What If Near-Term Recovery Rally Psychology Is Spent?

Increasingly, my view of all of the action in ES (e-mini March S&P futures contract) from the Dec 25 electronic Christmas Day low at 2316.75 into last Friday's (Jan 18) high at 2677.75 (+15.6%) represents three distinct psychological phases of market influence, which I have color-coded on the accompanying chart: 

1) Natural Acute Oversold Market Recovery Rally (highlighted in red), 

2) Fed Rate Pause (Algorithmic Headline) Rally (coded in turquoise), and

3) China Stimulus, Positive Trade News (Algorithmic Headline) Rally (noted in blue).

Phase 1:  Acute Oversold Recovery Rally

The initial sharp recovery rally after Christmas Day coincided with a Fear and Greed Gauge reading of 0, and a Daily Sentiment Index (DSI) of 6. The sharpness of the vertical upmove from the Dec 25 low of 2316.75 into the Dec 28 high of 2523.00 (8.9%) in my experience represents a classic short covering, counter-trend rally that returns the price structure to the area of its most recent breakdown plateau, 2520-2550. 

The initial recovery phase off of an acute oversold condition was NOT precipitated by or associated with outside market influences. Indeed, at the end of December, the economic and geopolitical news was getting progressively more negative, while the Fed was silent, having hiked rates on December 19, intent on raising rates 3 to 4 more times during 2019! 

Phase 2:  Fed Intervention Rally

The second phase of recovery off of the Christmas Day low at 2316.75 commenced on January 4, just a few hours after Apple Inc. (APPL) pre-announced a big revenue shortfall for Q4. Imagine that on the first trading session of 2019 (Jan 3) Apple decided to drop a weak earnings bombshell on investors who already endured a 20%, three-month stock market beating! 

Coincidentally or not, the very next day, Fed Chair Jay Powell felt compelled to spring into action during a scheduled televised discussion with former Fed Heads Bernanke and Yellen, which he used to inform investors that (paraphrasing): The FOMC will exhibit more patience and data dependence before hiking rates again during 2019, and listen more intently to the "message" of the equity markets (even though the economy is neither synonymous with the market, nor is the market synonymous with the economy). The markets took Powell's comments to mean that Fed is pausing in its rate hike cycle. 

The headlines triggered algo buying that ripped the ES from 2470 on Friday morning January 4 to 2580 the following Tuesday January 8. However, at that point investors and traders were beginning to fret about Powell's apparent intransigence about walking back his prior comments that Quantitative Tightening (QT) remains on "autopilot."

On the afternoon of Thursday January 10, less than one week from his original televised discussion telling investors about the Fed's more patient, deliberate approach, Fed Chair Powell held a second televised Q&A session to re-emphasize what he said during his January 4 televised Q&A session, but also (paraphrasing): re-emphasized that the monthly drawdown of the Fed's balance sheet (aka Quantitative Tightening) was not set in stone. In other words, QT was not on autopilot after all, even though The Powell Fed has not suspended or modified the monthly roll-off of mortgages and Treasury bonds from the balance sheet. 

Once again, the ES ripped to the upside as the algo buy programs kicked in at 2560, propelling the index to 2599.50 in a matter of a couple of hours, and The Powell "Double-Down" on a rate hike pause was complete (see Turquoise shaded area on the chart). The impact of the January 10 Powell televised Q&A was to double down on the Chairman's January 4 back-pedaling on expectations of higher rates during 2019 that could have ratcheted Fed funds to 3.00%-3.25%, and as such, closer to its "Natural Rate" of "Normalization." After January 4, the Powell Fed was telling investors and the markets that the nine rate hikes of 25 bps from 0% to 2.25% from December 2015 into December 2018 was all the stock market and the mighty U.S. economy could handle for now. It is time to pause and to assess the data. 

Phase 3:  China Stimulus/Positive Trade News Rally

Heading into last week's trading session, starting on Monday January 14, the ES stood at 2595.00, 6% above "The Apple Earnings Low" on January 3, which was the day prior to Fed Chair Powell's initial capitulation on pausing his rate normalization cycle, and 12% above the Christmas Day low at 2316.75. 

It was on January 14 that I penned an article entitled, "Is the Recovery Rally Nearing Exhaustion?" In the absence of a new, bullish catalyst, such as a resolution of the U.S.-China trade dispute, the 12% upmove off the December low (amounting to a healthy 44% recovery of the entire decline) suggested that the combination of the declining 50 DMA and the 50% retracement-resistance zone at 2635, coupled with a healthy rebound in investor sentiment, would put a lid on upside continuation.  After all, the second phase of the recovery rally period had amounted to a climb in ES of 6.2%, somewhat less than the 8.9% advance seen in the first phase. 

My logic might have been spot on in a bygone era when central banks were neither rock stars nor saviors, but since 2009, perceptions certainly have "evolved." On Monday morning January 15, China (PBOC) announced a massive liquidity injection, and supposedly even intimated that it may intervene in the China equity markets to "restore investor confidence." 

That news was all it took to trigger the third phase of the recovery rally period, which involved another algo headline knee-jerk thrust from 2580 to 2605 in about 15 minutes right after the opening bell, which then morphed into unsubstantiated stories and rumors that the Trump Administration was considering lifting sanctions on China in a good faith measure to extract concessions on intellectual property rights. And if that wasn't enough positive news to send the algos into orbit, another story emerged indicating that China intends to spend $1 trillion on US goods to redress the trade imbalance by 2024! 

Phase 3 of the recovery rally is demarcated by the Gray shaded area on the accompanying chart. Mysteriously and prophetically for the bulls, all of last week's news shifted from Fed back-pedaling on rates to promising evidence that meaningful progress was being made by both sides towards ending the U.S.-China trade spat. The prospective bullish news propelled ES from the opening bell on Monday January 15 at 2580.25 to the close on Friday January 18 at 2677.75, a climb of 3.8%. 

We can make the case that the 57% recovery of the entire September-December decline is at or nearing exhaustion of three phases of bullish psychology: 1) an acute oversold condition, 2) Fed Intervention, and 3) China Stimulus and Anticipatory News about an End to the U.S. Trade Dispute. Each of the three phases has coincided with upmoves of lessening magnitude and amplitude, which if nothing else is a warning to us that justification for buying strength at current levels is waning rapidly, especially in the absence of more bullish news catalysts. 

I suspect additional algo-triggering bullish news could come in the form of an actual U.S.-China trade deal, or even an end to the Government Shutdown. Then again, the Trumpian Way seems to have a penchant to play games of brinkmanship with adversaries, foreign or domestic. In the case of China, given recent weaker-than-expected economic data, the March 1 deadline is likely to encourage delay into 11th hour event risk, while the month-long Government Shutdown, though damaging to a small segment of the population (and disheartening to millions), so far has failed to extract a potentially severe political or economic cost, and for that reason, might extend for considerably longer than anyone expects. 

With the foregoing in mind, all eyes on 2635/40 in the ES, which if violated and sustained will argue that near-term bullish Fed and China supportive psychology has been expended, and will leave the algos inversely poised for negative news triggers. 

See ES chart highlighting the three distinct psychological phases of the market's recent advance.