Analysis, Perspective, Trading Strategy
Cash Is King and this Stock Market Needs an Energy Drink
By Joe Duarte on June 24, 2018
As Steven Tyler of Aerosmith once crooned in the
classic hit “Sweet Emotion” - “my get up and go musta got up and went,”
cash is king and the stock market seems in need of an energy drink.
Rising interest rates and the prospect of further rate increases
by the Federal Reserve are starting to drain the bull market’s energy.
In my prior note (June 17, 2018)
I described a scenario where the lure of higher yielding treasury
bills, money market deposits and other income producing low risk investments
would eventually attract enough investors and thus cause a sluggish
stock market as money flowed into cash. Unfortunately after last week’s
crushing decline in the major indexes, it seems reasonable to consider
that the process maybe well under way. And while these trends take
a while to be fully evident, this week, I want to expand on the mechanics
of this unfolding process as well as to provide a historical parallel
which seems to be repeating at the current moment and can serve as
a guide as to what may happen next.
Is History Calling?
As usual I will start with the New York Stock Exchange Advance Decline
line (NYAD), the invaluable indicator whose accuracy regarding the
stock market’s trend has made its analysis indispensable since the
2016 election. But before looking at the present, let’s have a look
at what happened to NYAD in 1994, a period where the actions of the
Federal Reserve were similar to the present.
In 1994 the Federal Reserve, after a three year period of lower interest
rates to aid in the recovery after the now forgotten savings and loan
crisis and banking meltdown, raised interest rates from 3 to 5.5% starting
in February - leading to a bond market rout where the U.S. Ten Year
note yield (TNX -middle panel bottom row of indicators) rose from 5.5
to 7.9%. The result was a meltdown in the NYAD and a very choppy trading
pattern for the S & P 500 (SPX). Most significant, from a charting
standpoint, is the February to April period as the effect of suddenly
rising interest rates led to a highly volatile stock market in which
SPX dropped a full 10% before bouncing in April and July before finally
falling apart by September.
Flashing forward to 2018 we can see that so far the stock market
(SPX) has slowed its advance and has entered a trading range between
2580 and 2820 after the January swoon in stocks. It is troubling to
see the index behaving this way even as the NYAD has made several new
highs. Interestingly the plot of the U.S. Ten Year note yield (TNX,
middle panel of current NYAD chart) is eerily similar to the 1994 plot,
both in scope and trajectory. Indeed, it’s a bit unnerving that SPX
took a dip in February, similar to its 1994 decline and that it is
also struggling in the present as it did in 1994.
A closer look at the money flow in SPX suggests
traders are struggling with the market direction as the Accumulation
Distribution (ADI) indicator has rolled over along with ROC while On
Balance Volume is trying to improve as the index gropes for support
at the 20-day moving average.
FAANG Stocks Seem Tired As Market Turns Sluggish
Although the Nasdaq 100 (NDX) recently made a new high, this was
likely influenced by the likes of Netflix (NSDQ: NFLX) and the rest
of the FAANG pack of stocks, whose market valuation heavily influences
And although these stocks (FB, AAPL, AMZN, NFLX,
and GOOGL) have been money magnets carrying NDX higher for most of
the year, a look under the hood of AMZN, a stock which is representative
of the entire group, shows negative money flow is increasing, as investors
start bailing out.
Especially alarming is the nearly broken down On Balance Volume on
NDX coupled with a rapidly falling ROC; the latter indicating a loss
of momentum. You can see similar indications on the AMZN chart as well.
Even more concerning is the lower low registered by ROC during each
subsequent new high in NDX and SPX over the past twelve months, a sign
that each new high in the indexes has been reached on lower momentum
than the preceding rally.
Is it time to fade the next Rally?
We may be near the point where even a good shot of caffeine, amino
acids, and vitamins may not fully energize the stock market, at least
for a while. That’s because higher interest rates are usually the death
knoll of bull markets and there are now persistent indicators that
we may be closing in on that inflection point where investors realize
it’s less risky to earn interest in cash than to throw money into the
markets just to have the robots take it away.
In 1994, because interest rates were at 3% when the Fed started raising
interest rates – compared to near zero in 2015 when the current cycle
started – the stock market swooned soon after the central bank started
its moves. This time around it’s taken longer for the stock market’s
struggles to begin as rates remained historically low even after three
or four hikes. But, based on what I’m seeing at the moment with rates
above 1.5%, the inflection point is either close at hand (weeks away)
or has already passed. That said, it’s not certain, although not completely
out of the question, that the stock market will crash. Instead, as
best as I can tell at the moment, it seems as if there will be attempts
to take stocks to higher highs from current levels at least for a while
albeit with each rally being pushed by ever failing momentum. Accordingly,
until proven otherwise, I’d say the odds of the rallies failing are
well above even.
Thus, as I’ve said before it’s a good time to trade small lots (if
you trade at all), to increase hedges, to reduce longs during rallies
and to put any new money into the confines of cash accounts which.
It also makes sense to use rallies to lighten up on stocks and ETFs
unless they are inverse ETFs used in hedging. Finally, if you’re looking
for a reference point as to where the Fed may stop raising rates, history
shows that the so called “sweet spot” – the range where the Fed thinks
GDP can grow at 3% with inflation under control is a Fed Funds rate
between 2.5 and 5%. We are nowhere near that destination, which likely
means that stocks will need energy drinks for the foreseeable future.
Joe Duarte is author of Trading
Options for Dummies, now in its third edition. He writes about
options and stocks at www.joeduarteinthemoneyoptions.com.
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