Does rising fear lead to a stock market bottom?
Uncertainties surrounding the Fed tightening process, rising inflation, recession fears, Ukraine/Russia and China geopolitical concerns, Mid-term elections, seasonality factors, and hurricane season are attributing to global market turmoil. However, many other things can still go wrong.
If this is a normal market, and based on the current heightened level of fear and the oversold market conditions, a tradeable oversold bounce is reasonable. However, many unknowns may be preventing the stock market from bouncing.
Sustainable market bottoms and the ensuing rallies require a simple driver – plenty of liquidity or money to entice buyers to return. However, to reach this level, sellers must be exhausted. Short sellers also need to cover their short positions. Fundamental and technical investors must agree that the market risk/reward profiles are favorable.
One of the primary reasons the summer rally ended abruptly is the Fed’s continuation with its tightening monetary policies and the Fed’s withdrawal of $95 billion per month of liquidity from the financial system.
The Quantitative Tightening (QT) program of selling treasury bonds and mortgage-backed securities has the opposite effect of the Quantitative Easing process of injecting liquidity into the financial system during the Covid-19 pandemic timeframe.
Besides the known geopolitical and economic concerns, market gauges such as the bond market, VIX, sentiment indicators, and the Eurodollar Index (XED) may need to get worst before a sustainable stock market bounce materialize.
US bond yields continue to climb higher due to the restrictive Fed monetary policies and the QT process to unwind its balance sheet, which shrinks liquidity in the financial system. The recent technical breakout in TNX and other bond maturities warn of higher yields. The selling of US treasuries is likely to continue until the Fed completes its rate hikes and balance sheet rebalancing.
The fear indicator, the VIX index (32.26), still needs to surge above the mid-to-upper 30s to confirm a breakout, triggering the next move toward the high-40s and the low-50s and possibly to the prior 2020/2008 highs in the mid-to-upper 80s. The CBOE put/call ratio (1.36) may also need to revisit the previous highs of 1.50-1.80 to reach extreme fear.
Two market sentiment surveys, including the Wall Street Sentiment and the AAII retail surveys, continue to diverge. The AAII retail investors survey is decisively bearish, with the bullish camp at (60.90) and the bearish camp at (17.70). However, the Wall Street sentiment survey shows Wall Street Bulls (21%) still need to decline further toward 0% to 10% to achieve prior extreme bearish conditions.
Eurodollar Index (XED) is the interest rate from the London Interbank Offered Rate for US dollar deposits. It is the dollar deposits in foreign banks that many macro money managers use to conduct transactions that require fast settlements.
Hedge funds and large institutional trading desks tend to place their funds in Eurodollars for easy and rapid access. XED typically declines when large institutional investors begin to utilize the money and when money exits the financial system. The implication is that these professionals cannot trade stocks at the same level as before.
When XED declines and the bond yields rise, stocks struggle to rebound, often delaying or postponing their bounces. Also, the historical correlation is the rise in VIX and a decline in XED leads to a fall in SPX.
Although oversold stock market rallies can occur at any time, the current readings on the above market gauges suggest a meaningful stock market bottom or a sustainable bull rally are not likely yet. However, if the market gauges reach extreme conditions and rising yields subside, a solid stock market bottom can develop.