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Reaping Early Benefits of Inflation in Stocks

Published 06/05/2020, 11:30 AM
Updated 05/14/2017, 06:45 AM

Something big to move stocks is brewing under the surface – Treasuries are down, the U.S. dollar is under pressure, gold refusing to decline much. I think it's the market's growing realization that all the post-corona money printing, stimulus bills, will be hugely inflationary, and the participants are coming to grips with that realization. Will stocks provide a shelter?

S&P 500 in the Short-Run

Let’s start with the daily chart perspective (charts courtesy of http://stockcharts.com ):

As the S&P 500 was again reaching for new highs, the action attracted more participants. The temperature is rising, and stocks didn't get anywhere yesterday. They're still trading inside the bearish wedge (thin red lines connecting April tops at its upper border, and May bottoms at is lower border) as it's nearing its completion.

I wouldn't write off yesterday's action as a daily consolidation. These were my thoughts from yesterday about the extended daily indicators, stock prospects and fundamental drivers:

(…) e.g. RSI is approaching the 70 level where it months ago used to muddle through before rolling over. For how long can they keep rising day in and day out – is the daily grind higher like clockwork sustainable? I don't think so, as every healthy uptrend needs to be punctured by the occasional sideways or down price action to make it sustainable – indirect Fed support present or not.

Please recall also the February bearish wedge – the predictable measured rise, and what came next. While I don't say that stocks are due such a watershed moment, for such a momentuous plunge with lasting capacity, I expect hesitation, sideways trading and an attempt to push prices lower in what I would describe as an opening stage in the summer doldrums. Yes, we're in a stock bull market but no tree grows to the sky (in one line, stocks especially).

What could drive that fundamentally? A growing realization that the (protests) are not a several days' event? .... Can't that help bring about some form of the dreaded second coronavirus wave in around eight weeks?

Curfews or lockdowns, what good will that do to economic activity, reopening and small business wanting to just get back on their feet? And what about the potential to play the China card to divert attention from issues at home?

These are serious fundamental risks to the stock advance in the short- and medium-term. Sure, the Fed stands ready to act, and should things start getting out of hand, they will act – and as we've seen during the once-in-a-lifetime reaction to corona getting exponential (not even during the Spanish flu did the economy grind to such a screeching halt, fiat or not), the central bank would sooner of later overrride whatever deflationary forces might have had the upper hand in the short run.

Looking at yesterday's trading only, what events have actually had the power to bring the stock bull down temporarily?

First, it was the Trump threat to block Chinese airline flights to the U.S., which also coincided with the intraday upswing in the USD Index.

The second fly in the ointment was continuing jobless claims that instead of falling to just over 20,000K, rose to 21,487K. But stocks soon recovered from the shallow sub-3,100 dip.

Overall, it's just about China (remember the runup to Friday's Trump press conference?) and whatever happens with the Fed's printing press.

This is what I wrote as we approached today's nonfarm payrolls:

Yesterday's new unemployment claims moved below 2,000K – and the market viewed it as a success (the datapoint's downtrend continues). Sure, the June figures will likely keep getting better, just as May was better than April. Today's nonfarm payrolls will likely take a cue from surprisingly strong Wednesday's nonfarm employment change, and beat expectations.

That means the economy will be perceived as being on the mend, putting a floor below any temporary S&P 500 downswing we might see shortly – regardless of the daily chart's bearish wedge.

While the S&P 500 hasn't been trading with high volatility, the general air of calmness is deceiving, and a bigger move is about to unfold.

There are several omens that point in the prevailing direction of the upcoming stock move. Enter bonds.

The Credit Markets’ Point of View

For the first time in quite a while, high yield corporate bonds (HYG ETF) closed lower, justifying my call yesterday for a short-term consolidation as a minimum. It wasn't that hard to reach such a conclusion, because of Wednesday's daily reversal candlestick after the preceding prolonged runup.

While the price action is bullish, corporate bonds might attempt to break below yesterday's lows. The volume though says that this is a consolidation, not a reversal, which is why I think the HYG ETF will power higher. Investment grade corporate bonds (LQD ETF) confirm this opinion, because their decline happened on relatively lower volume. And as the ratio of high-yield corporate bonds to investment grade corporate bonds (HYG:LQD) stood still yesterday, these factors bode well not only for corporate bonds, but also for stocks.

