“Stimulus Hopes” – A Dog That Ain’t Hunting No More

A Rebound in Stocks Begins

Given that a very sharp downturn in so-called “risk assets” is well underway globally, but not yet fully confirmed by US big cap indexes, we are keeping an eye out for confirmation. This is to say, we are looking for events, market moves, positioning data, even newspaper headlines, that will either confirm or refute the notion that a larger scale bear market (as opposed to just a deep correction) has begun.

Haruhiko Kuroda will stimulate us back to Nirvana! Hurrah!

Photo credit: Yuya Shino / Reuters

Readers may recall an article we posted earlier this year, discussing historical examples of the stock market swooning in the seasonally strong month of January (see: “Stock Market Suffers Worst Start to the Year Ever” for details). When the market does something like this, it is more often than not sending a message worth heeding. Chart patterns of course never repeat in precisely the same manner, but such historical patterns are nevertheless often useful as rough guides.

As a reminder, here is a chart of the DJIA from 1961 to 1962. Both the distribution period preceding the sell-off, as well as the timing and pattern of the sell-off itself show many similarities to what has so far occurred in 2015 to 2016:

The DJIA from 1961 to 1962. We may be at the beginning of the period equivalent to the one in the green rectangle – click to enlarge.

In keeping with this, we would now normally expect the market to rebound from the initial sell-off and retrace a portion of its losses over a period of several weeks before resuming the decline from a lower high. Last week the bond market delivered a technical signal on the daily chart, which based on well-known inter-market correlations suggests that such a rebound has likely begun.

Assuming that the positive correlation between treasury bond yields and the stock market (resp. the negative correlation between bond and stock prices) persists, the island reversal in bond yields last week is signaling the beginning of a short term relief rally. The bullish consensus in the bond market has recently become extremely stretched, so a rebound in yields would be quite normal – click to enlarge.

A certain degree of support for the idea has also emerged on the US economic data front: for instance, growth in retail sales exceeded expectations. More importantly though, initial unemployment claims, which traditionally are strongly negatively correlated with stock prices, fell sharply last week. In the process they have negated a recent short term uptrend that threatened to lead to a breakout to higher highs:

The reversal in the short term trend in initial claims lends support to the idea that the stock market is in for a sizable rebound – click to enlarge.

Crash Risk Still Remains High

There are of course a number of caveats to all of this: Neither the VIX nor put-call volume ratios have so far shown any signs of an emerging panic in the US stock market. If one looks at gold stocks, in spite of the sector being overbought and more than ripe for a pullback, numerous charts of individual gold stocks actually look as though they may have even more short term upside. Since the sector is currently negatively correlated with the broader stock market, this counts as a mildly negative factor for “risk”.