Are We On The Verge Of A Classic October Crash?

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by: Jasper Lawler
Summary

Recent history has taught us to buy the dip- but (famous last words) this time feels different.

On Wednesday the Dow Jones closed down 800 points and the S&P 500 dropped 3%.

The Strength of the rebound since February is in doubt - the Dow Jones and US yields are at an important juncture.

Recent history has taught us to buy the dip. Even the eye-watering declines in February proved worth buying. On Wednesday the Dow Jones closed down 800 points and the S&P 500 dropped 3%. It’s a big move for one day- but 3% is a natural pullback and many will be buying the dip. But this time looks different. This may not be a dip worth buying.

Strength of the rebound in doubt

The rebound is US equities since the February crash have a few question marks. The rising price of the S&P 500 index has been accompanied by falling volumes- typically a sign of waning enthusiasm from buyers. On the Russell 2000, the stocks most shorted in the February crash have significantly outperformed on the rebound. So short-covering was a significant factor. According to fund flow data, funds from US retail investors (excluding dividend reinvestments) have dried up completely since February. In the past few months, a sign of defensive investing has shown up in the outperformance of high dividend-yielding sectors like healthcare.

Reasons a crash could be on the cards

We are probably all familiar with the risk-factors for today’s market. The trade war, the Italian budget, rising protectionism, a growth slowdown in China, anxiety over US mid-term elections – even Brexit. These are all valid concerns. Emerging markets entered a bear market months ago and European shares have not made new record highs this year. In the US, the impact of these global concerns has been masked by tax cuts which has seen capital return to the country while companies have initiated plans for a record-breaking $1bn in share buybacks. Markets are looking 12 months ahead to when the positive impact of fiscal stimulus fades and voting with their feet.

The real issue: a liquidity crunch

The central concern- that has building and is now rising to the surface is the issue of a shortage of US dollars- and its impact on the price of the dollar and US interest rates. Overseas investors have found it harder and costlier to get hold of US dollars this year. This is an issue when global debt is higher- and dollars represent a higher proportion of that debt- than in 2007. When debt is high, and the cost of borrowing reaches a certain level, the natural result is a rise in defaults and a more difficult time for the global economy. The IMF’s warning this week has clearly hit a few nerves.

Why a crash can still be avoided

The reason many have looked over rising yields and a stronger dollar as an issue is because the US economy looks very strong. The idea of the US sneezing and the rest of the world catching a cold isn’t a worry when the American economy has such rosy cheeks. And with earnings running near 20% y/y, corporations look even healthier.

The current dip in confidence can be allayed were the Federal Reserve to signal it is easing off its quantitative tightening and rates rises. But the Powell Fed has shown more confidence in the face of market uncertainty. We expect the Fed will hold on for the ride. The aim being to signal strength of its policy convictions. The silence from the Fed to this market weakness will be deafening.

Dow Jones and US yields at important juncture

The biggest worry for any fund manager is the inability to diversify- ie when stocks and bonds move down in unison. This what is staring them in the face right now. The chart below shows a potential shorter term double top in the Dow at the same time as a breakout of a longer term double bottom in 10yr treasury yields.

Dow vs US 10yr yields

dow jones vs bond yields

Perhaps fortunately, a flight to safety is pushing bond yields lower this morning- countering the worry about rising rates. If investors are calmly look at the fundamentals, falling rates today should ease fears for equities. More likely though- the previous day’s huge slump means fundamentals are out the window and traders will dive for cover.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.