In line with the above observations, yesterday's downswing in high yield corporate bonds to short-term Treasuries appears as merely a blip on the daily screen that stocks largely ignored.

That doesn't mean though that stocks might not be getting too complacent. At least, that's what the favorite volatility measure, the VIX, says:

Refusing to move lower much further, stocks declined a little in response. If you look carefully at VIX, you'll see that it's been also trading in a wedge pattern – this time, in a bullish wedge. And as breaking below its lower border hasn't succeeded for two days in a row already, what does that mean? Rising volatility in all likelihood. And I think that the bears will be surprised by the prevailing directional move.

Are Treasuries trying to tell us that the rising volatility would come on the heels of another push higher in stocks? Looking at the two charts below, that's what I indeed see.

Treasuries are falling down across the board, which means that yields in the deepest of safe-haven markets, are rising. I think that this marks the rush into riskier assets, a rotation under way, with the Fed remaining as an ever larger buyer in the Treasuries market, relatively speaking. Treasury yields will thus remain lower than they would have been absent the interventions, and the fiscal deficits will remain serviceable. Unless the bond vigilantes show up one day.

That's what financial repression looks like – everyone is happy, and only the pension funds and people living off fixed income can't get returns that would keep up with inflation. Sure, the outlook for TIPS is better than for other Treasuries, but I guess it's clear.

And it's the prospect of inflation that is working its way through the system, that drives the stock bull run as well. That's why the stock bull market has much higher to run – just think about all the money sitting on the sidelines in bond funds waiting to be deployed, still looking for the other shoe to drop and none is arriving.

Another subtle sign of the run into equities is that corporate bonds aren't likewise crashing or leading to the downside. Conversely, even the safest investment grade ones are holding value much better than Treasuries. And I've already covered the stronger showings of high yield corporate bonds over their safer counterparts.

But there is more.

The USD Index is rolling over as I called for it to do later this year, and I think we're witnessing the opening stage. While the daily indicators are conducive to a rebound, and so is the vicinity of a major rising support line (the 200-week moving average on the USDX weekly chart, currently at 96.27), I think the greenback will rather muddle through with a sideways-to-down bias over the coming months.

But this is not about the USDX as such, but about its influence on stocks. The key takeaway here is that it won't be an obstacle to rising stocks regardless of whether it goes down, sideways, or a bit higher over the coming months. Given the strongly positive jobs data arriving (2,509K non-farm payrolls with unemployment rate decreasing to 13.3%), the dollar could have staged a rebound. The fact that it doesn't, is
telling, and supports my thesis of the dollar not really rising (there aren't such deflationary pressures anymore) but rather rolling over and going sideways-to-down. This short-term dynamic means that unless the greenback makes really bullish moves, stocks won't come under significant selling pressure.

Inflation is coming, that's what the many asset classes are telling us. These were my parting thoughts yesterday:

Given the Fed's and fiscal measures taken (they're joined at the hip, because where would all the new Treasuries to buy come from if not from deficits?), the odds favor the Fed to keep at winning this reflationary game right now.

Good for stocks for they don't love many things more than money printing.

Summary

Summing up, yesterday's hesitation in stocks went hand-in-hand with a decline in corporate bonds. The bearish wedge meant that the S&P 500 was vulnerable in the short-term to a temporary takedown, regardless of the strong showing of the early bull market trio (energy, materials and industrials). We didn't get much in terms of a temporary pullback in the index, again confirming that we're indeed in a bull market, where money is to be made rather on the long side. While the intraday sectoral dynamics favors much more upside to come, it's the debt markets' performance that is the cornerstone of my bullish outlook.

