EC US Stock Market – Sentiment And Positioning

Market Drivers

The recent outbreak of a dangerous respiratory illness caused by a new Coronavirus in China was widely blamed for the stock market sell-off on Monday last week. It is undoubtedly true that the epidemic has the potential to severely disrupt economic activity, although it is too early to come to a definitive conclusion about that. Be that as it may, the event actually serves as an excellent example illustrating that the news of the day are incidental to market action rather than causing it.

(Click on image to enlarge)

S&P 500 Index, 10-minute chart. A fairly strong sell-off on Monday last week, a vigorous rebound on Tuesday.

Consider the vigorous market rebound on Tuesday depicted above. Did news about the epidemic get better? Quite the contrary, news on the spread and deadliness of the illness actually worsened substantially. Granted, the rebound failed to completely make up for Monday’s losses, but at this stage the market is certainly not “discounting” the potential economic impact of the epidemic.

We would actually argue that the market was ripe for a setback regardless of the news accompanying it – and it certainly remains vulnerable. After the sell-off on Monday, a headline at Zerohedge informed us that Morgan Stanley analysts immediately concluded that “The Correction Has Begun, But The Fed Will Keep It To 5%“. It is heartwarming to see that the superstitious belief in the magical powers of “potent directors” to prevent market downturns remains alive and well.

We would suggest that if risk aversion actually makes a comeback, there is precisely zero the Fed or anyone else can do about it. Mind, we are not asserting that money printing does not affect interest rates and asset prices, but no-one can control the time lags involved, or which assets will be the beneficiaries. Naturally, we concede that the Fed’s policy bias u-turn in late 2018/early 2019 and the sizable jump in the money supply since last September have helped the recent blow-off type rally in the stock market along.

However, this was predicated on the fact there was genuine fear in the market at the late 2018 correction low and that risk appetites have gradually, but steadily increased again ever since. Furthermore, although some evidence of deteriorating economic conditions has emerged, a recession has to date remained out of sight. As the monthly Merrill Lynch fund manager survey revealed, the combination of renewed central bank largesse and a weak– but not too weak – economy has emboldened previously cautious fund managers to venture back into the market with great gusto.

All these conditions remain in place, but two things have changed: for one thing, stock markets around the world are now trading at far higher levels and multiples– the valuation of the US stock market, in particular, is extremely stretched by historical standards. Valuation is, of course, a long term concern and has no bearing on market action in the near term.

For another thing, there is the current positioning and sentiment backdrop, which may indeed have bearing on short term market action: compared to late 2018 low, it has essentially reached the opposite end of the spectrum. Below are a number of charts that have caught our attention in this context. They strongly suggest that utmost caution is advisable – and should the market reverse and continue to rise in the short term, these indicators will probably deteriorate even further.

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