The bears have been successively tempted, taunted and trapped throughout 2013. It’s now looking as if the debt-ceiling brinksmanship in Washington will serve as the bears last obvious chance to eat this year.
On its way to a 20% gain at the recent market highs, the Standard & Poor’s 500 Index (GSPC) has offered market skeptics a series of fleeting and frustrating setbacks, bending as some crisis or another flared only to quickly rebound with a bear-singeing rally.
Even before the year began with a deadline fiscal agreement and relieved surge in stocks, a deep reservoir of investor anxiety was in place. Still shaken by the 2008 financial crisis and its aftershocks, exasperated by Congressional dysfunction, and suspicious of the “reality” of the bull-market gains amid unprecedented Federal Reserve money-pumping, the public and Wall Street pros alike have been prone to flinch at any unwelcome headline all year.
The list of potential bull-slaying financial and policy snafus since January include:
- a messy Italian election that imperiled European debt-service pacts
- the de facto insolvency of Cyprus
- Fed's surprise move to continue its heavy asset-purchase commitment at current levels
- a potential “hard landing” in China
- capital flight from emerging markets
- a threatened attack on Syria
- the impending expiration of the U.S. Treasury’s borrowing authority amid a government shutdown
These episodes – which seemed daunting and fully capable of derailing the upward run in risk assets – led to a half-dozen 2% to 5% pullbacks in the equity market, none of which lasted long and all of which gave way to a new high. As a result, the pool of bearish sentiment has been partially, but nowhere close to entirely, drained away.
Gold, which many view as doomsday insurance, is in a bear market, evidenced by the steep drop from $1,700 per ounce to a summertime low of $1,200. And the public has begun sending fresh money into stock mutual funds in recent months, after years of shunning the market in favor of bonds.
Last Thursday, when stocks rallied hard on hopes that a debt-ceiling breach would be avoided and a short-term budget deal accomplished in Washington, one could see signs of some bears beginning to make tracks away from their downside trades. Gold fell 2.2% on the day to a three-month low. And, as I discussed with Yahoo Finance Editor-in-Chief Aaron Task in the attached video, bets that stocks would become increasingly risky and volatile were unwound.
The CBOE S&P 500 Volatility Index ( VIX), a gauge of expected skittishness in stocks, collapsed by more than 20% from midday Wednesday through Thursday, from above 21 to around 16. These days, this index is not a mere abstract statistical curiosity, but something that one can virtually buy and sell. VIX futures and options and exchange-traded baskets such as the iPath S&P 500 VIX ST Futures ETN (VXX) are among the most popular new trading instruments launched in recent years. Despite the fact that buyers have consistently lost money betting on sustained higher volatility, they are heavily traded and owned.
It’s striking how many bearish bets remain in place given the negative reinforcement delivered to the negative camp all year. Volume in options that are meant to profit on a big jump in VIX was at record levels last week. Short interest in the stocks of the S&P 500 companies was back at its 2013 highs at last report even as the indexes have marched higher. Hedge funds, which have not nearly kept pace with the market this year, appear to be positioned cautiously once again as the D.C. fuse burns down.
Pessimism has built quickly with every little 2% dip in the market, perhaps because of the lingering sense of unease -- true or not -- that the market has become detached from fundamentals and is riding on Fed generosity and perceptions that it will last.
In this respect, this year’s market resembles that of 1995, also the fourth year of a bear market beset by deep DC divisions, a government shutdown, general societal malaise after the Oklahoma City bombings and a Fed that was seen as micromanaging a fragile economic recovery. Stocks were up more than 30%, never suffering a serious correction, as skeptical traders fought them all the way up.
Michael Hartnett, global strategist at Bank of America Merrill Lynch, articulates the “What if?” scenario on many traders minds: “On Oct. 29, 1929, the Dow fell 13%; on Oct. 19, 1987, the Dow declined 23%; and in October 2008, U.S. stocks were down by 27% at one point during the month. On Oct. 17, 2013, the U.S. government will apparently run out of funds to repay its debt. Will 2013 be remembered for another October stock market crash?”
Hartnett ultimately concludes “probably not,” pointing out that investors have been alert to this prospect and have bought significant amounts of insurance against it. Yet the very agreement among most commentators that default is out of the question -- and that a relief rally will follow any agreement -- is a recipe for market chaos. Will politicians fall short of already low expectations of them?
Many bears seem to think so. And, in fairness, there are plenty of plausible reasons to worry that stocks are vulnerable. The market is no longer cheap, having gained some 150% since its 2009 low. Margin debt is at an all-time high, raising inherent risks of liquidation in a correction. Each new high this year has come on weaker underlying momentum in the broad spectrum of stocks.
And, crucially, earnings growth has stalled out, with companies collectively eking out low-single-digit collective gains thanks to share buybacks and low interest costs. With profit margins at record highs, it appears investors have been busy paying up for the big earnings gains of the prior three years. While expectations seem muted for third-quarter results and stocks haven’t blinked at weak profit performance the past couple of quarters, the bears ask, “How long can this last?”
Markets that have been strong all year and fail to succumb by October tend not to suffer much downside through the remainder of the year. That could make the next week the bear’s final moment to salvage their year.
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