Thursday, April 21, 2016

The Great Crash of 2016?

At the end of March, Ivan Fallon of the UAE's The National asked, So, what happened to the Great Crash of 2016?:
Whatever happened to the Great Crash of 2016? The year began with the worst few weeks ever across the entire financial system – oil plunging below US$30 per barrel (briefly), commodities crashing, the Chinese economy slowing dramatically, panic spreading across the emerging markets causing chaos in Brazil, Russia and South Africa, and Wall Street, London and all the big stock exchanges recording massive losses.

While most of us felt we had not yet recovered from the 2008-09 recession, the gloomsters were forecasting another one was on the way – except this one was going to be a real whopper, plunging the world into conditions even worse than the 1930s. A highly leveraged international financial system, over-borrowed consumers, and banks that had not yet rebuilt their balance sheets spelt disaster.

Volatility, the market’s barometer of confidence in the markets, hit new highs in the first few weeks of January. The Chicago Board Options Exchange Volatility Index, known as the “fear gauge", was up 13 per cent and hit an all-time peak of 28 in February (the long-term average is 20); the Nikkei Stock Average Volatility Index, which measures the cost of protection on Japanese shares, climbed 43 per cent in just five days.

George Soros said at the time: “China has a major adjustment problem. I would say it amounts to a crisis. When I look at the financial markets there is a serious challenge that reminds me of the crisis we had in 2008." On a panel in Washington in September 2011, he said the Greece-born European debt crunch was “more serious than the crisis of 2008". Lots of crises there. Of course, no one enjoys a good crisis more than Mr Soros, who has made $27 billion riding them, but this time even he was getting scared.

The widespread view at that time was that the market crash was either anticipating something awful or else had the power to cause it. Falling prices would weaken confidence and frighten managements, and governments to take evasive action that could lead to another crash.

And yet two months later it does not look so bad. Oil, which hit a low of $26.03 on February 11, has bounced back by more than 60 per cent. The bears, who looked like masterminds then, now look like fools. They certainly did not see that coming. Commodities and commodity stocks have also staged amazing recoveries: Anglo American hit an all-time low of £2.15 in January and two months later topped £6 despite – or maybe because of – announcing a £5.5bn (Dh28.6bn) loss for last year. Most of the other big mining and oil stocks have also staged recoveries, albeit less spectacular than Anglo: Glencore, for instance is up from 67 pence to £1.50.

The result is that, despite that horrific start to the year, share prices look as if they will end the first quarter of 2016 higher than they started. Wall Street’s “fear gauge" dropped to 15 last week, its lowest level since mid-August – at which point China devalued its currency, sparking a period of financial turmoil.

“Capital markets are basically unwinding earlier fears of a global economic recession," said Michael Underhill, a portfolio manager at RidgeWorth Investments.

James Paulsen, the chief investment strategist at Wells Capital Management, put it more wittily: the market behaviour of the past year, he said, can be “characterised not by a bull nor by a bear, but rather by a bunny that hops about a bit but really doesn’t go anywhere". Bunny markets, he adds, require nimble and opportunistic behaviour by investors – as those who took advantage of the commodity price crash in January have discovered. I met someone over the Easter weekend who was happy to boast of his plunge into Anglo shares at the bottom of the market; and I don’t think he is alone.

At the macro level there is also little sign of the crash we were bracing for. The latest data, published last week, shows the US economic recovery is still intact. In Britain last week, the chancellor George Osborne downgraded his economic forecast for this year to 2.0 per cent growth (marginally worse than the 2.2 per cent I suggested in this column last week) from 2.4 per cent, but the economy is still in reasonably good shape. Europe is slowly – oh so slowly – coming out of its recession, as is Japan, and the markets have built a Chinese downturn into their global forecasts.

So all is well. Or is it? The warning signs that so panicked the markets at the beginning of the year are all out there still: there is still a glut of oil; demand for commodities will not recover until China does, and that could be some time; the fundamental weaknesses among the emerging markets have not gone away. Worst of all is the growing prospect of Donald Trump becoming US president and imposing his protectionist vision on the world: imposing tariffs on Chinese imports, ripping up trade deals and forcing companies such as Apple to bring manufacturing home to the United States.

That’s enough to make any economist quake in their boots.
Fast forward to today, George Soros is still warning that China’s debt-fueled economy resembles the U.S. in 2007-08, before credit markets seized up and spurred a global recession, but nobody seems to care.

In fact, Patti Domm of CNBC reports, Stocks seen getting ready to 'break higher':
Earnings from dozens of companies could set the tone Thursday, but analysts are looking at the action in markets themselves.

