Stocks have stabilized over the last few days as fears over a sooner-than-expected interest rate hike from the Federal Reserve have faded — thanks to a slowdown in the economic dataflow. The focus has instead turned back to the simmering geopolitical hotspots in Iraq and Ukraine.
The buyers came back in, though, thanks to an apparent de-escalation by Moscow on Friday, as it ended a military drill on the Ukrainian border. But on Tuesday, the sellers are out in force once more, reversing Monday’s gains in a broad market selloff.
The market has been bouncing up and down all month. The question is: What’s next?
One can sense the market is at a major decision point with the Dow Jones Industrial Average trading near its 200-day moving average — a level that hasn’t been breached in a significant way since 2012.
The geopolitical situation is by nature unknowable and unpredictable. But it’s clear that both the situations in Iraq and in Ukraine have become much more complex over the past week — making a clean-cut resolution more and more difficult.
Not only is there a political power struggle underway in Baghdad, but U.S. airstrikes against ISIS militants in the north has only moderately slowed the advance of the extremist group. And Russia has deployed a convoy of hundreds of “humanitarian” vehicles to the Ukrainian border, setting the stage for a showdown with Kiev later this week.
What we do know is that the economic data here at home keeps strengthening, which sets the stage for more hawkish commentary from Federal Reserve officials in the weeks to come. Remember, the QE3 bond purchase program is on track to end in October. On Monday, we learned the number of job openings increased to levels not seen since 2001.
Moreover, if you look at the job openings as a percentage of the labor force, it suggests the unemployment rate should be closer to 4.5% rather than near 6% as it is now. That means the job market — which is sort of broken and enfeebled — is closer to full capacity than many realize. And if that’s the case, we could see wage gains accelerate more sharply than the Fed expects, putting it behind the curve with where interest rates should be.
As this becomes clearer, the market will once again be rattled by the approach of the end of the Fed’s 0% interest rate policy, and we could see a continuation of the market selloff.
And finally, let’s take a look at what’s happening deep within the market itself.
For one, all the overconfidence and greed seen back in June has given way to newfound caution and fear. That’s exactly the behavior we want to see, because it forces buyers to pause, refresh, and set the stage for the next leg higher. The percentage of investors that are bullish has dropped more than 12 points to 50.5% according to the latest Investor’s Intelligence Survey.
Moreover, the folks at Bespoke Investment Group point out that nine of the 10 major S&P 500 sector groups have moved down into oversold territory and 20% of S&P 500 stocks are above their 50-day moving averages. Not to mention that the 10-day advance/decline line has moved to the bottom of its range.
We’ve also seen plenty of fear and loathing over in the high-yield corporate bond market, where Lipper notes that a $7.1 billion outflow from U.S.-based junk bond funds is the largest on record is and is the fourth-straight week of outflows.
There are legitimate reasons to be worried about high-yield bonds, including the approach of the first Fed rate hike in eight years and a big drop in trading volumes (which will make exiting positions much harder and more expensive if there is a run for the exits).
But markets rarely go in one direction for long, which explains the big relief rebound we’ve seen in junk bonds as represented by the iShares High Yield Corporate Bond Fund (HYG) shown in the chart above.
How to Play It
For now, I continue to recommend a cautious approach with a focus on specific areas of market underperformance such as semiconductors. The leveraged inverse Direxion 3x Semiconductor Bear (SOXS) that I recommended to clients on July 24 is up more than 9% so far. There have also been a number of exciting put option position plays, including the $84 put in ConocoPhilips (COP) that are up 300% since I recommended them to Edge Letter Pro clients on July 30.
For the more conservative, considering booking some profits and raising some cash here as we head into what’s set to be an exciting September.
Disclosure: Anthony has recommended SOXS and COP puts to his clients.