July 3, 2018
Earthquakes are associated with massive destruction and chaos. The word itself conjures images of flattened buildings and major damage. The common conception is that they are rare. The fact is, only the destructive ones are rare. An earthquake greater than 8 on the Richter scale happens maybe once a year, but quakes with a magnitude of 2 or lower happen hundreds of times a day, but most aren’t noticeable.
Just as in the stock market, we don’t (or shouldn’t) pay any attention to the small tremors. There are many down days and many up days. We only pay serious attention to the REALLY BIG down days.
The stock market has been very strong in recent weeks. We have seen a wave of heavy institutional buying concentrated in Information Technology, Consumer Discretionary, and Real Estate sectors. I interpret these as very bullish for the overall market. As money flows into growth-heavy and discretionary spending sectors, the strong economic implications are obvious. And as investors plow cash into yield-intensive sectors like REITs, it signals a dovish view for the near future of interest rate policy. In short, the market action is supportive of a continued bull market in U.S. equities.
Despite all this as the backdrop, it seems investors were looking for an excuse to take some profits. The stage was set perfectly for this past week to be the time. We are at the start of summer, between earnings cycles. Liquidity is typically lower, and minds are generally focused on vacations, lazy summer days and the upcoming July 4th mid-week holiday. The market was nearing overbought territory heading into last week. All it took was some trade war rhetoric heating up over the weekend to usher in a sloppy Monday.
Monday’s market action was typical for a defensive rotation. By this, I mean growth-heavy sectors got punished while defensive sectors got rewarded. Consumer Discretionary, Energy, Tech, Financial, and Materials stocks all sagged. Utilities and Consumer Staples saw an influx of cash. Tuesday’s short-lived rebound gave way to some more weakness on Wednesday. The end of the week saw the market firm up. The talk of tariffs and trade wars make for great TV. We have pundits and news people whose job it is to keep eyeballs glued to the TV or screen. Once there is traction for a story, gas gets thrown on the fire.
The Ups and Downs of the Trade War Story
I believe we are seeing continued evidence of the prominence of algorithmic trading. If you can step back, you can watch this drama unfold. When stories come out in concert through multiple media outlets, all one has to do is look at the stock prices to see if the stories cause concern or not. Earlier this year we saw the market’s disapproval of the news about trade war fears. Once the market caught its footing again, however, growth was back in favor and the broad market indexes were back on track for new highs.
What is interesting is that the news outlets kept trying to fuel the trade war story for weeks. The market kept shrugging it off and vaulting higher. If you paid attention, you could often see an initially negative reaction vaporize and reverse to positive trading. This happens because computer-driven algorithmic trading systems are focused on headlines, so we can see the action unfold. As negative news hits, these traders “test” to see the depth and liquidity of the market by shorting shares. If their offers for sale are met quickly with firm bids, there will be quick bids to cover, and sell orders covert to become net buyers for the day. The “test” failed, and small losses are taken to give way to long stock trading, looking to generate small profits to offset any losses. These types of days are not big money makers for the algorithmic firms.
Contrast this to when short sell orders are harder to fill on bad news days. Weak bids mean insufficient liquidity to absorb sell orders. Algo firms can get more aggressive and fade any bids to cover any they may have entered. Sell orders accelerate with more volume. If the market begins to free-fall, we know the algo guys are making serious money. In fact, in a conversation I had with a trader, he said “we can make our year in days like these.” In short, algo traders wait for particularly soft markets so they can sell the stuffing out of it. For them, a few standout bloody days in the stock market can create standout years.
I think we saw a mild version of that last Monday. In summer, market liquidity is generally lower and there are fewer positive catalysts, like earnings, to bolster stocks. The right negative story came along, and bids softened. Shorting began, which propagated selling, but these were all traders. I bet that most everyday investors were not out emptying their stock portfolios at the crack of dawn on Monday morning.
Why am I telling you all this? Because the summer months are prime times for short-term traders to try to move markets based on liquidity factors like those discussed above. But the underlying theme hasn’t changed. The environment is bright for U.S. businesses. The economy is strong. Consumers have more disposable money to spend, and growth is evident in past consecutive earnings reports. Company guidance is strong, and any market pressure has been overwhelmingly positive for the past 18+ months.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
This is why market dips – like these short-lived ones we saw last week – should be viewed as buying opportunities. Until the fundamental undercurrent changes significantly, the data is bullish for U.S. stocks. This can be seen easily in the strongest sectors for the last 3 and 6 months. Consumer Discretionary, Information Technology, and Energy are sectors attracting investment capital. This is the hallmark of a strong bull market. This did not change on Monday. Nor do I envisage it changing anytime soon.
“Ask yourself the question, ‘Will this matter a year from now?’”
– Richard Carlson, author of “Don’t Sweat the Small Stuff.”