Latest comments

You're good, and often great.  You save me a lot of time and many headaches by laying out the index's relationship to corporate debt, usd, etc.  My strength is charting, especially S&P Futures (ES).  In general I'm seeing what you are.  If this move up from mid May continues as a measured move it could take us to a fib extension just above/below 3500.  Horrible covid news and/or an implied change in direction by the Fed on Wed are could derail this run.  But without those, I'm don't think much else can prevent that new high.  I'm currently eyeing entries at 3145 or at the bottom trend line of your "wedge" at about 3100.
Thank you, I'm happy my contributions are valuable to you. You mention the Fed - for me, it's more about the next $3T (?) stimulus bill, if it makes through Congress in time and in good shape. That's where the Fed buying would go - they need assets available out there. Last week was exceptional for the bulls, and I think we're in for some chop - and I also think we'll take on the Feb highs and overcome them still this year.
Great article Monica! Wondering your thoughts on retesting the March lows and how and how long we may get there? My current strategy has been selling SPY DIA puts below or at the March lows 30-45 exp days out so this bullish trend has made it easier. I guess another way to ask this, what would be the price threshold broken that should concern someone like me? Thanks!
As April progressed, I stopped thinking we would break below the March 23 bottom, let alone retest it. Given the monetary and fiscal policy response so far, I don't see that as likely. Should the incoming facts (e.g. botched stimulus) and data change my mind, I'll write about that. Monday's article will touch on that, and you'll learn what I think about the S&P 500 trading path throughout summer
at what time is good to sell the s&p 500
Keep on reading, and you'll learn when I flip bearish - you'll see my thoughts precisely. As a trader and investor, I would think about the risk-reward ratio foremost. Picking tops and bottoms is appealing, but when the market is trending, people remember the saying that the trend is your friend. Of course, the definition of a trend depends upon the choice of time frame... What I want to say is that there are quite a few points to be added to the question to make it actionably relevant (namely what kind of a move do you want to catch, and what are the chances that the market travels that far, what you're willing to risk, how would it reflect on your account etc)
Reading your article gave me a broader point of view. I'm glad that you shed light on some issues from a different angle. I'm trapped on a considerable sum with shorts and was on the denial stage, looking for answers that I'm blinded see. Lots of conspiracy theories against the government interference on free stock market sometimes makes you tunnel vision. I'm humbly sorry that I used stern comments on your earlier article and asking you why are you calling this manipulated market a bull market but now hear you loud and clear. I Thank you again for taking my questions sincerely and answering them with the facts. Have a nice weekend.
It's great that you're looking for answers, examining various viewpoints. Thanks for your courageous message - don't hesitate and ask directly (it's common knowledge that), I'll answer your question(s) within the nearest article :) It'll be my honor to help you out along your way. You can perhaps formulate that in a way that Haris Asd would also find beneficial - e.g from the angle of what to do if I'm stuck in whatever pickle (individual company, sector, index...) if you want to. Take care
Will do, Many thanks.
All right, keep on posting, discovering and asking :)
Just enjoying the ride, ECB's bond buying programme extension certainly was a game changer. From your website I gather you have background in economics, can you cover specific blue chip stocks in your articles, right now I am interested in ford (f) and ge?
Yes, anything the key central banks around the world do, has a certain spillover effect to the US as well (currency markets are usually reflecting that first). Yes, the branch of economics for central bankers is indeed my cup of tea. Picking individual stocks that would interest most readers at the same time, is virtually impossible, but I'm covering the key sectors from the S&P 500 point of view, often stating my views (bullish-neutral-bearish). You can always see how your individual stock of interest performs vs the sector it belongs in - is it a leader/laggard, or more or less matching it? Betting on a sector makes you less vulnerable to company-specific risk too... Was that helpful to you?
yes, very helpful. Do you think the horses have left the barn, I mean is the correction over, and the market will continue where they left before this february?
I depends upon what you consider a correction (how big a move it has to be) - but certainly, it'll take some effort to overcome them both from an index or the many sectors' point of view. I guess it'll be more obvious from Monday's article :) Have a nice weekend!
Yes, the stock upswing is unfolding just great, but I would like to ask you whether there is anything else you would like to see covered - how can I make the articles even more helpful to you? Do you like the expanded scope of today's article, or S&P 500 sectors are your cup of tea? Looking forward to hear from you, have a pleasant and safe weekend!
Cornel Pod: I want to thank you for your post - I got the gist of your thoughts but couldn't dig into specifics of the example given...I just love writing for it gives me the very freedom to express ideas precisely, with all its colors and hues. In a broadcast, navigating these is harder for the listener whereas the reader can fast-forward, rewind to any passage at their convenience more comfortably. I don't want to cheat anyone out of the full experience of what's out there interesting to comment on clearly.
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