The 'Number Of The Beast' Strikes Again

The "Number of the Beast" is 666. In our case, it was 665.75, the magnitude of the point decline of the Dow Jones Industrial Average last Friday, after sharp sell-offs in both stocks and bonds. It finally sunk into investors' minds that the Federal Reserve was likely to up the pace of quantitative tightening as some regional Fed surveys suggested the economy was running "hot" with 1Q GDP on track to be up over 5%. (In an odd coincidence, the S&P 500 bottomed out at 666 at the start of this bull market in March 2009.)

What gives? Earnings are accelerating yet stocks are sliding. This makes no sense, right?

Actually, there is such a thing in the stock market called "prices getting ahead of themselves." The types of extremes to the upside that I have seen in January 2018 I had not seen since November of 2008, when I saw extremes of similar magnitude to the downside. For example, let's look at some widely used indicators such as 50- and 200-day moving averages. When that difference is expanding to the downside, we have a strong downtrend. When that difference is expanding to the upside, we have a strong uptrend.

Dow Jones Industrial Average Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The difference between the 50- and 200-day moving averages had been expanding for so long that at last count it stood at 2313.53 (25016.11 minus 22702.58), the widest such difference we have seen since the latest bull market started on March 9, 2009. The only other similar divergence to the upside that I recall was in the Nasdaq in early 2000. Still, I don't recall such momentum buying in the Dow in my lifetime.

These two key averages tend to move away from each other to the downside too. For example, on March 9, 2009 - the last bear market low - the 200-day moving average stood at 9741.38 while the 50-day stood at 7930.60, or a difference of 1810.78. The difference between the 50- and 200-day moving averages in this latest extreme to the upside is bigger by almost 500 points than the last downside extreme. We could get into a discussion of whether the numbers are more meaningful on a linear or logarithmic scale, but in both cases, we witnessed significant extremes in the market, one to the upside and one to the downside.

We would not know if we have made a top in the stock market until after the fact. Tops are much different than stock market bottoms as they tend to form over much longer periods, like 6-12 months, while in many cases bottoms are climactic events. Some climatic bottoms in the stock market were March 9, 2009 as well as lesser-known bottoms in March 2003, October 2001, and October 1998.

I actually think the chances that the stock market makes more new highs in 2018 are good given the accelerating profits picture, but with increased Fed fund rate hikes and quantitative tightening, it is highly unlikely that the year 2018 will be as profitable as 2017. It may look more like 2015 or 2016.

The Expected Culprit for the Stock Market Sell-off is Bonds

The 10-year Treasury yield closed at 2.84% on Friday and given the downside momentum in the stock market it is now a foregone conclusion that it will cross 3%. If it happens this week, I think the Treasury market will cause more pressure on the stock market and it would be a perfect welcome for the new Fed Chairman Jerome Powell who starts on the job this week. As I have suspected all along, the markets were likely to test the new Fed Chairman, but I did not suspect that it would happen in his first day on the job!

United States Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

How high could the 10-year yield go? My working assumption is that the bond market may calm down in the 3.0% to 3.5% range, even though markets have been known to overshoot both to the upside and the downside. A key question here is not only how far the 10-year yield goes, but how fast it gets there. If we cross 3% to the upside this week, I would expect more sharp selling in the stock market.

This is an overdue correction in the stock market, which would put a target anywhere between 5% and 10%. I remember the time when even 15% corrections were considered normal and, given the speed of rise in Treasury yields, overshooting beyond 10% is clearly a possibility. I seriously doubt we have started a bear market in stocks, though even given the strength in the economy, if the new Fed Chairman Jerome Powell is not too careful with his QT operations he has the power to cause a recession.

I think he knows that.

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