On Wednesday oil again defied expectations and moved higher, serving as a positive force for stocks and a negative one for bonds. Stocks were slightly higher, with the S&P 500 up almost 2 points at 2,102, and the Dow up 42 at 18,096.

"What's not to like here?" said Ari Wald, technical analyst at Oppenheimer, of the stock market. "We're expecting the market to break higher." The S&P is closing in on its all-time high of 2,134, set in May 2015.

Wald said he believed the market had shaken off a "bear market" that occurred between the time that high was set last May and February, when risk assets bottomed and began to turn higher.

As for Treasurys, the 10-year yield had a big move Wednesday of between 1.75 percent to 1.86 percent.

"Why on a day when there's no Fed speak, and the only data is existing home sales, why on earth would the bond market have a breakout technical day?" said David Ader, chief Treasury strategist at CRT Capital. "It was clearly a risk-on day. Argentina brought this big debt and it rallied hugely. Clearly, risk is upon us."

Ader said the 10-year yield set a lower low and a higher high than Tuesday.

"An outside event is an important technical event, and this is a particularly important one. The range is even bigger than the day before," he said. Ader said his target on the 10-year had been 1.87 percent but could now move to 1.90 to 1.92 percent.

"This is not a Fed story. I guess to some degree, it's an oil story," he said.

Oil was up nearly 4 percent, while many analysts had expected it to trade lower after OPEC and non-OPEC nations failed to strike a deal to freeze output over the weekend. Since then, Russia, Venezuela and Saudi Arbia all said they could pump more — normally a negative. West Texas Intermediate futures for May rose to $42.63, the highest close of the year.

Analysts said oil was somewhat boosted by a drop in distillate inventories, but also by weekly data that showed another 24,000 barrel decline in U.S. oil production to 8.9 million barrels a day.

"I think the market continues to push higher on expectations that we'll see reduced production levels from U.S. drilling," said Gene McGiliian, analyst with Tradition Energy. But the trend in production had been heading in the same direction for weeks, and the government data brought no real surprise, he added.

"We saw another wave of technical buying. We saw a record amount of open interest in Brent," he said.

"I think we'll continue to see speculative length. There's a lot of money pushed into commodity funds in the past week. It seems as if a lot of the fears we saw earlier this year and the slowing economic conditions, particularly in China, seem to have evaporated," said McGililan.

"Even though we didn't' get a production freeze – a lot of people are banking on this expectation that the production cut is going to come from North America."

Energy stocks gained 0.8 percent Wednesday, and is one of the top three major sectors year-to-date, up more than 10 percent.

"If that was a bear market…what we would expect to see is that resumption of strength," said Wald, noting the move in the energy names supported his thesis. "We'd expect to see internal breadth broaden. We'd expect to see leadership by the major broader names, credit conditions improve and commodities stabilize. We're seeing all of that."

Wald said the advance/decline line was at its highest level since February.

Paul LaRosa, technical strategist at Maxim Group, said there could be a sell-off in the offing after the recent run up, but it would be shallow if so.

"It's much better quality than the rally we had last fall. I'm much more encouraged that any dip that comes will be much more controlled will be met with buyers. But I don't think we break to new highs and go substantially higher. We've had such a good run it makes sense we had a broader correction," said LaRosa.

Some analysts expect to see the first quarter mark the trough of the earnings recession.

"If there was concern about the earnings season, it was already priced into the choppy behavior we had in the first quarter. We're still in a place where a lot of people missed this move. A lot of institutional accounts are underinvested. I think we'll continue to climb this wall of worry. There's still some skepticism in this advance. We're still far from extremes," said Wald.

Earnings are expected Thursday morning from General Motors, Novartis, Biogen, Travelers, Blackstone, Bank of NY Mellon, Under Armour, Union Pacific, Alaska Air, Southwest Air, KeyCorp and Quest Diagnostics. Google parent, Alphabet and Microsoft report after the close.
The key here is that last paragraph I underlined where a lot of institutional investors remain underinvested. Julie Verhage of Bloomberg reports, Clients continue to doubt the U.S. stock market rally:
Welcome to Dow 18,000. You're going to love it here. Or not. Some of the biggest investment managers on Wall Street certainly don't seem to.

New research from Bank of America Merrill Lynch and JPMorgan Chase & Co. underscores the degree to which the banks' biggest clients remain hesitant to believe that the recent rally in U.S. stocks will continue. BofAML notes that last week, when the S&P 500 Index was up 1.6 percent, its customers were net sellers of stocks.

It's the 12th week in a row that has seen big investors eschewing equities, BofAML said, though the rate of such selling does appear to be moderating.

