Why Is The Stock Market Crashing?

Such an annoying question to ask, isn’t it? The correct answer is because people desire to hold stocks less and prefer to hold cash more than they did prior to the crash. The reasons for this are ultimately unknown but we can speculate.

The value of a stock to an investor is the present value of all future expected cash flows, discounted by the risk free rate. If you wanted to be 100% accurate you’d need to use the expected rate from now through the day of each individual cash flow, respectively, but I like to use the 20 year t-bond rate for simplicity’s sake.

Based on this there are two major reasons for stocks to crash: a drop in future expected earnings and/or a previously unexpected increase in the risk free rate.

Market action from Feb 1-8 has basically been marked by the following factors:

  • crashing stocks
  • slightly falling gold prices
  • falling/stable short term Treasury rates, rising long term Treasury rates, with a shift occurring around the 3-5 year duration (see graphic below)

Falling/stable gold prices indicate that investor expectations of future inflation haven’t fundamentally changed in recent days.

There’s no evidence that I’m aware of that indicates that corporate profit expectations are collapsing, in fact, the recent earnings season was upbeat, with positive news & expectations all over the place. But it’s also important to point that after the recent tax reform which is expected to expand deficits (a net positive on corporate profits, as I’ve explained before) one big factor towards rising corporate profits is now 100% priced in, whereas before it wasn’t.

Furthermore, there’s currently no evidence that the Fed is planning on accelerating the expected schedule of 3 rate hikes this year. In fact, at this very moment CME Fedwatch probabilities even slightly lean towards only 2 vs the widely expected 3 rate hikes!

In my opinion, this kind of action more than anything hints at a sudden change in investor expectations in the schedule of Federal Reserve interest rate increases over the coming years.

The one significant factor that I’ve been able to pinpoint is the seemingly subtle change in language in the most recent FOMC statement from January 1 2017. Minor shifts early on in the future schedule of expected rate hikes can have a huge impact on long term rates, since long term rates are basically just a bet on the average rate of short term rates inbetween.

If you do a text compare with previous FOMC statements, the following changes in verbiage stand out:

  • While most previous Fed statements said that “Market-based measures of inflation compensation remain low”, the most recent one states that “Market-based measures of inflation compensation have increased in recent months but remain low”.
  • Furthermore, most previous statements said that “Inflation on a 12‑month basis is expected to remain somewhat below 2 percent in the near term”, while the most recent one states that “Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term”.
  • And finally, another subtle difference is that statements recently always said “The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate”, while the most recent one stated that “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate”.

These changes could indicate that the Fed is beginning to prepare markets for an acceleration in the pace of raising interest rates, not immediately this year, but in the coming years.

This could explain why there hasn’t been a big shift in the rates on 3-5 year bonds, but after that the rates have increased substantially, with the 20 and 30 year Treasury rate (the one I like to use to discount future expected profits) rising by 13 basis points over just a few days. Such an adjustment in the medium to long term schedule of expected rate hikes, without corresponding changes in future profit expectations, can absolutely lead to significant adjustments in current stock market valuations, after which things should continue at the usual pace. For simplicity’a sake you could run a simplified model of present value at constant growth using different discount rates to get an idea of the possible magnitude of such adjustments.

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Most Violent Bear Market Wave Around the Corner?

From the recent EWI newsletter:

Is the most powerful of all waves right around the corner?

The short answer is “YES.”

The long answer will help you anticipate where and when …

First, let’s describe wave 3.

If wave 3 was a superhero, he’d probably be The Flash (though he could be The Hulk).

Like The Flash, there’s no mistaking wave 3’s characteristics:

* It gets to where it’s going in a hurry.
* It usually catches everyone by surprise, and
* You’ll know it when you see it.

Robert Prechter describes third waves in his seminal book with A.J. Frost, The Elliott Wave Principle:

“Third waves are wonders to behold. They are strong and broad, and the trend at this point is unmistakable. … Third waves usually generate the greatest volume and price movement and are most often the extended wave in a series.”

But to truly appreciate the power and lightening-speed of third waves – and be prepared to anticipate one – you must first know how to identify the waves that precede it, namely wave 2.

Here’s what Prechter writes about wave 2 in The Elliott Wave Principle (two words have been reversed to apply to bear markets):
“At this point, investors are thoroughly convinced that the (bull) market is back to stay. Second waves often end on very low volume and volatility, indicating a drying up of (buying) pressure.”
If you’re thinking the description of wave 2 seems eerily similar to today’s environment, you’re right.
On February 23, Robert Prechter’s Elliott Wave Theorist recommended aggressive speculators close their short positions to avoid being caught in a “sharp and scary” rally. Just a few trading days later, the market began a multi-month rebound – wave 2.
BUT … Volume has steadily decreased since that rally began in early March. Volatility is on the rise. And perhaps most noteworthy of all: The investment herd – more specifically, the financial media – has jumped to proclaim the “worst is over.”
All the classic characteristics of bear-market rallies are there. Even a quick online search turns up headlines like:
“Worst of the recession is over” ~ July 7
“Econ Crisis Not Over, But Worst Has Passed” ~ July 8
“June job bounce could mean worst is over” ~ July 7
“Wall St’s fear gauge suggests the worst is over” ~ June 28
Recognizing the personality of wave 2 allows you to prepare for what’s next, a move you really want to look out for, wave 3 – The Flash.
Third waves move far and fast. They make good opportunities for aggressive speculators, but they can become a death knell for longer-term investors’ portfolios.

