Dead Cat Still Bouncing

Dead Cat Bounce: A temporary recovery from a prolonged decline or bear market, after which the market continues to fall.

Investopedia explains Dead Cat Bounce
Ever heard the saying, "Even a dead cat will bounce if dropped from high enough!"?

After the market had rallied from exceptionally oversold levels and high panic levels last week, it was time to come down from that bounce. There was a perfect storm of sorts in the newswires today in which the equity market was assaulted from all sides. 1) The Federal Reserve Bank announced scrutiny of U.S. banks looking for European sovereign debt exposure. This was downplayed by the Fed’s Dudley just as the Euro markets closed. 2) Bank funding fears in Europe. 3) European equities suffered their worst day in nearly 2.5 years today. That caused our market to drop 2.5% in the first 5 minutes of trading. 4) Weak U.S. economics, i.e. Philly Manufacturing Index and jobless claims back over 400,000. 5) Weak earnings and guidance from NetApp (NTAP). 6) Countries want collateral from Greece. With the S&P 500 down 4.46% today, and the headline assault on all fronts, the retest of last week’s market bottom has commenced.

V-Spike Failure

The market had a chance to make a withstanding v-spike recovery in the last week; however, after the Merkel and Sarkozy meeting had disappointed the investment community on Tuesday, the recovery had petered out. No Eurobond and no bolstering of the €440 billion European Financial Stability Facility (EFSF) bailout fund. The market needed another catalyst to propel prices higher or lower. We of course got the needed gasoline on Thursday’s weak economic numbers and continued fear in Europe.

The Philadelphia Fed Business Outlook

Today’s release of the Philly Fed business outlook was quite dire. So far, the index has dropped 74 points from the high a few months ago.

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The most problematic component in the survey was new orders. The leading component plummeted from 40.3 in March to -26.8, which is a big deal and points toward future weakness in the outlook. Employment is now negative and the high inflation reading last spring at 67.2 is falling quickly, now at 12.8. Prices received is now contracting at -9.0 which is to say that profit margins are about to shrink. This is a key issue because bulls have been focusing on high profit margins in the 2009-2011 recovery due to cost cutting. Companies will have a harder time functioning if they cut more. So falling prices received will shrink profit margins, which will shrink earnings, which will justify lower stock prices as analysts slash forward earnings guidance (reactively as usual).

Technical Issues: Working out the cycles

As we all know, the market moves in three cycles: short, intermediate, and long-term. The long-term cycle on this market was dictated the moment the market fell below the March and May lows on August 4th, thus forming a long-term market top. The market was so far oversold on the intermediate and short-term indicators last week that a bounce was highly probable. 90% of the S&P 500 stocks were above their 10-day moving average yesterday which was to say, the bullish short-term cycle had bounced and was probably ending. Today, only 20% of stocks in the S&P 500 are above their 10-day moving average. What a volatile month we’ve seen in the market!

The intermediate term seems to indicate that a major low was put in last week looking at volume (peaked), the VIX (fear index peaked), and the formation of an accumulation (demand) zone between 1120 and 1150 on the S&P 500. Because of the intensity of last week’s bottom, this should likely serve as a very tough zone for the bears to crack over the intermediate-term. If we test last week’s low on lower volume and momentum, it is likely to hold and the dead cat bounce will remain the modus operandi for the stock market over the intermediate term. Consider the dead cat bounce in 2008 from January to May as an example of the same situation we find ourselves in now.

The action in Treasuries and the VIX over the last few days should have been a warning to bulls that this market decline isn’t over just yet. Treasury bond prices remained elevated over the last few days while the stock market rose. This indicated money was not coming out of the “safety trade” to enter into the “risk-on trade”. Traders were merely “renting” the market in ETFs from their cash horde. In fact, a buddy of mine at JPMorgan mentioned the order flow he’s watching showed that ETFs (exchange trade mutual funds) were accounting for 44% of volume versus 35% a month ago. Macro investing is taking over bottom-up investing (typically long-term investors).

