• Rates matter

    Strange market activity on Friday. I had been expecting a pullback due to the US$ surge, but the Friday selling was much stronger than what I had been expecting. The main point however is that lower prices attracted buyers both on the large caps (20DMF) and on the small caps (Non-SP500 stocks.)

    I do not have a good explanation for such a move, except that Friday was an options expiration day, which could have led prices reaching some options max pain levels. Hence, it could have been simply an options portfolio adjustment day, helped by renewed China/US trade (non-)progress communication.





    I found stranger that the US$ continued to show strength on Friday, while then 10Y Yield was pulling back.





    US/German rates differential is still rather high though and I believe that foreign money is a real help for the Fed to offload QE accumulated paper without triggering a rate surge.

    The negative aspect of this situation is when the rates differential reverses down... We would only need a non-contained Italian debt crisis for this to happen. But this is still two weeks away, when Italy will have to come up with a EU acceptable budget.



    I would like to come back to the long-term yields analysis that I last updated in August (See this link below, at the end of the August comment)

    http://www.effectivevolume.com/conte...al-Bull-Market


    In my comment of August, I wrote that stock prices would have to come down for the Fed to be able to increase rates in September. Prices came down after the Fed increase though, but they did come down, which helped the Pink/Green yield lines not to inverse.

    Below is the Figure with Yields dating of Nov 1.



    What would happen if the 10Y secondary markets yields jumped to 4%? The Pink/Green lines would inverse, which means that stock buybacks would stop right away and that investors would prefer buying high quality corporate bonds over the S&P500 index. This would probably put some weight on the S&P500.

    For the Pink/Green lines not to inverse, we would either need the S&P500 to pullback down to 2400 or companies earnings to increase. Hence, trade war issues would need to be soon resolved.



    Conclusions:

    The problem of the yields will be obvious at the end of December for the next Fed rates hike.
    In the meantime, I believe that a pullback to S&P 2750 is buyable in the prospect of enjoying a good Santa Claus rally.

    However, If the US/China trade issues are not solved before end of November, then the S&P500 could easily fall below $2700 by December 1rst. I have shown in the past years that when by December 1rst the S&P500 is negative for the Year then a Santa Claus rally has a very low probability to occur.

    This is due to the 2%/20% hedge funds profit rule: if on average hedge funds are in Red ink by December 1rst, they do not hope to be able to book their 20% commission and hence give up on the market. Profitable funds however want to push prices up in order to gain more commissions.

    This situation might be less correct in an index following algos environment though.