Last week we highlighted the similarities between the performance of equity markets in 2011 with that of 2015 and it seems others this week have followed suit as I have read several articles comparing the two periods. Interestingly not all conclusions drawn were the same as mine with some chartists literally trying to follow the performance of 2015 to the day with that of 2011. Sorry guys it won’t work like that for reasons I gave in the article last week.
To remind readers, we drew 3 main conclusions from our analysis (which for the record is more indepth than that just discussed last week as there is limited time and space here) being:
- Weakness would continue throughout this week as we approach the start of October
- A retest of the August lows would be broadly seen across the board with some indices making a brief new low
- Aggressive short covering would then immediately follow that had the potential to retrace the majority of the August sell off
This week drew further weakness with most major stock indices retreating towards their August lows with some such as Germany, Japan and Hong Kong making new lows. The local ASX 200 also made a new low with a mammoth fall on Tuesday of 3.8% to a two year low of 4918.
Immediately following this new low we saw aggressive short covering step in and effectively the last two days have seen markets recover the entirety of that drop. That is the price action we were expecting and importantly it delivered, almost identically to that of 2011.
S&P 500 2011 Performance
S&P 500 2015 Performance
It would be fair to say the expectation would be for further buying to step in over the coming days and weeks as markets now work their way higher. The key with short covering rallies is there are rarely any major catalysts and more often than not no underlying change in the fundamentals, that’s what makes them so random and largely unexpected. Appreciating prices squeezes short positions to cover which in turn forces other shorts to cover and so on and the rally is swift and aggressive, virtually non-stop. Catching one of these short covering rallies can turn a trader’s year from a good one to a great one!
As noted last week this short covering rally could drive the S&P 500 as high as 2040 and the ASX 200 to 5400. We would therefore now use any weakness as buying opportunities and ideal entry points for a 2-4 week recovery.
I should also point out that short covering rallies don’t last. Once the scramble to cover shorts end, the buying dries up, the underlying fundamentals haven’t changed and there is regularly a subsequent sell off. The same occurred in 2011 where after the aggressive short covering rally that put on gains of 200 points from the low on the S&P 500, it gave back 140 of those points the following month.
Therefore, this short covering rally is a trading opportunity not one to buy and hold. Profits must be taken!
Another point I wanted to highlight from this week is Carl Icahn’s video warning of a potential market catastrophe where he noted several market risks. One of those has been one which I have discussed several times here, that being the high yield corporate debt market. High yield corporate debt is fancy way of saying junk bonds and I have repeatedly stated will be where the next GFC-style collapse will occur. The low to zero rate policies of central banks around the world forced investors into riskier bonds to gain a higher return. The demand for such high risk bonds was so great that the premium earned on holding them at one point was near as close to zero, over and above the lowest risk assets – US Treasury bonds.
This chase for returns without any regard for the underlying risk of an asset is exactly what occurred with subprime mortgages in the last bull market. Eventually home owners couldn’t pay and declared bankruptcy leaving investors with huge losses.
The same is being repeated but rather than suspect home owners borrowing money they can’t afford, it is now suspect corporates. In truth, some cases the companies were not deemed high risk, such as oil producers, but when the price of oil more than halves forecasted cashflows are no longer what they were expected or needed to be. This is a problem for many oil producing nations too that have Government budgets and debt based upon the assumption oil prices would remain above US$90/bbl forever.
So there is a looming major catastrophe building in global markets that all investors should be wary of. We have used the High Yield Corporate Bond ETF – HYG – listed on the ARCA exchange in the US as a signal for corrections in the S&P 500. Refer to one of my earlier articles for the indepth analysis of the relationship between the two. But clearly as seen below these bonds are continuing to deteriorate in value which again supports we are in the very late stages of this bull market so profits need to be taken during rallies. This is no longer a buy and hold market.
