During early August, I bestowed an unofficial gold medal on Mr. Market for his remarkable ability to climb a wall of worry. Throughout the past year and a half, markets rose despite myriad worries about the economy, the virus, and other concerns large and small. This morning, however, we have seen a slip during that climb. The questions on many investors’ minds are “why today” and “how far”?

In the piece referenced above, posted on August 3^rd, we wrote:

The key conundrum that I’ve been wrestling with is why VIX is consistently lower now than it was earlier this year. We have far less consensus about the paths of monetary and fiscal stimuli, yet the relatively elevated 19 VIX is below the low end of the 20-22 trading range that persisted throughout much of the year.

It is quite possible today’s move and the relatively slight but steady declines that we have seen throughout this month are the result of investors’ recognition that this week’s Federal Reserve meeting could signal an end to the extraordinary monetary accommodation that we have seen since the Covid crisis just as the questions about the federal debt ceiling and proposed infrastructure spending come to the fore. There is broad-based selling in commodities, which may reflect investor fears about the pace of monetary policy and the anticipated economic rebound. Remember also that we wrote about the changing patterns of afternoon trading in the US markets over a week ago, noting that it was quite possible that US markets were seeing less support from large institutional buyers. Sometimes the cracks are building, just hard to spot.

The proximate cause of today’s fall is the potential default of China Evergrande Group (3333.HK), a heavily indebted real estate developer who has a payment due this week. Yet this is not a new problem. China Evergrande has been under pressure for months, as the chart below shows. Furthermore, we have asserted for months that China has been pursuing policies that appear to take little consideration of investor concerns, particularly when those investors are foreign. If markets efficiently discount future events, how did this suddenly become a problem today?

China Evergrande Group (3333 HK) 18 Month Daily Chart

Source: Bloomberg

Market dislocations occur when investors become more concerned about return OF capital than return ON capital. Bondholders in Evergrande and a wide range of Chinese property developers suddenly developed that concern this week. When those concerns become widespread, investors tend to seek safe havens like government bonds. Although we see 10-year Treasury yields falling by 4 basis points to 1.32%, that is hardly a major flight to safety. Gold, another traditional haven, is up about $11 – nice, but not significant. (Bitcoin, which some have touted as a safe asset, has recovered slightly from a 10% loss, belying that status.) Meanwhile, US high yield bonds are lower but hardly enough to dent their recent stellar returns. The chart of the iShares iBoxx High Yield Corporate Bond ETF (HYG) demonstrates that:

HYG 1 Year Daily Chart

Source: Bloomberg

If today truly was about investor fears, we would likely see more aggressive selling in risky corporate bonds of all stripes, rather than seeing those fears constrained mostly to the country and the specific sector that is most highly affected. 

As far as I am concerned, this is the most relevant chart today. We see that the S&P 500 Index (SPX) broke through the 50-day moving average that has supported its rise throughout the past year. It would not be at all surprising if traders and investors alike were using that as a level for stop-loss orders. The next logical support would be provided by the 100-day moving average, which is currently at 4328:

SPX 1 Year Daily Chart

Source: Bloomberg

Also worth noting is that both the 50 and 100-day moving averages are pointing upwards. That indicates that we remain in an uptrend until proven otherwise. Today’s stumble, while the largest intraday drop in two months if we close at or below current levels, is still not sufficient to bring us to even a 5% correction from the record high set early this month or the point where we are breaking our longer-term uptrends. 

Today may or may not be the start of something larger.  We can’t and won’t know that for some time. As of now, the first round of reflexive dip buyers are licking their wounds, many learning for the first time that not every minor dip is an immediate buying opportunity. But until or unless we see a pattern of continuing declines and weakening sentiment, we have to take a look at the next support level and gather more evidence about whether it is the start of a larger fall or simply a minor slip as markets climb that wall of worry.