This equity market rally has been a lot like an Indian Summer, the weather phenomenon where spells of unseasonably warm, gorgeous weather bring fall cheer before the merciless grip of winter takes hold. The markets have timed this rally perfectly for October, though if this were really a weather pattern it would already be an uncharacteristically long one.
Even though it seems like a lot has happened since the precipitous market drop in August, I cannot identify any tangible changes from our thesis in “All is (not) Well” that would drive a fundamental trend reversal in the market from the downtrend that it asserted in August and September. Every piece of economic information below questions the sustainability of this “Melt-up” of the markets.
- “more of the same” Central Bank maneuvers - the 6th Chinese interest rate drop in 12 months or the strong ECB hints at further easing
- our Fed’s back-pedaling from their September statement and instead attempting to convince the markets that they still intend to increase rates (which we think is a charade)
- Shrinking revenues in many Sectors of the economy (see WSJ article “US Companies warn of slowing economy”)
- Continuing Dollar Strength and corresponding macro weakness in Emerging Markets and Commodities
- China has been quiet in its disposal of US Treasuries in October, and the Renminbi has actually risen against both the Dollar and the Euro. This can’t be good for the Chinese economy.
However, one bright spot has been Technology revenues, which though under significant pressure from Dollar Strength, are still hanging in there because of secular growth trends like Cloud adoption (Amazon, Microsoft, Intel), growth of Internet retailing at the expense of Brick & mortar retail (e.g. Amazon vs Walmart), or simply just organic growth in adoption and penetration (Google and Apple).
So what are the markets telling us? The Nasdaq 100 Index (represents the best of Technology) has poked through the last of its important technical resistance levels, i.e. its July peak, and has made a brand-new intraday high yesterday. So at first glance it seems like this rally may no longer be just a technical reversal but an actual trend change. However, our fractal models and intermarket and macro analysis is indicating the opposite. Specifically -
- About 45% of the Nasdaq’s rally from the September lows came through Fed injected liquidity at various junctures in October, and from a significant surge in European inflows into both US Equities and Treasury Bonds corresponding to the date of ECB Chair Mario Draghi’s hint of further easing. Thus violations of these resistance levels are nominal and not meaningful.
- US Small Caps have behaved more rationally, and have been immune to these liquidity injections and surges even though these firms are the least impacted by global and currency factors. Hence, Small Caps may reflect the true effect of the same key resistance levels that were violated on the larger indices like the Nasdaq and S&P500 or the Dow. In other words, the other indices should reverse the same time as the Russell 2000 Small Cap Index does when it runs into its resistance zone (see Fig 1 below).
Figure 1: Russell 2000 Index Futures Chart showing the Resistance Band where strong selling pressure is expected to stop and repel the current rally from early October
- Structurally we appear to be near the mid-point of the rally from early October, and it could continue through much of November and even possibly December before volatility returns.
- Gold’s response during the remainder of this rally should be interesting to watch. It has risen, co-incident with the Equity Markets since late September, indicating that it is benefiting finally from the same liquidity flows that have lifted up US Treasuries and US/Global Equities in October. However, if this liquidity surge is limited and temporary (which we believe it is), Gold’s performance should be relatively weaker, and it should clearly top and reverse before equities do since it is much more sensitive to such flows.
In conclusion, we are in for an unusually long Indian Summer in the markets that may last for the remainder of 2015. “Winter” should reassert itself by the first part of 2016 if not earlier, with significant downside to the Equity Markets as the global macro-economic slowdown becomes impossible to ignore, even for the Technology sector. We believe that the risk is high of a severe decline that could retrace this entire rally, with a test or even a temporary breach of the all-important 15,000 resistance level for the Dow, which is a good 15% lower than current levels.
I hope you don’t find yourself in the wrong clothes when the long-due Winter finally arrives.