Sunday, 6 May 2018

Stock Market: Bull-Bear's Tug-of-War

The correction that started in late January represents a tug-of-war between the bulls and bears as evident by the triangle pattern in S&P 500. The bears manage to create lower lows while the bulls have carved out higher highs. Neither sides have yet declared victories.

This push and pull or tension between the bulls and bears come from the balances of bullish and bearish forces.

Bullish Forces:
  • The market breadth and risk appetite in S&P 500 is good and healthy as i pointed out in my post Stock Market: A Much-Needed Healthy Correction that i published 2 weeks ago. These measures remains very much the same.
  • The US and global economies are still growing and sound (albeit at late stage for US).
  • This earning season is phenomenal. This is the highest earning growth in history ! Of course, one can read this as the top, meaning the earnings and the stock market can only go down from here. That remains to be seen.
Earning estimates from 1990s to 2018
(Click chart to enlarge)

Bearish Forces:
  • Ongoing Trade War with China (this maybe temporary and mostly just rhetoric).
  • Rising yield (this in itself isn't entirely negative). Part of the reason for the rising yield could be due to the Fed's QT action.
  • The Fed's QT (Quantitative Tightening) program - the opposite of QE (Quantitative Easing) - whereby liquidity is being removed from the system the way QE is designed to pump liquidity into the economy.
Many believe the entire rise of the equity market since 2009 was due to the growth of the Fed's balance sheet via QE. They point out that the correlation between the Fed's balance sheet (of treasury holdings) and S&P 500 curve is too closely matched to be considered a mere coincidence (see chart below).

The Fed's balance sheet (treasuries holdings) vs S&P 500 from 2009 to 2015
(Click chart to enlarge)

Likewise, some would point out that the recent correction was in no small part due to the Fed's QT that started in November 2017. S&P 500 continued to power up. In fact put in the largest 2-month rise from late November to late January in many years despite QT.

Despite the background of QT, which is a bearish factor for the stock market, one can put down this 2-month parabolic rally for 2 reasons.

1.  The announcement of Tax Cuts trumps (no pun intended) the announcement of QT, especially among retail investors, who probably wouldn't even aware of such thing as QT. It's unlikely anyone who isn't aware of Trump's Tax Cuts and its bullish effect on the stock market.
2.  The amount of QT has been small in the 1st 2 months as the Fed wants to introduce this QT gradually, but the amount has been increasing in the last 2 months (see chart below) with ever larger tranche.

The Fed's balance sheet (treasuries holdings) vs S&P 500 from 2017 to 2018
(Click chart to enlarge)

The Fed's QT and rising yields are healthy things for the financial state of the economy over the longer term, but in the short term, it's negative. The market would need time to adjust to this new force, and ultimately resolve to either up or down side of the market.

The Fed is - as they have always been since their inception - the critical part in deciding the direction of the equity market.

At any given time, the Fed can either slow down or hold off the QT program temporarily or indefinitely, or becomes more dovish with interest rates policy to rescue the stock market if they choose to. In general, they wouldn't want to see the market tanked (price stability is one of their mandate. That's not to say they can always pull it off). Just because the economy does well doesn't mean the Fed can't ruin the equity market (or the economy) and vice versa.

The bearish factors, from the technical point of view, is that the financial (XLF), Industrial (XLI) sectors are so weak. This wouldn't bode well for the market until we see a turnaround in these 2 important sectors of the economies.

From a technical point of view, in the SPY has risen some 40% from early November 2016 to late January 2018, it needs to have a rest after these amazing run before another run up (if consolidation is resolved to the upside).

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