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Market Rally Fizzles, Cautious Times Return

It is always good to have a break from trading for a couple of weeks and return with a clear mind to be able to reassess the position and direction of financial markets. It is even better to take a break having been on the right side of market direction rather than take a break to nurse losses.

So after returning back this week has my views of global markets changed? No. In fact the price action and developments have only cemented the strategy and outlook we discusses in late September that should be adopted for the fourth quarter of this year.

As a reminder we compared the performance of the August correction to that of 2011 due to a number of technical and fundamental similarities. As a result we had a strong conviction that at the start of October we would see a huge short covering rally that would recover all off the sell off in the S&P 500. In effect it would be the strongest rally of the year and be the 2015 “Christmas rally”. The ASX 200 would reach 5350/5400 and like in 2011 and all short covering rallies, it would stall and reverse.

I left for a short break as the S&P 500 was in the late stages of the rally and in the middle of earnings season. The S&P 500 overshot our upside target slightly and the ASX 200 was smack bang on the 5400 level.

Trying to predict the trigger for a short covering rally to reverse is difficult but once known we can begin to reassess the downside potential based on the factors driving markets. Clearly, the trigger here is the Fed raising rates. The last employment number was a huge “beat” and now the market is pricing in a December rate hike. Since that employment number release – the S&P 500 has headed straight down – the exact opposite of the October release that triggered the huge rally.

Now, equity markets as I see them and have been positioning our prop desk book as a result, are in a unique situation where under a normal distribution of events can only fall. The start occurred last night and has been witnessed in the high yield junk bond market for the past week as well.

Let me explain.

Equity markets sold off in August due to the fears of a weak economy, China slowdown and pretty much anything to do with “weakness”. Fears the Fed would not be able to raise rates until late 2016 received a lot of airplay. Fast forward to this month and one strong employment number has shifted this market view to a rate rise now in December. There is still one more data point on the employment front to be released in early December before the Fed meeting. If we see a strong employment number again the market will begin to question whether the Fed is behind the curve and if a more aggressive rate hike schedule will be needed. So the market is cornered. Weak numbers are bad for growth and corporate profits so equities decline, while strong numbers will add fuel to the rate hike cycle and although good for the economy, will drive equity markets lower as the initial reaction will be to fear there will be more rate hikes than the market has currently priced in.

Similar scenario plays out for the high yield corporate debt market too which I have discussed a dozen times in this column via the High Yield Bond ETF (HYG) and the leading indicator this provides to equity markets. Higher rates are naturally bad for corporate debt and bond markets so the HYG ETF falls as it has also been doing all week. Moreover, a weak economy also reduces the capacity of these corporates to be able to refinance given many are oil producers that used $100/bbl prices to issue large amounts of paper. Again under any scenario of bullish or bearish, this index also heads lower and with the correlation between the HYG and S&P 500 (which we showed back in June) so high, this is not good news for equity markets in the near-term.

So after the S&P 500 returned to test the record highs it has now stalled – priced to perfection in a world that clearly is not operating perfectly. After a strong rally that has taken a lot of buying energy to be driven that far in four weeks will lack the power to break levels across 2130 which has capped the index for the past year.

Given our predictions from September are still playing out according to expectations, there isn’t any reason to diverge from the view that following this rally we would see a retracement of the rally. That retracement has begun. The question is does it retrace 50% of the rally, 20% or make new lows? I would be in the 50% camp at this point. I don’t see any reason or evidence at this point to look for new lows. After all we need to correct 50% before making new lows anyway so let’s reassess when we approach that target and we can keep our short positions if need be or look to buy that decline. I always stressed this would be a short covering rally and not to fall in love with the gains to come. It is merely a trading opportunity.

The ASX 200 has already retraced 350 points from the 5400 level and could prove to perform a little better in the near-term, but by no means will it blast back up to its recent highs in the face of falling commodity prices, slowing housing market, rising bond rates and the RBA powerless to cut rates while employment remains solid as seen the data release yesterday. All of this equates to a market that has very little positive drivers while negative factors continue to mount on the horizon. We have been highlighting many of these in this column and this Bloomberg article highlights a few more http://www.bloomberg.com/news/articles/2015-11-12/five-strange-things-that-have-been-happening-in-financial-markets Number 3 is a personal favourite of mine and why I continue to scream from the roof tops that the next GFC event will occur in high yield corporate debt and emerging markets. It’s the same as the GFC with the same investors getting hurt. Let’s not be one of them.

View More Articles By Greg Tolpigin

Greg is the Head of Proprietary Trading at Global Prime and has over 20 years of experience as proprietary trader and high level strategist for the major investment banks including Citigroup, Bankers Trust and Macquarie Bank. He has been involved across all asset classes including commodities, bonds, currencies and equities right across the globe.

After a 10-year career within the comforts of the large investment banks and research firms he branched out on his own to form his own proprietary trading firm successfully building the business into a multi-million dollar trading operation that turned over a billion dollars a year. This same team now runs the proprietary trading desk at Global Prime, risking their own money in line with the firm's and client's capital.

Greg has appeared on CNBC, Channel 9 - Business Sunday programme, a guest columnist for the Australian Financial Review, a regular author for Personal Investor, Wealth Creator and Shares magazine and is the former Treasurer of the Australian Technical Analysts Association.



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