Stock Market: Non-Standard Behavior

Includes: DIA, SPY
by: Acting Man

Possible Post Election Plunge Triggers

We sure got that one wrong, at least in the short term. We expected the market to be relieved that everything stayed as it was after the election. Of course we cannot test what would have happened had Mitt Romney won. The market may have sold off anyway. In fact, Mish theorizes here that the temporal sequence of the selling seems to suggest a different trigger than the election outcome altogether, namely very bad economic news coming out of Europe.

While some named the so-called "fiscal cliff" as the selling trigger – on the theory that the market is worried that the configuration of a Republican House of Representatives and a Democratic Senate and Administration may forestall a compromise ahead of the automatic spending cut deadline, this is somewhat blunted by the fact that presumed House Speaker Boehner showed himself conciliatory and ready to compromise, specifically on "new revenue" – tax hikes. Of course, the market doesn't necessarily like tax hikes, but as long as they're not taxes on dividends and capital, it should take such news in stride.

Meanwhile, the economic data coming from Europe are indeed grim. Specifically, German industrial output plunged far more than expected, by 1.8%, led by a 2.3% manufacturing output decline.

The latest plunge in Germany's industrial output was the biggest since April 2009

Mario Draghi's Downbeat Assessment

Negative sentiment in Europe was already growing following a string of weak final service PMI data and Composite PMI data that have emerged over the past two days, but were initially ignored as the focus shifted to the U.S. election.

Yesterday, Mario Draghi delivered a speech to German bankers in Frankfurt and gave a fairly gloomy assessment of the economic situation and outlook in the euro area, specifically noting that the effects of the crisis are spreading to Germany's economy as well:

“Unemployment is deplorably high. Overall economic activity is weak and it is expected to remain weak in the near term. And the growth of money and credit are subdued.

In this context, inflation is well contained. We expect it to fall below 2% next year.

Germany has so far been largely insulated from some of the difficulties elsewhere in the euro area. But the latest data suggest that these developments are now starting to affect the German economy. This is also evident in the KfW-ifo-Mittelstandsbarometer.

Germany is an open and integrated economy, so it is not surprising that a slowdown in the rest of the euro area has an impact here. Intra-euro area trade amounts to around 40% of German GDP. And around 65% of foreign direct investment in Germany comes from other euro area countries.”

(emphasis added)

Evidently, the markets were just looking for excuses to sell off, and this provided another one.

Technical Conditions and Sentiment

As we have pointed out two days ago, the bears have been unusually timid in the recent correction. This was surprising, given the breakdown in many momentum stocks and the high beta sectors of the market. Yesterday's gap down open and subsequent selling finally created more demand for puts:

The CBOE total put-call ratio begins to spike higher

However, this is not yet enough – over the past three years, market lows required spikes to the 1.40 to 1.50 region in this indicator. Most other sentiment data we are watching have also not yet budged sufficiently. In fact, the data we have discussed in the recent article on "timid bears" have not seen any noticeable changes at all – it is not worth showing them again at this juncture.

Perhaps the SPX will test its 200 day moving average and then reverse, but to this it should be noted that many other market sectors have broken down much more noticeably. Moreover, even if one goes by the still relatively strong SPX, all buyers over the past three months are now underwater, which creates resistance.

The SPX is approaching its 200 DMA in a hurry

A quite important technical juncture has in fact been reached, as was pointed out last night by Schaeffer Research. If one looks at the heavily traded S&P 500 ETF SPY, it has closed slightly below the $140 level yesterday:

The S&P 500 ETF SPY – it sits now at the first lateral support level

Not only is the 140 level the first line of lateral support, it is also home to the biggest amount of put strikes on the ETF:

Open interest in SPY options by strike price. The 140 level is home to a huge amount of puts

Normally, a strike price with such huge put open interest will provide technical support. However, it becomes a problem when it is broken decisively, as then a decline is usually magnified by delta-hedging (i.e., the writers of the puts will attempt to protect themselves by selling the underlying instrument short). In that case, the next strikes with large open interest will become potential support points, but obviously, the 140 strike is currently the most important by far.

Given insufficient support by sentiment data, the large put strike may well be breached. Also, the NDX simply looks ugly – it gapped below its 200 day moving average yesterday. The best thing that can be said about it is that it is beginning to become slightly short-term oversold:

The NDX is looking ugly -- it has gapped below its 200 day moving average and trading volume has increased noticeably in the sell-off.

Historical Market Behavior in Election Years

So why is what has happened "non-standard behavior"? Because the market has a statistically well-known tendency to rise in the second half of a presidential election year. The average of the near-term moves around the election can be seen below:

Average S&P close around elections, via Deutsche Bank

A longer-term historical election year chart put together by Barclay's is depicted below. Interestingly, the market was following the historical average pretty well until recently:

The average movement of the DJIA in election years since 1900 compared to this year's move

The conclusion from this is that unless the stock market recovers fairly quickly, we are looking at one of the "exceptions to the rule." Such exceptions are usually an ill omen. The last ones occurred in the years 2000 and 2008, which suggests that the "exceptions" happen more frequently in secular bear market periods than secular bull market periods. Note also that the obscure indicator we discussed yesterday is indicating trouble for the market in the year ahead.

Given that the market rises about 66% of the time (an artifact of monetary inflation), it is clear why the exceptions have so little influence on the historical average. However, experience tells us to regard exceptional market behavior that deviates from well-worn seasonal tendencies as a big warning sign.

Lastly, here is a chart that shows the diminishing returns from "QE" and other monetary pumping measures. Note that the first settlement proceeds from "QE3" are expected to arrive in mid-November, which may lend support to prices. However, eventually we expect such monetary pumping to produce a negative market return, as it does more and more damage to the economy on a structural level. Once too much scarce capital has been consumed and real resources are no longer sufficient to allow for them to be diverted into bubble activities, excess liquidity may simply begin to flow somewhere else.

Diminishing returns: "QE" and the S&P 500 index

Charts by: stockcharts, Scheafferresearch, Deutsche Bank, Barclay's, US Global, Markit