Breakout Rally?

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The Fed and geopolitical situations continue to be the daily volatility driver into the market. Yellen’s gaff in the Q&A session sent the market down sharply and yesterday the President stated that a military option is off the table with Ukraine, sending the market up sharply. All this shows how jittery and reliant the markets are on the Fed’s monetary policy. Adding in the fact the West is in massive debt and in full bailout mode, any conflict with the East will only further stress economic situations.

Breakout Rally?

The market is always cautious before any big news events. There are two types of news events, those that are expected and the unexpected.

Courtesy of Julie Willis

The Expected

The expected news events are FOMC meetings, earnings, and other planned events. We know on these days the market CAN be exposed to market volatility, we can also make reasonable assumptions as to what to expect and how the market will react. What usually happens is that we see option premiums rise into the event, the equity’s volatility contract, and the underlying poised and ready to move. It is somewhat analogous to watching a coil spring put under tension and then released. The only certainty is that on a specific date we expect volatility. How much volatility and market direction remains unknown; however, from my experience we usually see premiums (implied volatility) rise into the event and then rapidly collapse after the event.

The Unexpected

The unexpected events are issues like the Ukraine or Cyprus bailout. These events don’t have an exact date, but in many cases we know that the probability is rising that something COULD happen. The when, how much volatility, or whether it will be a non-event remains unknown. These unexpected events are frequently referred to as “headline risk”, aka headlines in the news.

Trailing Risk

We also have trailing risks. These are the simmering pot situations, which is what the Ukraine has now turned into. First, the market was given a solid JOLT from the news, and then the volatility faded. However, it now becomes another simmering pot on the over-crowded stove and we wait to see if it boils over. One of the problems with these trailing risk “simmering pot” scenarios is that unless they can generate a “headline” in the 24-hour news cycle they are moved to the back burner. However, just because they are out of the headlines doesn’t diminish the risk. In fact, in many of these situations the market implied volatility declines as we forget about them, then we act all surprised and this trailing risk makes a new headline. There are a few massive trailing risk stories which could easily become headlines at any time and bring huge volatility to the market.

European Debt – the bailouts for the Club Med, Socialist countries have only bought time. Greece’s march back to the well for another bailout has become a regular pilgrimage, Italy’s government volatility is like a pushme-pullyou going nowhere, and then are Portugal, Spain, and Cypress.

Ukraine – this is the newest addition to the trailing risk pot. Russia has moved forward, there are oil/gas issues, trade issues, and currency issues. Nothing happens today or tomorrow, but that doesn’t mean that the Ukraine situation has been resolved, it is just simmering on the back burner right now.

Middle East – Probably the biggest global powder keg is the Middle East, as a whole. We know about the oil trade and trailing risk that is associated with it. There are so many issues that it takes the entire world to keep this massive pot from boiling over; Israel/Palestine, Egypt now on the radar, Iran and Nukes, Syria and the Red Line, Libya revolution, then we still have the aftermath of Iraq and Afghanistan. The sad reality is that this is only a powder keg for the globe is because of oil, remove oil from the equation and it turns into a localized government/human rights/civil war issue that really have no direct impact to the East or West. The more the East and West can become energy independent, the more it defuses this powder keg, as it directly relates to the US, oil, and the markets.

Why are the Markets Strong?

With the rise in trailing and event risks, why is the market moving higher and with such vigor? The answer is a culmination of being insulated and aided.

The US financial markets are insulated from many of these events because of its isolation, the reserve currency, and liquidity. North America is similar to an island; we have two friendly neighbors (Mexico and Canada) and massive oceans on either side. The problems in Europe and the Middle East are geographically far away, making it hard to physically disrupt our markets. The Dollar, while now a fiat currency, has one massive advantage, it is an oil currency or petrodollar. In some ways the dollar is backed by oil because the majority of world oil trade has been in dollars. That has been a significant factor in helping keep the dollar a world reserve currency, even after the epic failure of Bretton Woods. However, the dollar has been losing its reserve status at an accelerating rate. We also have the most liquid markets in the world, you can trade in or out of our financial products quickly and efficiency.

The US markets are also significantly aided. With the Great Recession, our Federal Reserve took on “extraordinary measures” [QE] by printing money to buy US bonds, while at the same time setting the Fed Fund rate to Zero. This forced bond prices to all-time highs, while sending yields down drastically. This single massive money printing and bond buying scheme has forced any investors looking for returns out of bonds and into equities. Investors today have very little hope for making any returns in the US treasury markets. The interest rates don’t even beat the REAL rate of inflation and unless you are willing to hold them to maturity, you could take massive losses if rates go up prior to maturity. So investors have one choice for a return, the equity markets. It could be stocks, ETFs, indices, MLPs, REITS, etc. Add in the expansion of leveraged debt again, and this market is going higher.

Supply & Demand

To simplify all this, it is Supply and Demand.

You have the world’s best markets (liquidity, technology, access, efficiency, isolation from localized geopolitical risks). It is backed by the world reserve currency (petrodollars). It is backed and aided by extraordinary measures by the Federal Reserve. It has the ability to massively leverage and margin your positions to increase returns. This determines the Demand part of the equation.

