Massive Market Swings – What Gives?

Originally posted at Briefing.com

"This is an environment right now where, frankly, anything is possible. The market could go up big, it could go down big, or it could just go sideways." That was a view I expressed in a Market View update on September 19 and it has been spot-on with the exception of the sideways action.

Since September 19, the stock market has gone down big and it has gone up big. It hasn't spent much time at all going sideways. Accordingly, there is an easily identifiable V-shaped move on a short-term chart of the S&P 500 (and other major indices for that matter).

I don't typically like to write backward-looking pieces, but in considering the big picture, it sure seems warranted given what has transpired over the last six weeks.

I'm not going to expound much in literal terms on why the stock market experienced its biggest wave of volatility since the debt ceiling crisis of 2011.

Instead, I'll employ a bullet-point format to highlight the reasons why the stock market has been down big and up big over the last six weeks. Some reasons fit in both cases.

Down Big

From its all-time high on September 19 to its low on October 15, the S&P 500 declined 199 points or 9.8%. It was a sudden and swift sell-off to be sure. Why that happened is open for debate. Here is what we think precipitated the selling:

• The market was overextended on a short-term basis and due for a pullback
  • From its low on August 7 to its high on September 19, the S&P 500 went up 6.0%
• The Alibaba Group (BABA) IPO
  
  • Not because it was bad, but because it was so good and stood out as a focal point of buyer complacency
• Lowly economic news at a highly complacent time shakes faith in central banks and sparks valuation concerns
  • Deflation threat in the eurozone
  • Data pointing to a slowdown in China, Japan, and Germany
• Rate hike fears
  • Notwithstanding the weakening data abroad and the U.S still fighting to achieve escape velocity, the Fed's commentary seemed to be shifting increasingly toward policy normalization efforts
• The strengthening dollar
  • Piqued worries about the earnings prospects for U.S. multinational corporations
• Big drop in oil prices
  • Viewed as a proxy for global economic deterioration (i.e., seen as more of a demand issue than a supply issue)
• Small-cap stocks and Dow Jones Transportation Average take a dive
  • Russell 2000 declined 11.5% from its high on September 2 to its low on October 13. The DJTA dropped 11.6% from its high on September 19 to its low on October 13.
  • Underperformance of domestic-oriented small caps and the transports triggers concern U.S. economic recovery to be choked off by rate hikes and/or foreign weakness
• Ebola contagion concerns
  • Worries about a possible nesting effect with the spread of Ebola outside West Africa and specifically to the U.S.
• Capital gains harvesting
  • The month of October is fiscal year end for many mutual funds. Recognizing the market's overbought condition and sensing the easy-money trade is coming to an end, fund managers were compelled to lock in some big, long-term capital gains.
  • Redemption requests from investors spooked by the macro picture and material decline in stock indices

Up Big

From its low on October 15 to its high on October 31, the S&P 500 gained 197 points or 10.8%. Why the quick reversal? Here is what we think precipitated the buying:

• The turn in the Russell 2000 and Dow Jones Transportation Average
  • They bottomed on October 13. As they bounced back, there was a burgeoning sense that the sell-off had run its course.
• S&P 500 finding support at the doorstep of an official 10% pullback
  • Holding the so-called correction line affirmed for many that the selling was simply a pullback from an overbought condition
  • Bears were emboldened by signs of weakness in the global economy and the stock market. When the indices turned, they were forced to cover short positions to avoid suffering large (and potentially larger) losses.
  • With buy-the-dip efforts proving successful yet again, sidelined investors put cash back to work on the fear of missing out on further recovery gains
• Better-than-expected third quarter earnings news and better-than-feared fourth quarter outlooks
  
  • Apple (AAPL) really turned the tide here with its earnings report after the close on October 20
  • S&P 500 earnings, projected on October 3 to be up 6.7% year-over-year, are on pace to increase 7.4%, according to S&P Capital IQ
• Ebola contagion concerns simmer down
  • Recovery of two Dallas nurses who had contracted Ebola builds confidence in idea that the virus is curable
  • Very limited spread of virus in the U.S. (so far certainly) helps quiet noise in the echo chamber
• Asset rotation out of bonds and into stocks
  • The turn in stocks coincided with a key reversal in the 10-yr note, whose yield dropped as low as 1.87% on October 15 before settling the day at 2.14%. It was the biggest one-day drop in yield (34 bps) since March 2009 and was regarded as a capitulation day for bond bears
  • As stocks have rebounded, the yield on the 10-yr note has risen as many as 48 basis points from the October 15 low
• Drop in commodity prices, namely oil
  • Slide in oil prices will be detrimental specifically for energy and energy service companies, yet it is a boon for consumers (via lower gas prices) and other companies that use oil and oil-based derivatives in their production process
• Faith in the central bank put
  • Stocks rallied after St. Louis Fed President suggested on Oct. 16 that the Fed should consider delaying the end of QE
    • His statement, which was deemed wishful thinking by many, wasn't as important as the bullish response to the statement. Prior to it, there were some signs the market might be losing faith in central banks. The big rally after Mr. Bullard's remark implied market participants hadn't lost faith in the safety net of the Fed put.
  • Global stock markets rally after the Bank of Japan surprises with announcement that it will increase purchases of Japanese government bonds (annualized rate of 80 trillion yen compared to prior rate of 50 trillion yen), ETFs, and Japanese REITs
• Politics
  • Many political pundits have been pointing to the prospect of the GOP taking control of both houses of Congress after the mid-term election. Such prognostications have fueled hope that corporate tax reform can be achieved.
• Seasonality
  • November and December are typically good months for the stock market. With the sharp rebound in the latter half of October, participants begin angling for a bullish year-end push

What It All Means

It has been some October indeed. Were we surprised by the roller-coaster action? Not really.

It is something we suggested was a possibility, because sentiment, more so than earnings, was driving the market.

In that vein, we think the most important factor in the stock market's bullish turn was the existential moment where it realized it hadn't lost its faith in the ability of central banks to support the market with both words and actions.

Yes, there have been murmurings about the Fed's latest directive sounding hawkish. It isn't. If anything, it is simply less dovish.

A fed funds rate at the zero bound may not be here to stay, but it's here now. With inflation rates likely to head lower in the near term and labor resource underutilization still high, the prospect of it remaining there for a good bit still seems pretty good.

That matters a good bit, too.

There will be a stronger sense this bull market is running on borrowed time when the fed funds rate is raised for the first time. That time isn't now.

I said the same thing in concluding the Market View update on September 19 and I've said it again today knowing that everything and nothing has changed in the standing of the S&P 500 over the last six weeks.

Related:
Axel Merk: The Fed Will Be Late in Raising Interest Rates