"The pace of selling slowed for the second week, but persistent sales suggest to us that clients continue to doubt the market rally," BofAML's Jill Carey Hall and Savita Subramanian said in the note.

On the plus side, BofAML notes that hedge funds were last week net buyers of stocks for the first time in about two months. However, even that nugget of cheerfullness may be susceptible to pessimism.

JPMorgan's prime brokerage team, which provides services for hedge fund clients, noted in recent research that many of its customers have been busy buying stocks to cover short positions betting that equities will fall.

"March brought the heaviest net [short] covering seen by the prime brokerage in several years," they said in a note published late last week. "Activity was skewed towards single names but [exchange-traded fund] activity also was strong. All sectors experienced net covering, with energy and consumer, [and] cyclicals in the lead."

Investors first became skittish when the stock market had one of its worst starts to the years on record, trickling into everything from the market for initial public offerings to startup valuations. Each period of bullishness has been followed by worries over global growth, low oil prices or what happens in an economy with less action from central banks.

Since the lows of the year reached in February, the S&P 500 has rallied roughly 15 percent.
Just as I thought, a lot of the big moves we witnessed in March in energy (XLE), metals and mining (XME) and industrials (XLI) were driven by hedge funds covering their shorts.

So what happens now going forward? Dani Burger of Bloomberg reports, Quant Buying May Add `A Few Percent' to Stocks, Kolanovic Says:
The unleashing of $100 billion into the U.S. stock market by computer-driven quant funds would boost benchmark indexes by a few percent, though after that buying may dry up, according to Marko Kolanovic, the JPMorgan Chase & Co. derivatives strategist.

Speaking Wednesday on Bloomberg Television, Kolanovic expanded on research reported yesterday that said the Standard & Poor’s 500 Index has reached a level above 2,100 that may trigger momentum buying by automated, trend-following strategies. Should the S&P 500 remain there for a few days, it could coax $80 billion to $100 billion worth of inflows, Kolanovic said.

Other automated managers that use volatility and risk parity strategies already own a lot of stock and that leaves trend-followers as the last group with room to buy, he said. Kolanovic has built a following on Wall Street with predictions on how sophisticated quantitative funds will react to volatility, valuation and other market inputs.

“If we see this type of trend following inflows into equities, that will probably be the last leg. I don’t see many more buyers in the market after that point,” the New-York based head of quantitative and derivatives strategy said. “Multiples are pretty high and systematic funds apart from CTAs are fairly leveraged, so they will probably be the last buyer of the market.”

Should the market reverse recent gains and the S&P 500 fall more than 2.4 percent from here, CTAs may start selling. At the 2,030 to 2,050 range, momentum becomes negative and it could “turn things ugly,” Kolanovic said.

The gauge breached the 2,100 level for the first time in four months on Tuesday, putting it only 1.4 percent away from an all time high. The S&P 500 was little changed at 2,099.73 at 10:24 a.m.
As someone who used to invest in the world's best CTA funds, I take this research very seriously as it highlights the importance of quant funds in these markets when technical levels are breached.

In other words, just because stocks had a big move from their bottom based on hedge funds covering their shorts, doesn't mean they can't go higher as CTAs and big trading outfits engaging in carry trades (using the yen or euro as funding currencies) can push stocks a lot higher.

But I remain very skeptical of all these moves and think that once fundamentals catch up to the quants, things will reverse very quickly.

Below, Ari Wald of Oppenheimer and Chad Morganlander of Stifel Nicolaus discuss the relationship between oil and stocks with Brian Sullivan.

And Bloomberg reports on George Soros's warning that China’s debt-fueled economy resembles the U.S. in 2007-08, before credit markets seized up and spurred a global recession.

Third, Tony Dwyer, chief market strategist at Canaccord Genuity, looks at the climb back to 18,000 by the Dow Jones Industrial Average and why he feels the Federal Reserve is behind the curve on inflation and the U.S. economy. He speaks on "Bloomberg Surveillance."

Fouth, Brian Belski, BMO Capital Markets provides his outlook on the markets and reveals where he is seeing the best investment opportunities, including a "generational opportunity" in financials.

Fifth, Bloomberg's Tom Keene speaks with Jim Paulsen of Wells Capital Management and Anastasia Amoroso, global market strategist at JPMorgan Funds, on "Bloomberg Surveillance."

Lastly, the Credit Suisse Fear Barometer is near record highs, signalling investors are panicky. Dennis Davitt and Rich Ross discuss with CNBC's Dominic Chu. Is the Great Crash of 2016 still ahead?

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