The Bull Is Tired, Without Great Sentiment And Lacking Volume, But…

Leading up to the Friday trading session last week, the markets appeared to be expressing exhaustion and have been with overbought conditions for the better part of the last 10 trading sessions. Nonetheless, the YTD rally carried forward on Friday. (Table from Bespoke Investment Group)

From Monday through Thursday, the S&P 500 (SPX) and its peer indices sold-off into the closing bell. Even with a rally on Friday, the Dow Jones Industrial Average (DJIA) finished lower for the week as the transports began to break trend. When it was all said and done for the week, the Dow slipped 0.02%, ending its winning streak at nine weeks. The Nasdaq rose 0.9% and the S&P 500 rose 0.4 percent. With the rally on Friday, the S&P 500 broke and closed above the critical 2,800 level.

It is undoubtedly true or reasonable to deduce that the rally in global equity markets has largely come on the back of a more dovish Fed, liquidity injections from the Peoples Bank of China (PBOC) and to some degree improved liquidity offsets between the Fed and the U.S. Treasury. With regards to the “offsets”, while the Fed continues to unwind its balance sheet monthly, the Treasury Department is dumpling liquidity into bank reserves. This was exampled again this past week when on Thursday the Treasury Department dumped $60Bn of liquidity into bank reserves and on Friday dumped another $90Bn. What does this mean?

Reserves injected back into the banking system through the liability side of the balance sheet i.e. the Fed, incrementally and temporarily improves Dealer LCR/RLAP Liquidity Coverage Ratios. This enables big reversals of GC Repo rationing process come the end of the fiscal year for the big banks. Visually it looks like this.

The Fed and the U.S. Treasury Department are making life very difficult for the permabear camp in 2019 and at least temporarily. In the coming weeks, the U.S. government will need to raise the debt ceiling and this topic will prove a battleground for legislators. Nonetheless, these liquidity measures don’t necessarily offset overbought conditions and the potential for market exhaustion to result in a retracement in the equity markets. No one variable dominates the market short-term.

It is important to understand that just because markets are overbought and most indicators have reached an extreme level, this doesn’t suggest that the market will all of a sudden die, roll-over or play dead. It is a warning sign that suggests further upside in the market is statistically limited compared to the downside risk. In other words, historically the market takes a breather when reaching extremes.

  • Exhaustion is not necessarily a “sell signal”, as the timing of a market retracement is often unknown and to a great degree demands a catalyst.
  • Dow Transports have been lower for 6 trading sessions in a row. This might be the first sign that the market is preparing to turn in the near future.
  • Consider the 10-week rally has brought the SPX/DOW up by 11%+ YTD and the Nasdaq is up 14% YTD. It is highly probable that if one was to sell their equity holdings, they are likely to be able to recapture certain equities at lower prices and/or not miss out on much more gains in 2019. In other words, if the market rally persists in 2019, it is highly probable that it won’t happen with the markets going up in a straight line.
  • When the markets have become this over extended previously, it has generally been a better opportunity to reduce portfolio risks/take profits rather than expanding risk.
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