6 Reasons the Selloff Isn’t Over

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Stocks have stepped back from the edge after looking into the abyss, last week.

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The Dow Jones Industrial Average tested below the 16,000 level not once, but twice, before the bulls got back in the fight. After a big rebound on Friday, the question now is whether the selloff we’ve been suffering since the middle of September is over.

In other words, it is time for investors to close their eyes, ignore the fear, and buy?

It’s worth remembering that the most violent and flashy rallies tend to occur in the context of medium- to long-term downtrends. Volatility, of the type we’ve seen since the middle of September, is coincident with periods of market weakness; uptrends, on the other hand, are nurtured by calm periods of low volatility.

So it’s possible this is just a typical dead-cat bounce designed to trap as many overeager bulls as possible before.

This idea that it’s too soon to jump back in is supported by other evidence as well. Here are six things to consider.

The Fed

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The main catalyst for all the chaos — nervousness about the potential end of the Federal Reserve’s QE3 bond buying program next week — remains unresolved. The economy and the stock market suffered setbacks when the Fed stopped the QE1, QE2 and Operation Twist programs in 2010, 2011 and 2012

Investors have grown dependent on the flow of cheap money stimulus. And like junkies, they suffer withdrawl symptoms when the juice stops.

The chart above shows how the performance of the stock market is closely correlated with the amount of bond buying the Fed is doing. Given that the unemployment rate has fallen to 5.9% already — hitting the Fed’s year-end target months ahead of schedule — it’s likely QE3 will end, removing one of the stock market’s main supports.

The Bond Market

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Of course, the stock market isn’t the only game in town.

The bond market is arguably a more important, more sober financial arena. And it’s warning of big trouble. Last week, we saw panicked flight into long-term U.S. Treasury bonds, suggesting bond traders are front-running something terrible happening to the economy.

You can see this in the chart above, which compares the 10-year Treasury bond yield to the Citigroup Economic Surprise Index, which measures where the economic data is coming in vs. analyst expectations.

This could be related to concerns that the economy can’t handle the end of QE3, or the concern that if the Fed is forced to restart its bond buying sometime in 2015, it’s not going to provide the lift we need.

Moral Hazard

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The impetus for the stock market rebound was chatter that, if the selloff deepened, the Fed would be forced to reopen the spigots of liquidity and ramp up its bond purchases again. This despite the fact the Dow hadn’t even fallen into outright correction territory by falling 10% or more — something that hasn’t happened in more than two years.

Since then, there has been some pushback by Fed officials in the press. And for good reason: The Fed seems to realize that it’s repeated efforts to swoop in with more stimulus whenever the economy and markets have swooned has created the expectations among investors that they won’t allow anything bad to happen.

That’s the very definition of moral hazard, which is dangerous since it encourages excessive risk taking. You can see this in the way that, heading into the selloff, investor sentiment had moved to an extreme not seen since 1987 at a time of record margin debt and low mutual fund and hedge fund cash levels.

Limits of QE

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So why not do it? Why not say, “To hell with it!” and just keep printing money and keep the party going?

Well, for one, the Fed’s bond buying is sort of breaking the bond market. There has been a rise in “fail-to-deliver” among the big banks as the supply of Treasury bonds — which are used as collateral in short-term inter-bank lending — dries up. The Fed already owns about one-third of all 10-year T-bond equivalents.

Moreover, the Fed’s monetary base has already swelled from $800 billion before the recession to more than $4 trillion now. No one knows what the consequences of this will be, since nothing on this scale has ever been attempted before. While inflation isn’t a problem now, it’s hard to believe this will continue to be benign.

At some point, the Fed’s stimulus efforts could be interpreted as monetizing the national debt, which would have repercussions for the dollar, interest rates, and the bond market.

Job Market and Economy

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The job market is recovering quickly, with the number of job openings at a level not seen since the Clinton Administration. While wage inflation hasn’t materialized yet, we seem to be on the cusp of it as Baby Boomers drop out of the workforce and employers find themselves having a tougher time finding qualified replacements.

And other measures of the U.S. economy are looking pretty good. Cornerstone Macro’s weekly U.S. real retail sales monitor increased to the highest level in 11 months. Housing starts rose a greater-than-expected 6.3% on a month-over-month basis in September. And weekly lumber orders suggest the bounce in housing activity will continue.

So long story short, the Fed is justified in ending QE3 and preparing for the start of interest rate hikes. And if they are ever going to break the market of its moral hazard problem, they need to stick to their guns on this. Sure, it’ll result in some short-term turbulence. But it the market will be healthier for it.

Technicals

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And finally, while stocks are oversold in the short term, they have room to go deeper in the medium term. The chart above shows how the percentage of S&P 500 stocks that are in uptrends has fallen to around 40%. While that’s a depressed reading for this measure, it’s above the lows near 20% we saw during the last significant market pullback in 2011.

And while sentiment has started to roll over, we’ve yet to see a real, cathartic panic selling event that would set the stage for a sustainable move higher. Moreover, while market valuations have improved, they are still lofty.

Safe havens?

In response to the difficult outlook, I’ve been recommending investors consider moving into precious metals, which have been pushing higher all month — despite the U.S. dollar’s strength — on safe haven inflows. Ideas include the leveraged VelocityShares 3x Gold (UGLD), which is up more than 9% for Edge subscribers 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.


Article printed from InvestorPlace Media, https://investorplace.com/2014/10/selloff-isnt-over-bonds/.

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