Ask yourself where money will go first. The answer is the US financial markets.

The Supply side has been significantly squeezed. Typically, money comes pouring into the financial markets as a whole, which are both equities and bonds. However, the bond side of the equation (primarily US treasuries) has been MADE extremely unattractive as an investment by Fed policy. Pension funds, savers, retirement accounts and conservative investors have been brutally punished because of this policy, and that is a massive amount of money. This money is now moving into equities.

Courtesy of stephan smith FX

So we have created artificial demand in the equity markets, by making the rest of the US financial markets unattractive. This rally is NOT based on strong economic growth, strong fundamental data, strong top-line growth, or even lower costs expanding margins. No doubt there ARE great stories in the equity market, but as a whole, the bulk and heavy lifting is coming from government and Fed intervention.

What about event risk?

So, will these event risks (expected or not), trailing risk, and Middle East uncertainties bring volatility to the markets? Sure, we will see days and perhaps weeks in which the market will come under pressure and have huge intraday swings. However, because there are TRILLIONS of Fed dollars pushing demand into the equity markets and out of bonds and cash, it is over-riding traditional, fundamental investment theory.

Traditionally, investors had a CHOICE based on risk and returns. When the market rallied a tremendous amount and the geopolitical and economic risk became too high, they would have a CHOICE to leave the equity markets to seek out treasuries for fixed income and rates of return. Part of that decision was based on measuring expected returns and risks of the equity markets vs. the yield in the treasuries. However, with artificially ultra-low yields in treasuries, they no longer have a choice. The Fed has REMOVED CHOICE!

Bubble Risk

So, the real problem isn’t event risk (expected or not) or really even the trailing risk. The real issue at hand is the bubble we are building. The Fed policy is to INCREASE inflation, print more money and to keep rates at zero for an extended period of time, in HOPES that people will continue BORROW (take on debt) and spend more. This is a massive bubble in the dollar and US treasuries.

How much can the NYSE margin index go? It is already hitting new all-time highs daily (currently over $450 billion). I don’t know.

How much more debt can the US take on, 20 trillion, 50 trillion, 100 trillion before it collapses? I don’t know.

How much can consumer debt expand before it can’t anymore? I don’t know.

Courtesy of bluecollardollar

The equity market is expanding rapidly based on leveraged debt. A vast majority of money coming into the markets is not money, it is credit, it is borrowed somewhere, it is creating debt and a lot of it. The NYSE alone is over $450 billion. I was looking at the growth rate of margin/credit (debt) and it is starting to become parabolic. How much more? I really don’t know.

Remove the Fed and allow Treasuries to make a real market, and you would see the equity markets lose support as money floods back into normalized yields in Treasuries. Additionally, you would see the equity markets see more fundamental impact from event risks, which impacts the bottom line.

Breakout Rally?

So, this market is going higher despite event risks or even tail risks. It is going higher because it is the only game in town and the house is giving you a credit line.

The Fed is all-in on their bet. They are hoping they can slow down the money printing bond buying (taper), eventually stop, and raise rates and see if the economy and market can stand on their own. That is going to be hard, only because they injected trillions of leverage into the system. They forgot about the Pied Piper. When the Fed stops, who is going to pay the bill for the trillions of borrowed money?

Courtesy of Chartpattern

We can certainly go higher and see a break-out rally, however it will be based on how much credit (margin) is available and that depends on how much the Fed will print and the rest of the lenders are willing to extend credit lines.

Support & Resistance

INDU 16,000 – 16,500
I think we are shaping up for a dead-cat bounce in the near-term and will fall back down into the 16,100 range before we find support.

NDX 3650 – 3750
I am looking at a pull back to 3650, but am wondering if we can hold there as support. I would look at 3600 for an intra-day support next week if we do come down hard.

SPX 1840 – 1880
I think we will try a break-out this morning, but will hit resistance. I suspect we will see a pullback first, down to 1850-1860 range at least before a run higher. VIX is down in the 14′s, if we have a break-out rally first it will drop to 12 and fear will again leave the market.

RUT 1180 – 1210
The RUT continues to be the best gauge of the market and while the narrower indices are looking ready for a dead-cat bounce and pull-back, the RUT is looking to break-out and go higher. If we see this breach 1210 and close strongly above it, we could be in for another break-out. I would expect the other narrower indices to follow. Watch to see how the RUT closes today to get any idea how next week will line up.

Want to Rally!

The market wants to rally as demand keeps driving into the only large, liquid market in the world that offers any potential for return. The Treasuries are dead for investors and cash is losing buying power.

Talking heads, like Liesman, are making some odd connection that the market rally is proof of a strong economy. However, the facts on the ground dispute that. One only has to follow the money to get the answer. The money that is being printed by the Fed (by the 100′s of billions)  can keeping Treasuries afloat and buy down the majority of Mortgage Back Securities (MBS). Remove the Fed and where do we think this market goes?

Right now the bottom line and fundamentals have less to do with the broad-based equity markets.

One Response to “Breakout Rally?”

  1. McRocket says:

    I find the period in macroeconomic history depressing.

    Fundamentals are gone, government will reigns supreme.

    It’s like the umpires are calling all the strikes as balls just to keep the game lasting as long as they can.