I certainly agree that the current bear market rally has all the characteristics of a wave 2. How much longer it will last, only time will tell.

This chart, also from EWI, nicely displays the unrelenting optimism that we tend to fall prey to time and again during bear markets:

Bank Index

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Insiders Sell Shares at Record Pace

As markets have headed down south again the Financial Times reports Pessimistic executives cash out of shares:

Growing pessimism about the prospects for a global economic recovery sent stock and commodity prices tumbling on Monday while new data showed that leading US corporate executives were cashing out of their share holdings at a rapid pace.

And it is certainly likely that commodity and stock prices are headed lower while gold will outstrip them all – the deflation trade as Mish calls it.

US government bond yields followed equity prices lower, confounding analysts who had expected that Treasury rates would rise this week as the federal government auctioned off a record $104bn of debt.

I should point out that I was not among those who expected Treasury rates to rise, in fact I said that I expect them to go lower in Inflation Fears vs. Reality. How people can think that $104 billion alone will create a flight out of treasuries in a $10+ trillion market remains to be explained. Does anyone look at the demand side of things?

On another note, what I said in that article about silver applies to all other commodities to a much larger degree, in fact I think silver will recover once those who bought in for the wrong reason, namely inflation fears, are washed out.

Analysts said the market mood was captured by a World Bank report that said the global economy would contract 2.9 per cent this year, compared with a previous estimate of a 1.7 per cent fall. A White House spokesman said later in the day that the US unemployment rate was likely to rise to 10 per cent in the next couple of months.

The downbeat commentary reinforced the view that investors should be more worried about the impact of economic weakness on corporate profits than the possibility of higher inflation and interest rates.

Yes, inflation expectations where out of whack with reality as I pointed out already.

“We have had a great run in equities, emerging market currencies, credit and other risky assets, now people are struggling to justify lofty valuations,” said Alan Ruskin, strategist at RBS Securities. He added: “The ‘green shoots’ argument for the economy was very tentative to start with.”

Executives in charge of the largest US companies sent a signal of their concerns by selling far more shares than they bought this month, according to data based on Securities and Exchange Commission filings.

Share sales by so-called company insiders are outstripping purchases so far this month by more than 22 times. TrimTabs, the investment research company, said insiders of S&P 500 listed companies have unloaded $2.6bn in shares in June, compared with $120m in purchases.

“The smartest players in the US stock market – the top insiders who run public companies – are not betting their own money on an economic recovery,” said Charles Biderman, chief executive of TrimTabs.

The S&P 500 index fell 3.06 per cent to 893.04 – its first close below 900 this month. Analysts noted that the index closed below its 50-day and 200-day moving averages. “This is evidence that the rally since March has been a correction and not necessarily the start of a meaningful multi-year rally,” said Jack Ablin, chief investment officer at Harris Private Bank.

The yield on the 10-year Treasury fell 10 basis points to 3.68 per cent. Crude oil prices fell $2.62, or 3.77 per cent, to $66.93 a barrel.

Earlier, the FTSE Eurofirst 300 index slid 2.6 per cent while London’s FTSE 100 index fell 2.3 per cent. Emerging market equities also fell sharply, with Russia leading the retreat.

Even if for some reason we see another temporary bounce up in the stock and commodities markets, for the mid term it may make sense to look out and be prepared for a continuing implosion of consumer credit, declining production and sales of consumer goods, falling home prices, falling consumer prices, falling interest rates, a stronger dollar and, after a minor initial sell off, a solid and possibly rising gold price.

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Markets Slide Alongside Lousy T-Bond Auction

Markets took a slight hit today. The significant event of the week, maybe even of this quarter was a lousy auction for bonds maturing on 05/15/2039.

They traded as low as 4.13% before the auction and went as high as 4.30% to close at 4.26%, or 13 basis points higher.

Some random observations/expectations:
– Tech stocks, which lead the recent rally, lead the decline today.
– Short interest on some stocks is remarkably low
– In particular I am monitoring commercial property businesses, such as Simon Properties Group, and Vornado, both of them have a short interest of close to 0% in spite of the impending commercial property crunchtime.
– Jobs data on Friday will probably report something between 400,000 to 600,000 nonfarm jobs lost again, based on today’s ADP jobs report.

Nonfarm private employment decreased 491,000 from March to April 2009 on a seasonally
adjusted basis, according to the ADP National Employment Report®. The estimated change of
employment from February to March was revised by 34,000, from a decline of 742,000 to a
decline of 708,000

Whether these are signs that the recent bear market rally is coming to an end…only time will tell.

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