Oversold Rally Should Be Short-lived
Looks like the Oversold Rally this week is sending stocks higher. Personally, I think stocks rallied sharply on Tuesday because they were oversold. I don’t think Powell’s comments, which I will get to later, had much to do with the rally.
Stocks were oversold in the near-term. That’s why I suggested for a few days that there could be a big rally. This rally doesn’t change anything as the economic data is still weak and there is still a trade war with China.
Also, this rally is a great opportunity to short stocks. A full 10% correction is coming soon and the odds of the market hitting a new high are low. A recession causes stocks to fall 26%.
Therefore, this decline prices is an 18.8% chance of a recession.
Oversold Rally - As you can see from the chart below, the treasury spread shows there is a 29.6% chance of a recession in the next year.
It’s worth noting that this probability only got above 70% prior to and during one recession since 1960 which means it is very high now. It only got slightly above 40% prior to the last recession.
Only in the late 1960s did the percentage get this high without a recession occurring relatively soon. This supports the thesis that the stock market should be pricing in a higher recession risk, hence, why I see a 10% correction coming.
Oversold Rally - Specifics Of The Tuesday Rally
Oversold Rally - Tuesday was the 2nd best day of 2019 which isn’t surprising because the rally in the first 4 months of the year was placid. Stocks went up slightly almost every day.
Without losses, gains can add up quickly even if stocks move in small increments. S&P 500 was up 2.14%. Nasdaq was up 2.65% as it recovered from the regulation related selloff. And, Russell 2000 was up 2.62%.
Tesla stock had its best day of the year as it increased 8.17%. Tesla is the poster child for stocks that got oversold. I’m not bullish on Tesla or the market in the next few months, but stocks can’t fall every day.
VIX fell 10.02% to 16.97. It’s going to go higher before this correction is over.
This sharp rally in stocks could be a sign the decline is about to get more violent.
CNN fear and greed index increased 3 points to 26, just exiting the extreme fear category. Every sector increased except real estate which fell 0.56%.
Utilities were only up 4 basis points. The best 2 sectors were tech and materials which were up 3.26% and 2.76%. In the past 2 days, the materials sector is up 6.05%. Exon Mobile is up 3.98% in that period.
Powell Not As Dovish As Bullard
Oversold Rally - The Fed often likes to set out trial balloons to see how the market will react. For example, without the Fed committing to a cut, Bullard mentioned how a cut would be possible.
Then Evans said the market wants a cut. Then on Tuesday Powell made a statement. He wasn’t as dovish as Bullard. However, the Fed funds futures market barely reacted. That’s why I don’t think his comments caused stocks to rally.
The fact that the odds didn’t change much despite his comments not being dovish shows us the market is entrenched in its expectation for a cut soon.
Specifically, Powell mentioned, “recent developments involving trade negotiations and other matters.” He said, “the Fed does not know how or when these issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”
Closely monitoring the developments of the trade war doesn’t sound like he’s ready to cut in June. I don’t think the Fed will cut in June; there is a 15.8% chance of a cut in June according to the Fed funds futures market. It was recently above 20%.
It’s notable that Powell never said the word ‘patient’ in his statement.
Oversold Rally - He probably left that out because it suggests the Fed won’t act. While the Fed won’t cut rates in June, the Fed is expected to cut rates in September. Powell would be suggesting no cut is coming in September if he said he was patient.
Also, Powell doesn’t want to commit to cuts yet, But he also doesn’t want to take them off the table since the market thinks there is a 91.7% chance of a cut by September.
That being said, the Fed will need to commit to a cut this year at the June 19thmeeting which is only in 14 days. Personally, I can’t imagine the Fed not saying it will cut at least once this year at that meeting. It would be an obvious mistake. It worries me slightly that Powell wasn’t outright dovish.
Oversold Rally - Temporary Tuesday Treasury Selloff
Oversold Rally - There was a quick selloff in treasuries on Tuesday which I suggested would occur late last week. The 10 year yield increased 6 basis points to 2.13%; it has since given back 2 basis points as it is at 2.11%.
Similarly, the 2 year yield increased 5 basis points to 1.88% before falling 2 basis points to 1.86%. Even though the 10 year yield is 25 basis points above the 2 year yield a lot of the curve has inverted.
As you can see from the chart below, when this percentage of the curve is inverted, it always means a recession is coming in a couple years.
Bulls claim most of the inversion is because the Fed is expected to cut rates. However, usually when the Fed cuts rates it’s before a recession. The bulls are hoping if the Fed cuts rates once or twice this year the economy will rebound.
Problem is, the trade war is one of the reasons the economy is weak. The Fed can’t control that. If the trade war is called off, the economy can avoid a recession. That’s probably the bulls’ best bet. I don’t like to bet on hope which is why I’m expecting a 10% correction.
