Sunday, January 20, 2019

Making Sense of the Market's Split Personality

December was pretty much straight down in the stock market, with accompanying weakness in other assets, such as oil and high yield bonds.  January has been pretty much straight up, with reversals in all those asset classes.  How can we make sense of this "schizophrenic" market behavior?

An excellent blog post from David Moenning on the NAAIM site offers worthwhile perspective.  When Fed Chair Powell indicated continued shrinkage of the balance sheet and the possibility of future rate hikes, the market sold off hard that very afternoon and didn't look back.  The weakness was broad:  on December 24th, we registered 50 stocks making fresh one-month highs and 3158 hitting new one-month lows.  On that day, among the SPX stocks, we saw fewer than 5% of all shares trading above their 3, 5, 10, 20, 50, and 100-day moving averages.

In other words, pretty much everything was down.

Fast forward to Friday's close, January 18th.  Over 90% of SPX shares are trading above their 3, 5, 10, and 20-day moving averages.  A total of 1916 stocks across all exchanges registered fresh one-month highs against 67 new one-month lows.

In other words, pretty much everything is up.

Moenning, in his post, traces this reversal to the Fed's walking back their earlier "hawkishness", as they indicated flexibility in navigating the rate and balance sheet paths going forward.  Their hawkish stance was a game changer for institutional investors and led to a broad risk off.  Their flexible stance was an equal game changer and led to broad risk on.

What does this tell us?  Several things, I believe:

1)  Any effort to foretell the market's path with technical indicators, chart patterns, and wave structures is inherently limited in value.  We cannot operate with a crystal ball when game-changing events are occurring in real time.  Flexibility in managing money is just as important as "conviction".

2)  Monetary policy is a major driver of asset pricing.  This is the message from Ray Dalio's recent work.  The Fed is walking a narrow bridge in normalizing rates and not adding fuel to a strong economy versus pulling away the punch bowl and risking weakness.  The Fed has told us they don't want to fall off either side of the bridge, so we can expect balancing messaging at market extremes, as Chairman Powell and Co. seek Dalio's "beautiful deleveraging".

3)   Investors are behaving as a herd.  For over 90% of stocks to be above their 20-day moving averages, all sectors have to be bought.  Ditto when fewer than 5% were above their moving averages.  Everyone is singing from the same hymnbook.  This makes short-term breadth measures and short-term measures of upticks versus downticks handy in trading with the market's momentum.  It also means that fighting the herd is a losing proposition.

Of course, this, too, shall pass.  At some point valuations will matter and we'll see diverging behavior among stocks and assets.  So far, however, it appears that momentum is the upcoming starting pitcher.

Further Reading: