The market continues to sell on news that Japan’s major indexes dipped nearly into bear market territory overnight. This is certainly worrying for U.S. and European stock bulls, but the question is always whether investors will buy the dip, as they have for the past few years?
Busy Week for Economic Reports
Even if the market does bounce, will it be after a small decline of 2%-4% like we have seen so far in 2013 or something much larger in the 7%-12% range like we saw in 2012 and 2011? There aren’t any significant signals at this point that would indicate that the correction is likely to get larger than it already is, but that can change and investors have to pay very close attention on a day to day basis as forecasts are adjusted.
A shift in estimates from a short-term correction to something much larger is usually driven by a combination of news events and significant selling at the institutional level. That makes this a good week to stay flexible and potentially open new trades to take advantage of changes in market prices. This is a very heavy week for news, most of which should help set expectations for the intermediate term.
The most important headlines we are watching are changes in mortgage rates and labor reports.
How Dropping Mortgage Applications Affect the Market
Among the big news releases this week was a drop in mortgage applications for new and existing homes. Like the weekly unemployment data, this report can be noisy and erratic, but if it is confirmed in the stock indexes, then it becomes much more reliable. Based on both sources of information, we can be confident that the decline in applications is real, but why they have fallen is really the most important piece of information.
Mortgage interest rates are very highly correlated with the yield on the 10-year U.S. Treasury Note (TNX). When the TNX rises, mortgage rates are also on the rise. This is not always a bad sign. Mortgage rates and bond yields may climb because demand for loans and growth is high. In fact, it is more normal for mortgage rates to rise with stocks rather than the other way around.
10-Year U.S. Treasury Note Yield (TNX) vs. S&P 500: Chart Courtesy of MetaStock Professional
However, if what is driving the rise in yields has nothing to do with demand for mortgages, then mortgage applications are likely to drop, which should ripple through other market sectors starting with the finance sector. Once in a while, a divergence will appear when yields and stocks don’t follow each other and the real estate market will respond rather sharply. In the chart of TNX vs. the S&P 500 above, you can see how bond yields (red and green) and the S&P 500 (black) have followed each other for most of the last year until March when yields dipped dramatically without a reciprocal move in stocks.
Although bond yields recovered, it indicates that there is instability in the market. Typically, instability is “discounted” into stock prices, which is why the major stock indexes are selling off. If stock prices were to retrace like the TNX did, we would expect the potential for a correction to work prices down towards the market tops that were established in April.
What to Expect on Friday
As we mentioned above, yields aren’t rising due to demand. Rumors that the Fed is planning to taper its bond-buying program sooner than originally expected has been the catalyst for the rise in yields and mortgage rates. That would explain why mortgage applications and stock prices are down and why they may continue to drop, but how confident are investors that the Fed really will start to taper this year? The answer to that question will make the difference between a decline that is running out of steam now and one that continues to decline to April’s highs.
Accurate estimates for a taper depend on the “quality” of economic data this week. Inflation numbers are very low, so there isn’t any problem with the Fed continuing to buy according to the so-called “Evans Rule.” Therefore, labor data should be the make-or-break report that settles the taper question. Because this is the first week of the month, we will get the latest monthly labor report from the Bureau of Labor Statistics. According to the Fed, they will continue to buy bonds until the unemployment rate gets below 6.5%, as long as inflation remains manageable.
On the Wednesday before the first Friday each month, ADP releases a jobs report that is designed to shadow the same data that comes out later on Friday. That report was released yesterday and it wasn’t great, which paradoxically may indicate that there is a near-term floor on stock prices.
If the Fed is committed to buy as long as unemployment remains high, then traders are worried over nothing. If the official labor report on Friday drops like ADP’s did, then traders may use it as an excuse to buy the dip before prices decline to April’s highs. Over the last few years, we have seen bad news act as good news for stock prices like this several times. In fact, the most recent rally in April and May was preceded by relatively large declines in the labor numbers over prior months.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.