Unfinished Business? – September 23, 2021

Unfinished Business? – September 23, 2021
Morgan Lewis Posted on September 25, 2021

Weekly Hard Asset Insights
By David McAlvany

Volatility reasserted itself this week in both directions. On Monday, the Dow Jones declined 614 points. All of the major Wall Street Indexes closed in the red. Monday’s heavy selling led to the biggest drop in equities since last spring. Monday’s drop also did some significant technical damage to the S&P 500 and other major averages, as prices broke below major trendline support as well as the 50-day moving average.

The early week selloff was primarily associated with news of imminent default risk at China Evergrande. The company was once China’s top selling real estate development firm. Its brewing implosion carries a myriad of risks that ultimately threaten institutions carrying associated counterparty risk. It also impacts China’s epic real estate bubble, commodity demand, and eventually the entire global economic outlook. The wide-ranging risks involved with the Evergrande debacle are more than severe enough to potentially catalyze a dramatic shift from global risk-on sentiment to a decidedly risk-off stance. If that transition happens, market participants will be ever more compelled to perform a comprehensive reappraisal of all market risk factors. If fresh risk reassessments are made through the prism of a newfound risk-off lens, market selling pressure could certainly start to cascade to the downside.

Indeed, with Evergrande concerns front and center, at market close on Monday, all signs pointed to a very rough week ahead for markets as fear took hold. In addition to equities being down sharply, the safe haven assets confirmed the risk-off sentiment. Gold, bonds, and the dollar all caught a flight to safety bid, while the VIX volatility index spiked well over 35% at its intraday peak. While further selling throughout the week might have been a rational expectation, this is the mightily resilient “everything bubble” we’re dealing with, and it won’t easily be denied. As the week progressed, news of a modest Chinese liquidity injection, some mixed, albeit mostly underwhelming, news out of Evergrande, combined with short-term oversold market conditions was all it took to get global asset prices bubbling back up once again. 

By mid-week, markets returned to an aggressive risk-on rally. Wednesday and Thursday, stocks ripped higher before ending the week with another positive close on Friday. Despite a third straight higher finish in the S&P 500, however, the Friday session was only barely green, and some of the now familiar negative market internals that have dogged indexes of late reasserted themselves once again.

Friday’s mild gains were on low volume, and market internals increasingly darkened throughout the day. In fact, the New York Stock Exchange saw more selling (56.1%) than buying (43.9%) volume. In addition, the NYSE advance/decline ratio showed strong positive breadth in early trading, but reversed sharply lower as the day progressed. By day’s end, breadth was negative as fewer securities advanced than declined by a ratio of 0.66:1. Friday’s low volume and deteriorating internals introduce the question of whether the late week rally will be sustained or ultimately prove to be merely an oversold retracement rally destined to fail and rollover back into declines.

Next week’s price action will be extremely interesting. Ignoring risks, buying dips, and riding this market’s tremendous momentum has been the winning trading strategy since the Covid lows of last year. There may be some important trading consequences if the late week rally continues to have legs. If markets further demonstrate their resilience by once again shaking off the latest challenge from an ever-growing number of worsening risk factors, emboldened traders may abandon altogether any concern for risk, froth up sentiment, and push market momentum into a full-fledged blow-off dynamic.

Regardless of bull-market bubble dynamics and near-term trading flows, the reality of an ongoing economic phase change along with a growing and intensifying list of fundamental factors increasingly threatening this market has been chronicled at length in recent HAI pieces. Highlighting this reality, Morgan Stanley offered a warning this week that, regardless of developments in China, the risks of a “destructive” correction in US markets are still rising.

Morgan Stanley’s chief equity strategist Michael Wilson outlined two scenarios for how an expected correction associated with the economic cycle transition may play out. The scenario Wilson calls “fire” is a significant but less severe correction associated with the withdrawal of Federal Reserve monetary accommodation. The second scenario he refers to as “ice” involves negative corporate earnings revisions, higher frequency decelerating macro data points, supply chain issues, and margin pressures. Wilson details both scenarios, but cites “accelerating risks on both the policy and growth fronts” as favoring the odds for the more severe 20%+ correction anticipated in the “ice” outcome.

In Wednesday’s Federal Reserve meeting, the FOMC did not, as of yet, announce the start of tapering their $120 billion monthly asset purchase program, but guided the market, saying that, “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted….” Expectations are now for a tapering announcement to be made in November, and for an initiation of interest rate hikes to commence by the end of next year.

If the Fed holds course, the conditions for Morgan Stanley’s fire scenario look soon to be met. Meanwhile, all of the issues associated with the ice scenario are increasingly flashing a disconcerting shade of red. So, perhaps rather than fire or ice, the reality now confronting markets is fire and ice. We shall soon see whether fire and ice along with the tremendous ongoing threats in China will be enough to derail the firmly entrenched bubble momentum and potentially percolating blow-off market dynamics now in play. Either way, more of the sort of volatility seen this week seems certain.

Market commentator Larry McDonald, author of the Bear Traps report, recently relayed a market pearl of wisdom shared with him by hedge fund legend David Tepper. Several years ago, while discussing the market dynamics that eventually led to a significant correction, Tepper said, “Larry, the market can drive higher with one or two risk variables coming into the picture, not three, four and five…. It’s not market timing, just common sense.” Well, at present, the list of risk variables is long and distinguished, but bubble dynamics are, in themselves, also a particularly powerful force of nature that can defy common sense for a surprisingly long time. This battle between mounting risks, deteriorating fundamentals, and blow-off bubble dynamics should soon intensify and eventually reveal whether the declines early in this past week still have unfinished business.

As for weekly performance: The S&P 500 closed the week up 0.51%. Gold was flat, up 0.02% while silver gained 0.36% on the week. Platinum rallied 5.30% while palladium was the lone physical PM casualty, dropping 1.65%. The HUI gold miners index also fell 3.05%. The IFRA iShares US Infrastructure ETF was down 0.81% for the week. Energy commodities were higher again. WTI Crude Oil gained 3.01%. Natural gas rallied by 1.86% on the week. The CRB Commodity Index was up 0.61%, while copper rebounded somewhat from last week, up 0.94%. The Dow Jones US Real Estate Index ended the week down 1.68%, while the Dow Jones Utility Average Index lost 1.22%. The dollar was slightly higher this week, gaining 0.17% to close the week at 93.33. The yield on the 10-year Treasury surged 10 bps to close the week at 1.47%.

Have a great weekend!

Best Regards,

David McAlvany
Chief Executive Officer

Stay Ahead of the Market
Receive posts right to your in box.
Out of the Gate and Ready to Run – December 1, 2023
Happy Thanksgiving Weekend! – November 24, 2023
Confidence Bubbles and Pipe Dreams – November 17, 2023
All the King’s Men – November 10, 2023
Writing on the Wall? – November 3, 2023
Confidence Sand Piles and Omnipotent Feelings – October 27, 2023
Playing by the Old Rules – October 20, 2023
A Match to the Powder Keg – October 13, 2023
Double your ounces without investing another dollar!