Not Systemic

 

In mammals, fear and memory are intimately tied.  This makes sense within the context of evolution and survival; it is adaptive to be fearful of dangerous situations and to remember those situations for future reference.  Perhaps because of the crucial role that fear plays in our survival, it has been 'hardwired' into humans as the dominant emotion.  Sometimes, we end-up remembering some fearful situations too well, resulting in problems such as phobias and (even more challenging) post traumatic stress.

The market, in general, has still not recovered (forgotten) how scary the great recession was.  It takes time for the fear to fade, and the scarier the situation, the longer it takes.  Ten years later, and the fear is still just under the surface.  In fact, that underlying-fear is what has been driving this bull market breathlessly higher.  But every time the market drops back more than 1%, the terrifying memory of 2008 rears-up to the surface in a screaming panic.  Which is where we are today.

However, this is not a systemic event. Deutsche Bank’s Aleksandar Kocic, is suggesting that when you look at it from a volatility point of view, you realize this is a localized event within the secular bull market (which is what we have been pounding the table with).  He takes three benchmark volatility measures and notices that they do not move concurrently.  He points out that “When rates or equities vol spikes, EM is calm and vice versa” (chart below).

If this was the end of the secular bull market, everything would blow-up together.

 

Equities

Sentiment

Too much fear for this to be the end.

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The put-to-call ratio has a strong negative-correlation with the SPX; down-spikes in the 8-week MA indicate local market tops, while up-spikes indicate local bottoms. The average has made two short-term up-spikes and a third is in the process of forming. The pink squares on the chart below, outline the peak in the nominal (not the average) put-to-call ratio which generally precedes the peak in the 8-week MA. A bounce is highly likely when the ratio is so extended.  The ratio hit this level in February.

 

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The bear-to-bull asset allocation of the Rydex family of funds, has a strong inverse correlation with the SPX; a declining 36-week MA in the Rydex ratio is bullish for the SPX. Down-spikes in the ratio, correspond with tops in the market. In other Weekly Summaries, we have pointed out the similarity in trading patterns of the current bull market, with those of the tech bull market of 2000. During the later-stages of the tech rally, the Rydex ratio (nominal) made a down-spike early in 2000, but the 36-week MA continued to move lower while the SPX moved higher for another six-months before hitting its second (and final) high, and the Rydex ratio made its second (and final) down spike, after which, the 36-month MA started to rise as the S&P 500 corrected itself into a bear market.

Despite the fact that we have many reasons to think that this is not the start of a bear market, the behavior of the Rydex bear:bull asset allocation ratio is starting to worry us.  Each time that the nominal ratio value made a double down-spike and the 36-month MA started rising, the SPX corrected into either a bear market (2000), or into a significant local correction (2011 and 2015).  That is the situation we are in now; the nominal ratio has formed a double down-spike, and the 36-month MA is starting to rise.

In 2011, the market corrected -19%, in 2015 it went down -14%, and as of this past Friday, the market is down almost -10%.  The market could end up correcting down to meet the long-term trend-line in the 2400-2450 area which would result in a -17% correction.  The bull market would not necessarily be over at that point (just like it wasn't over in 2011 or 2015), but it would be a painful correction.

 

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Technical

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The long-term technical situation continues to mirror the 1999-2000 period, but there could be a difference developing which also corresponds to our discussion (above) regarding the Rydex Bear:Bull asset ratio.  In 1999-2000, the 8-month MA never crossed under the 12-month MA, while in 2011 and 2015, it did cross.  The MAs are still 12 points apart and may never cross, but we need to keep an eye on them because a cross would portend a more substantial correction (like 2011 and 2015).

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Fundamental

Q3 earnings continue to come in at about +20%.  Historically, in terms of GAAP earnings, bear markets do not start until the RSI drops below 70 and the MACD makes a bear cross-over (red-ovals in the chart below). We are not heading in that direction at the moment.

 

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Gold

Gold has disconnected from its normal correlation with currencies.  This may be a result of a fear-trade connected to the equities correction.

The Euro/gold correlation has turned negative, but it may be turning back up as the Euro bounces off resistance.

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The gold miners have been turned back from resistance, even as the gold price has held up.  The HUI Gold Bugs index has closed below resistance at 150, and the RSI has fallen below the upper trend-line.  This weakness predicts future pressure on the gold price.

The gold/TIP correlation has started turning back toward the more normal positive as both gold and TIP rallied.  We are not convinced that the inflation expectations will continue to increase, especially since the latest PCE came in at a low of 1.6%.  Once the fear generated by the equity correction calms down, we expect inflation expectations to continue trending lower and taking gold down with it.

The commitments of gold futures traders have turned back from historical levels, but remain extended.  The large speculators have decreased their net short position slightly, but continue to be net short -38k contracts.  Under normal circumstances, large speculators have been contrarian indicators, but over the last several months this has not worked.  It may be starting to return to normal, and if that is the case, then an increase in the gold price becomes probable.  At this point, we are viewing this indicator as neutral.

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