November 6, 2018

The deepest place on earth is Challenger’s Deep, about 36,000 feet below sea level – so deep that if you put the base of Mount Everest in it, the peak would still be 1.2 miles below sea level.

Likewise, market bottoms can seem deeper than market highs seem high. The latest psychological bottom was likely put in on October 25. One main reason I feel this way is that we received an ultra-rare “oversold” signal the following Friday morning, October 26. In short, a ratio of unusual buying to selling I follow plunged below 25% for only the fourth time in the last 6.5 years. This means that under 25% of all unusual trading activity was buying. More than 75% of such activity was selling, and that is an unsustainable level. The prior times this happened, the forward returns of the market 2-8 weeks out were positive 100% of the time, and the average return of the Russell 2000 was roughly +8% after eight weeks.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We have seen a big rally in the market in the last few days, up 4.5% from Monday’s lows. Each day I run my model looking for unusual institutional trading – starting with the volume and volatility components that comprise the initial screen. Each day in this slide, we have seen nearly 1,200 stocks out of 5,500 tripping our model. Our daily number of institutionally-tradable stocks is roughly 1,400 out of 5,500.

The number of stocks that violate the volume and volatility thresholds and also breach interim highs and lows is what gives us our UI signals. That has been around 85 a day – down from anywhere between 200 and 800 in the height of the selling. What this means is that out of 1,400 stocks, about 1,200, or 85% of them per day, have shown unusual volume characteristics. This means 85% of the institutionally-tradable universe of stocks is exchanging hands in big volume on the way up from the bottom in late October, and only a handful are making new highs or lows on that unusual volume.

This is very bullish and constructive to me. After a market establishes a floor, the liquidity needs to moderate and constructive price action needs to begin. That’s where I think we are.

Add to that the recent sales and earnings reports: About 62% of the S&P 500 have reported, with an average of 8.25% sales growth and 24% earnings growth. Those numbers sound pretty fantastic to me.

What about “peak earnings momentum”? If this really does become the peak quarter (as was the concern in each of the prior three quarters), we are looking at a market only slightly less healthy. That is not a catalyst for a crash. It just calls for sector rotation and new leadership, which is where my focus will be.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Trade Resolution Now the Market’s Main Concern

As far as company guidance is concerned, as companies keep beating sales and earnings estimates, the overwhelming concern has become “tariffs and trade disputes causing us to be cautious on guidance.”

Many companies fear that trade problems will dilute their bottom lines in the future.

I have been saying for a long time now that I believe Trump will come out with a “magic bullet” to rescue the China trade talks before the mid-term elections. Right on cue, the positive language from his tweets asserts that he and Xi had “very productive talks and they all want a deal.” Trump can’t afford to see a floundering stock market and a damaging trade dispute going into the elections, giving the potential to threaten his chances for Congressional obstruction going forward. I believe the trade issue will resolve itself soon. When it does, these companies warning on guidance will likely restate their guidance higher.

Former Fed chair Janet Yellen came out last week with dovish comments, essentially warning the Fed about raising rates too fast. She was concerned that if the increases are not “moderate,” we could see inflation in 2020. So now Powell has both Trump and Yellen on his case about not being too aggressive on rates. The 10-year note is still at around 3.2 %, hardly a catalyst to dump equities and buy bonds.

The bottom line is that this selloff was caused by buying which dried up in the face of uncertainty over trade and elections. High-frequency traders (HFTs) shorted into weak bids. Technical levels triggered forced ETF selling, with hedging putting further pressure on stocks. That pressure caused forced institutional selling elsewhere. This spread to retail selling. This level of uncertainty is in the process of rolling off, and now there is a strong technical case from my perspective for a market bottom already being in.

There are many bullish catalysts from my perspective. Most of what I hear is despair and discomfort, from pain endured by the recent slide. The sentiment shifted to being almost entirely bearish, which is when I want to be bullish. China is rebounding, tech stocks are seeing some pressure from Apple’s weak guidance, but the Russell 2000 is flat, as of this writing. Domestic small caps, which have borne the brunt of so much punishment, are remarkably resilient. To me, this means that global trade resolution is getting priced into the market. This is the single largest market impediment now, in my opinion.

I know I sound like a perma-bull, but until the backdrop really changes, I think this is a “noisy” period which has inflicted a lot of damage, but it is not the beginning of a bear market. It was a “backdraft” event, in which buying liquidity got sucked out of the market. The explosive force of shorting and low liquidity was amplified into forced selling, which created a massively toxic month for the market.

I believe this was a reset for many crowded trades and an opportunity to see which sectors emerge, spawning new single-stock leaders. If someone asked me which was a bigger risk now – being long or being short – I’d say I am likely going to feel bad for the shorts very soon. After last week, I already am.

As Dan Rather put it: “Once the herd starts moving in one direction, it’s very hard to turn it, even slightly.”

About The Author

Jason Bodner

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. *All content of “Sector Spotlight” represents the opinion of Jason Bodner*


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