Market Lab Report - Dead bat bounces vs. Fed turning dovish

by Dr. Chris Kacher

Leadership remains non-existent in stocks and cryptocurrencies. Both have one of the highest overall correlations in years due to the lack of money supply which takes down risk-on assets such as stocks and especially cryptocurrencies. Wednesday's rate hike of 75 bps came as no surprise, yet markets strongly rallied as the Fed's softening tone came as comfort to the markets. While they acknowledged that growth was coming in weak, jobs remained strong. They also said they must keep a close focus on inflation. Translation: stagflation in here. But while stagflation is bad for markets in the long run suggesting another leg down to retest lows at some point, markets breathed a sign of relief when the Fed not only kept to their 75 bps rate hike instead of a surprise 100 bps hike, but also suggested a 50 bps rate hike when they next meet in September is reasonable if supported by the data. A moderating CPI after its huge spike along with lower commodity prices including oil and soaring inventory/sales ratios for the retail sector suggest the data will give the Fed room for "only" a 50 bps rate hike. Housing prices are also looking to come in soft after its accelerated run due to doubling mortgage rates.

The Fed also does not believe the U.S. is yet in a recession despite the overwhelming data, even when not accounting for the reductive distortions in CPI which in turn reduce GDP, thus believe they can achieve a soft landing though Powell did admit the airstrip has narrowed and shortened. The hope for such illusory landings is prevalent. The illusion becomes "real" the more people believe in it. Because markets are smarter than the Fed or any governing body, markets find price based on actual reality. That said, the illusion buys the Fed time to find a reason to reduce or halt rate hikes which then carves out a new reality.

Come the next major crisis brought on by higher order effects from crippling debt, a strong dollar, and/or rising rates, the Fed will no doubt step in and use such a crisis as the excuse for halting rate hikes. Governments know never to let a good crisis go to waste. They did this in Jan-2016 for the whole year. 2016 was a mild bull in both stocks and crypto followed by 2017 which was a raging bull for crypto.

It is possible when the Fed meets again in September that Powell will continue towards a more dovish stance suggesting that he will take a more moderate and measured approach. He may use reasons such as those cited above. They will strive to find a reason because if they have to continue to hike rates aggressively into the end of the year, major averages in stocks and cryptocurrencies will have more than just one major leg down from here. One more major leg down would be in keeping with prior crypto bear markets where Bitcoin lost -84% and -87% in the last 2 bear markets. Such a correction would put Bitcoin at around $10,500. Any additional major legs down beyond this would put the crypto bear market into something worse than we have seen since 2014. In stocks, we would see corrections in the major averages that may begin to look more like the great financial collapse of 2008 which was the last major, prolonged bear market. The Fed is unlikely to want this situation thus will find a reason to justify the halting of hikes or even the launch of QE5 before this happens.

Perhaps they aim for a continued market rally by doing a 50 bps hike in September (below the original 75 bps estimated), then two more 25 bps hikes to bring the FFR to 325-350 by the end of the year. CME Fed Futures are predicting exactly this at the time of this writing. Of course, reality will set in by this point as such hikes will choke GDP as well as make debt even more onerous, but if the major averages continue to weakly rally in sloppy fashion off their lows with limited to zero leadership by the Fed's meeting in December, there is room for a sharp correction much as we saw in late 2018. Perhaps Powell is testing markets to see how high he can hike rates before markets retest lows.  

Dead Bat Bounces

I have received questions on dead cat bounces as it related to the Market Direction Model. Some got out at a profit as they may employ various profit-taking strategies, so want to know when to re-enter assuming the MDM stays on its sell signal.

The Market Direction Model looks to capture the larger swings in the market. It made this key adjustment 3 1/2 years ago on Feb 9, 2019 which accounts for its substantially improved performance. Prior, it would trying to capture smaller trends so would get whipsawed as the printing of global money across major central banks which started in 2009 continued ruthlessly onwards and upwards.

Dead bat bounces are typical in bear markets. They are born from hope that interest rate hikes will be halted or reversed based on the economy being too weak among numerous other reasons. For example, if the economy shows signs of life, this could be a reason for a bear market rally. Such bounces can induce short squeezes which can last from several days to weeks which further extend the bounce.

Across major averages and leading stocks and cryptocurrencies, watch for rallies up into logical areas of resistance such as prior intermediate highs which can create sell walls or use the 21-ema, 50-dma (55-ema with crypto), or 200-dma as guides. Keep a count of distribution days including stalling days (high volume without much further price progress) vs. accumulation days. A general rule of thumb is if you see 5 or more distribution days within a rolling 20-day trading period in a major average especially the NASDAQ Composite, this suggests growing selling pressure so be on the alert.