Stocks dribbled lower on Tuesday in response to the West’s application of additional pressure on Russia in the form of expanded economic sanctions — on growing evidence Moscow is directly furnishing weapons and support to pro-Russian Ukrainian separatists.
The Dow Jones Industrial Average lost 0.4% after trading in the green earlier in the session.
After enjoying a smooth, easy rise in stock prices since May, investors are about to be hit with another bout of volatility. Normally, this liquidity-boosted market wouldn’t blink an eye. But given the divergences underway — with significant weakness among small-cap stocks and high-yield bonds as large-cap stocks remain unaffected — it could set the stage for some fireworks.
The market must face a number of major catalysts starting Wednesday when the Federal Reserve wraps up its latest two-day policy meeting. No major changes are expected, but the QE3 bond purchase program will likely be wound down another $10 billion and is on track to end in October. We also have the government’s initial estimate of Q2 GDP growth, a key metric following the abysmal showing in Q1.
We’ll have a read on possible wage cost inflation on Thursday, which has been a key hang-up the Fed has been waiting to see turn higher before starting to raise short-term rates. And on Friday we’ve got the mother of all data points: The non-farm payroll report. The jobs report will be joined by the personal income and ISM manufacturing activity reports as well, proving a glimpse into the health of consumers and factories.
If the data is strong, it could very well be considered a net negative for the cheap money junkies that pass for investors these days, since it would bring forward the timing of the Fed’s first short-term interest rates hike into the first half of 2015. The unemployment rate, at 6.1%, is already just three-tenths of a point away from the Congressional Budget Office’s estimate of full employment.
In other words, with the job market tighter than most give it credit for, the Fed is running out of excuses to keep the money pumping going. Once wage inflation turns up (a very lagging indicator that is one of the last things to improve in an economic recovery), the Fed will already have fallen behind the curve.
A simple Taylor Rule analysis, considering where inflation and the economy is vs. its full potential, suggests short-term interest rates should already be near 2% — not pegged at 0%, where they’ve been for nearly six years.
And while a look at the Dow Jones suggests Wall Street couldn’t care less, other more sensitive areas of the market have already pulled back.
Click to Enlarge The Russell 2000 is mired below its 200-day moving average for the first time since May, down nearly 6% from its recent high. Moreover, on a weekly basis the Russell 2000 is at risk of finishing the week below its 50-week moving average (which stands at 1,130) for the first time since 2012.
Click to Enlarge Also, key areas of the market are rolling over badly including industrials, transports, semiconductors and biotechnology.
The first two are the backbone of any healthy uptrend, while the last two have been red-hot areas of speculative focus over the last few months. At the same time, buyers are rolling into defensive areas of the market including utilities and healthcare stocks.
Not exactly a sign of confidence.
The fact that all are rolling over suggests the large-cap indices like the Dow are being held up with a narrowing base of support. You can see this in the dwindling number of New York Stock Exchange stocks that are above their 50-day moving averages — it stands at 55%, down from a peak of nearly 90% at the start of the month.
And yet, large caps have barely budged: The Russell 2000 is down 4.3% for the month-to-date while the Dow is up 0.5%.
The more speculative areas of the bond market are also warning that something’s wrong, with the iShares High Yield Corporate Bond Fund (HYG) suffering its weakest performance since last summer after Fed chairman Janet Yellen warned of some frothiness here.
Click to Enlarge Some areas of been weaker than others, presenting profitable trades such as the Direxion 3x Semiconductor Bear (SOXS), which is up 7% for my subscribers since recommended on July 24. With sanctions set to squeeze the Russian economy, the Direxion 3x Russia Bear (RUSS) is already up more than 15% for my subscribers since added on July 17 as Russian stocks — shown to the right in this chart of the Market Vectors Russia ETF (RSX) — are pummeled.
Click to Enlarge Finally, for the options crowd, there are put option opportunities in names like General Electric (GE) and Freescale Semiconductor (FSL) with recommended contracts in these names up 72% and 92% since they were recommended earlier this month.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he had recommended SOXS and RUSS to his clients. He also has recommended GE September puts and GSL August puts.