The stock market started off 2016 with a nasty 8% decline in the S&P 500 that appeared to be accelerating, until Wednesday January 20th, when the Dow Jones Industrial Average reversed a 560 point intraday loss to close down 250 points. Markets rallied Thursday and Friday, reversing the accelerating downtrend and appear to have made a low, from which the markets should recover for the next few months. We rarely make market timing calls, but several indicators hit levels where it appears that there is a compelling case for a tradable rally for the next few months. Sentiment, oil, key opinion reversals, technical behavior and monetary policy developments all have turned favorable.
Sentiment shown by the S&P 500 volatility index (^VIX) hit an extreme of 32 at 12:45 on Wednesday, January 20th on the 5 day chart, on the left, and shown on the 3 month chart on the right.
One of the key drivers of the market move downward was the continued decline in oil prices. Oil, too, appears to have bottomed on Wednesday, January 20th, two business days after the Iranian oil sanctions were lifted. The charts below shows the volatility of oil and the USO–an oil ETF and proxy for oil. Panic also peaked for oil on Wednesday, January 20th when West Texas Intermediate traded to $26/bl. Oil weakness reflects concerns over an economic slowdown in China and worldwide, that seemed, until Wednesday seemed to be reinforcing a negative feedback loop of fear hurting consumer’s investments and potentially spilling back over into the economy. However, the second leg down in oil began in earnest in early July, 2015 with the Iranian nuclear deal which will usher in potentially millions of barrels per day of oil in an already oversupplied market. With the final removal of sanctions last weekend, the full brunt of this development was laid to bare last week, prompting a sell the news reaction, and a critical reversal in oil (WTI) which rallied from $26 to $32/barrel by week’s end.
Some highly regarded bears on oil, including Pierre Andurand switched from their bearish forecast to positive, this week. One vocal bear on Master Limited Partnerships also Brian Nelson, CFA of Valuentum switch his views on the MLP space recommending Kinder Morgan after being negative on it for nine months. Since these bears had been reading the market correctly for the last few quarters, their reversal in their market view suggests that all of the negatives have been fully discounted and valuations now are attractive.
Technically, oil and MLPs appear to have put in island bottoms, a chart pattern often associated with a major market turn.
The major driving factor of US and global equity prices since 2008 has been the unprecedented monetary accommodation by the Federal Reserve and other foreign central banks. This spurred a wealth effect and stimulated the cyclical recovery that is one of the weakest on record. The US has been slowly reducing this accommodation by ending Quantitative Easing and on December 16 2015, raising the Fed Funds rate for the first time in seven years. The ensuing market decline may have jolted central banks because the European Central Bank, the Bank of Japan and China to some degree, have indicated since Wednesday that they will be active in the markets buying assets and keeping policy highly accommodative. We believe that this reaction will stabilize equity markets for the next few months and this is the last an final piece to our argument for our bullish note.