percentage of total market capitalization, margin debt was 2.03% in September, matching the January 2014 level. It should be noted that the 2014 stock market did not have any major corrections but prices did fall nearly 10% from a September high to an October low. Yet with our estimate for October market capitalization, this ratio edged lower in October.
As a percentage of GDP, margin debt hit a record 3.93% in September. This ratio is a less meaningful measure than margin debt to market cap, but it does suggest that the level of leverage in the system is high. Our favorite indicator uses margin debt to help identify when a leveraged price bubble is about to burst. We have found that when margin debt is increasing at an unusually fast pace and this leverage is not moving the market indices in equal measure, it is a sign of exhaustion. This is the 2-month rate-of-change (ROC) index. A reading of margin debt growing at 2 standard deviations (15.3%) or more, without a similar reading in the Wilshire has marked significant market tops in March 1972, March and June 1976, June 1983, December 1999, June 2003, and May 2007. The good news is that this indicator is now neutral. See page 7. Last, but far from least, the chart of WTI crude oil (CLc1 – $66.18) has declined 20% along with stock prices but is still up 48% YOY. WTI has now dropped below its 200-day moving average and although there is substantial support in the low $60 area, the uptrend from the 2020 low is at risk. This sell-off will ease some of the pressure the household sector has experienced from increases in gasoline and heating fuel prices. Nevertheless, this sharp fall in energy prices does raise the specter of stagflation which is a scenario that could bring even more pain to investors in 2022. In sum, there are signs that the major trend in the market could be shifting, and this emphasizes the need for quality stocks that can overcome the forces of either inflation or a weakening economy.
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