Gold and the Safety Trade

On the opposite side of the ledger, the safety trade looks tired to me for the time being. As I mentioned last Thursday, gold appeared to be a crowded trade, and was moving up in parabolic fashion like silver in April. For one, silver is nowhere near its highs like gold. Why the divergence? Concerns over the economy, and those concerns over inflation quickly change into deflationary concerns that gave gold it’s 30% correction in 2008. Sigma stands for standard deviation. A 4 Sigma event is clearly visible in gold. These kinds of short-term moves are not sustainable. Though it is up only 3.5% from my short-term top call in gold last week, last week appeared to be the momentum high. This week’s higher high on less momentum is the kind of setup you get for a short to intermediate-term correction. Trimming some gold exposure is advisable. The wild card here is the Jackson Hole meeting next week. The Fed has been hesitant upon rolling out QE3 just yet, but the scheduled meeting will mark the anniversary of QE2’s real birth. It was first discussed in Bullard's July article, but Bernanke gave it wings at Jackson Hole 2010. The inflation trade was sparked and off went commodities and equities.

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Treasuries and the Safety Tade

On the opposite side of the same coin, we have U.S. Treasuries—specifically, the all-popular iShares Barclays 20+ Year Treasury Bond ETF, TLT. The Treasury Bond ETF has risen 16% in the last two weeks from . To put that into perspective, that’s three years worth of the income you’d receive from the fund at the current yield. TLT has become a trading vehicle and the crowd is present in this trade. Technically, we have broken out above last year’s high during the summer of 2010 when double-dip recession fears persisted; however, the breakout wasn’t on solid ground today. For one, there was a gap from 8 to 0 which has now created a vacuum under today's closing price. Secondly, volume was light compared to trading last week. You need strong volume to confirm breakouts, not light volume. Lastly, it sold off from the highs early in the morning and never looked back; unlike the stock market which tested the lows in the last hour of trading. Traders were selling the breakout.

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Conclusion

I don’t have a crystal ball, but last week’s bottom in equities was an important one on many technical levels: volume was high and the fear index (VIX) peaked. It’s possible that while last week may have been the “momentum low” we could still have lower prices in store for the market despite the conditions being ripe for a dead cat bounce. What we should all have our attention on is whether momentum fades the next decline. If the market re-tests and holds, or breaks down and whipsaws back above 1100 on less momentum, it would suggest that selling has been exhausted, and a meaningful dead cat bounce lasting 1-3 months will have begun.

If you look at the sovereign debt crisis in Europe, it has been a hot potato that bond vigilantes have passed around from country to country. In the first part of the summer, they raided the usual suspects of Greece and Ireland. Then they moved on to Portugal and Spain. Two weeks ago, they hit Italy. Credit default swaps (CDS) have risen on all European nations and European banks this week. The only safe havens there continue to be French and German bonds as yields have dropped. France’s CDS spiked last week. I wonder if their country is the next to get attention from bond vigilantes; thus driving bonds lower and yields higher.

Forward Catalysts

There are a few catalysts to watch in our near future. This week’s meeting between Sarkozy and Merkel was a disappointment, but if you read between the lines, they appear to be lining their ducks to set the foundation for a Eurobond. A Eurobond would be another blow to the U.S. reserve currency status.

Next week, Ben Bernanke will speak at Jackson Hole on August 26th. Whether they announce a new policy shift or not, it will likely steer the macro consensus for better or for worse.

There’s also been talk that Obama will announce a new economic stimulus package. Mr. President needs to get reelected and his approval rating for the economy has hit 11%. The Washing Post fielded his proposals before his September Labor Day address. Details pointed towards proposing tax cuts for companies hiring, extending unemployment, new spending on roads and construction, and possibly mortgage relief. At the same time, he will likely announce a major push for deficit reduction, urging the new fiscal commission to overshoot the .5T target they’re expected to achieve. There’s something there to appease every American.

On the negative side, economic data and company earnings have been disappointing as of late (i.e. Dell, BRCD, NTAP). We should have a slew of economic reports next week. If the Chicago Fed National Activity Index drops below -0.7, it has typically depicted the beginning of a recession. The Chicago Fed is even more important than the Philly Fed announcement today because it’s at the national level.

About the Author

Wealth Advisor
ryan [dot] puplava [at] financialsense [dot] com ()
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