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As Good As It Gets?


Chief Strategist at Interactive Brokers

Markets soared to new highs yesterday in a delayed reaction to the Good Friday release of March employment numbers.  No one should have been surprised that US equity markets rallied.  It was the first time that most investors were able to express their enthusiasm for a payrolls report that exceeded expectations by about 250,000 (350,000 if we include the upward revision).  Remember that this rally came on the back of a sharp rise on Thursday, though much of the move came in the last 20 minutes of the day.  This morning, stocks are meandering around yesterday’s highs, indicating that traders are consolidating yesterday’s gains ahead of the next move.  It has to be higher, right?

If you’re a momentum trader, that would certainly seem to be the case.  A couple of weeks ago we had a minor sell-off with tests of longer-term moving averages.  The S&P 500 (SPX) tested its 50-day moving average trendline before bouncing, for example.  Yet again, buy the dip proved to be trade that paid off.  For investors of a fundamental nature, we have improving economic numbers, and today the International Monetary Fund (IMF) upgraded its estimates for global growth.  In the meantime, fiscal stimulus is percolating throughout the reopening US economy while the Federal Reserve shows no willingness to remove its extraordinary monetary accommodation.  It is hard to blame anyone who sees nothing but blue skies ahead.

As of now, it is not clear that the bond market fully embraces that view – which in its own peculiar way is a positive for equity markets.  The mini-correction of late March was precipitated rising 10-year Treasury yields.  We saw rates rise about 50 basis points in roughly 6 weeks, which is a huge move for a market that had been anticipating extraordinarily low rates throughout the next decade.  That said, the bond market is still anticipating extraordinarily low rates throughout the next decade – just not as low as they were previously expecting.

Most encouraging in the short-term for bond and stock traders alike was that rates failed to rise after the payrolls data.  Equity and bond markets digested the rise from 1.25% to 1.75% with some fits and starts, but that was not especially upsetting when we consider that equity markets trended flattish to higher over that period.  It now appears that bond traders overshot the mark when they pushed rates to 1.75%.  The 10-year is currently yielding about 1.68%, meaning that the strong employment data was deemed by bond traders to be something they could largely ignore.  That was as close to an “all clear” as equity traders could get from the bond market.

So, it’s all good, right?  I wouldn’t be doing my job if I simply said “yes” and moved on.  I’ve learned over the years that the worst trading decisions come when complacency reigns.  There are always risks lurking out there, even if they are overshadowed by rewards.  Among the pitfalls are:

  • To what extent were the bond and stock moves over the prior weeks a function of quarter-end rebalancing?  There is a real possibility that the lack of change in bond yields since the payrolls was more a function of an oversold than a sanguine bond market.  There is also ample evidence that the rally that ended last week was the result of new money flows at the beginning of a historically good month for investors rather than a sea change in sentiment.  Will those persist?
  • What are markets discounting now?  After a blowout in employment data and subsequent upward revisions to economic outlooks, are investors setting a bar that is simply too high to surpass?  Every outlook is seemingly rosy.  What if the data fails to meet the high expectations?
  • Guess what’s coming next week?   Earnings!  JP Morgan kicks off the traditional start to quarterly earnings season in a bit over a week.  Typically, the banks report first, though their trading results can often lead to flawed extrapolations of their results onto the major corporations ahead.  As with the economic outlooks, earnings estimates are quite robust.  That said, companies have tended to beat their estimates – sometimes by a wide margin.  What if investor expectations – the so-called “whisper numbers” – are set at levels that fail to impress the market.
  • VIX traders saw something on the horizon yesterday.  The CBOE Volatility Index rose on a stellar up move for the SPX that underlies it.  Those traders took the opportunity to gird for potential movement in the coming weeks.  Do they see something that others don’t?

For now, enjoy the rally.  But I would use critical thinking to analyze the reasons for the recent rally and to be clear-eyed about the risks that most traders are willing to ignore for now.

Disclosure: Interactive Brokers

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