No Capitulation = No Bottom
Wash, rinse, repeat—that has been the script since 2010. Fading monetary and fiscal stimulus leads to a slowdown as economies can’t support themselves and then in come central banks to the rescue and off we go! We are currently in the period in which the third round of global monetary stimulus that began in 2011 is all but over and global markets and economies are weakening as a result.
According to Bridgewater Associates, the third round of monetary stimulus amounted to 2.8% of global GDP and at the end of May the remaining portion was down to 0.4% of global GDP. Unless policy makers step up for a fourth round of global monetary stimulus the path of least resistance appears down. In both 2010 and 2011 we saw major market capitulation in which investors threw in the towel and sent markets reeling. This causes central banks to spring into action and off markets go. Because we have not seen major capitulation and panic in the markets we may not see central bank action just yet, which leaves the markets in a precarious position. If we are to follow the 2010-2011 script we are likely to see lower prices ahead with less bearish participation (fewer stocks falling) which finally causes central banks to act followed by a strong market recovery. Until we see capitulation in the markets I would stay defensive and let the dust settle a bit.
Panic Has Not Gripped the Markets to Signify a Bottom
Bearish trends exhaust themselves with panic selling associated with a sharp broad-based decline on high volume and elevated fear levels. This was the case at the 2009 lows and the 2010 and 2011 summer lows, and can be seen in the image below. The regions highlighted in green show bottoms in the S&P 500 associated with first panic sell offs where NYSE down volume is more than 40-60 times the volume of up volume (see bottom red panel), then followed by panic buying that sees up volume 20-30 times the size of down volume. As you can see, when looking at the red shaded regions bottom right, we have neither seen panic selling nor panic buying to suggest that the current market correction has exhausted itself.
Another sign that selling pressure has exhausted itself is to see the S&P 500 Volatility Index (VIX) breach the 30 level and then reverse. This was the setup for the 2009, 2010 and the 2011 lows and while we have seen the VIX rise sharply from its low of 13.66 in mid-March to its high of 27.73 on June 4th, we’ve yet to see a sharp jump north of the 30 threshold to suggest panic selling.
We likely have two scenarios ahead and much will be decided in the next few days. The bullish scenario is that we are witnessing a nasty intermediate correction in a bullish trend and thus do not need to have panic selling often seen in the terminal phase of strong down trends. The bearish scenario suggests we are merely working off oversold conditions and setting up for the next leg down of panic selling to form a meaningful low.
The final arbiter between the bulls and the bears is always price. It is important to remember that price is the ultimate technical indicator and trumps volume. Price tells you who is winning and who is losing, and the price that is likely to determine if the bullish or bearish scenario is winning are the late May highs and 50 day moving averages (50d MAs) for the major indexes, which are converging to one focal point. This can be seen in the image below which shows the major indexes with their late May highs indicated by a solid red line and their declining 50d MAs shown by the solid blue lines. If we get uniformity among the major indexes of a break of the late May highs and 50d MA then the bullish scenario is likely at play and the correction would be over with a new leg higher commencing. However, if the major indexes fail at that key fulcrum then the markets are likely to head south.
The Wash, Rinse, Repeat Monetary Stimulation Cycle
By now market participants have been conditioned with a Pavlovian response dependent on central bank monetary stimulus—predictably falling once that stimulus exhausts itself. This point is made clear in the great image below from Doug Short in which periods of monetary stimulus are shaded with green boxes.
Source: Doug Short
We have three big dates ahead of us in which we may see the first signs of the fourth round of global monetary stimulus. The first big catalyst is the Greek elections on June 17th followed by the FOMC meeting on June 20th and the EU Leaders Summit June 28-29. If we get any new stimulus announced by the Fed or ECB then the market bottom is likely in. However, if central banks feel they have more time on their hands and disappoint the markets that may actually be the catalyst to set up a market selloff..
As things now stand there is not enough clarity as to whether the bullish or bearish scenario is playing out. If the markets fail at their late May highs and fail to exceed their 50d MAs then we are likely heading lower, particularly if central banks fail to deliver stimulus to the markets. This would likely lead to a selling panic that marks capitulation and the next market bottom. However, despite all of the many bearish headwinds in play, if the market indexes do clear their late May highs and 50d MAs then we have to shift our investing caps to the bullish side of the ledger. Given how close the markets are to their late May highs and 50d MAs—not to mention the quickly approaching Greek elections, the FOMC and EU Leaders Summit—we will not have to wait long to find out if the bullish or bearish scenario plays out.