SuttonWatch.Net: Has Icarus Flown Too Close To The Sun?

Jacob Peter Gowy's
The Flight of Icarus

Led by a 2% gain in the Dow Jones Industrial Average last week, most major U.S. stock indexes closed at record all-time highs on Friday, October 20th. There were some notable exceptions, such as the Russell 2000 Index of small-cap stocks and the Dow Jones Transportation Average, that didn't post all-time highs. However, even for the most vocal bears, it would be a stretch to call these lagging indexes "dangerous non-confirmations".

Why did the major indexes make new highs last week? Increasing odds of "favorable" tax reform legislation from Congress and well-sourced rumors that Jerome Powell, a known dove on the current FOMC, will be appointed by President Trump as the next Federal Reserve Chairman were two factors boosting stock prices late in the week. The October options expiration may have positively impacted equities on Friday, and quarterly earnings have been mostly "better than expected".

So how does this end? Why should anyone sell stocks? Where's the downside risk? The S&P 500 has not experienced a single-session decline of more than 3% since Nov. 7, 2016. This 241-day period without a single-session drop of that magnitude ties the record stretch from Jan. 26, 1995 to Jan. 9, 1996. There have only been 5 single-session declines this past year of greater than 1% and none greater than 2%! What's going to change?

The 30th anniversary of the great crash of 1987 was this past week on October 19th. There was much press about how "things are different now" and THAT type of negative price action could never happen again. Perhaps not, but how about a meltdown like the one that unfolded on August 24th, 2015, just two years ago! On that wild day the Dow Jones Industrial Average dropped 1,100 points (-6.6%) in the first five minutes of trading. A large drop in Asian equity prices overnight contributed to a 7% decline in U.S. stock futures before the New York opening on August 24th, 2015. Here are some interesting stats for that eventful day:

1) Only about half of S&P 500 stocks were opened on NYSE by 9:35 a.m.; on most days, nearly 100% of stocks in the S&P 500 are open by 9:35 AM.

2) 765 stocks in the Russell 3000 were actually down more than 10 percent on an intraday basis;

3) There were 1,278 trading halts for 471 different ETFs and stocks.

Because of these problems, it was impossible to calculate the value of many ETFs, or to hedge or to trade ETFs and stocks at a legitimate 'correct' price!

It's not hard to imagine a major catalyst right here and now that could cause this same kind of disruption in our financial markets. The obvious #1 choice is some sort of major confrontation on the Korean Peninsula. The Trump Administration already has enough firepower over there to start World War III. And President Trump just signed an executive order allowing the Air Force to recall up to 1,000 retired pilots to address what the Pentagon has described as "an acute shortage of pilots." This order, which Trump signed Friday, amends an emergency declaration signed by George W. Bush in the days after the September 11, 2001 terror attacks. The Air Force is only allowed to recall up to 25 pilots under current law. This order signed by Trump temporarily removes that cap for all branches of the military. Is the US Air Force preparing to put nuclear-armed bombers back on 24-hour ready alert for the first time since the Cold War ended in 1991? Secretary of State Rex Tillerson said this weekend that Iranian "militias" need to leave Iraq as the fight against Islamic State militants was coming to an end. “Certainly Iranian militias that are in Iraq, now that the fighting against (the Islamic State group) is coming to a close, those militias need to go home,” Tillerson said during a press conference in Riyadh, where the U.S. diplomat is holding talks with top Gulf officials. "All foreign fighters need to go home,” he added. Is President Trump preparing for war in North Korea AND the Mideast? While we all hope and pray that another war will not break out, mistakes can happen when diplomatic efforts are stressed to the limit as they are now!

I think that the global financial markets are underestimating the risks of a major civil war in Spain. That country's leadership in Madrid is playing hardball with "separatists" in Catalonia, who seem dead set on independence. And there are now two separate referendums up for vote in Italy for more autonomy in two of the largest and most productive regions of that country. First there was Brexit, then Catalonia, and now two major regions in Italy. Cracks in the Eurozone continue to widen. And how will the financial markets react when the European Central Bank begins to taper its quantitative easing program. Right now, the ECB buys bonds worth 60 billion Euro per month. Well informed speculation now indicates that the ECB will cut this amount to just 30 billion Euro per month beginning January 1, 2018 (less monetary accommodation, for sure!). This "taper" announcement is expected this coming Thursday, October 26th!

And here at home, how would the financial markets react to the following possible events:

1. What if President Trump unexpectedly nominates John Taylor as the next Chairman of the Federal Reserve (Taylor is my bet, because Trump wants the new Chairman to be HIS chairman, not some leftover from the Obama Administration). John Taylor is a well known "hawk" on monetary policy. Wall Street investors seem to think that Jerome Powell, a well know "dove" on monetary policy, will be Trump's nominee.

2. The Senate passed a budget resolution fairly easily this past Thursday night, which now sets the stage for possible Tax Reform (corporate tax cuts) before year-end. The financial markets have celebrated every time President Trump mentions "massive" tax cuts this year, but there are only so many times you can go to that well. Where's the beef? Where are the details? And can the Republicans navigate the myriad of obstacles already lined up in the path of potentially successful tax reform legislation that will eventually reach the White House? How will the markets react if the Republicans in Washington can't pull this all together? And what about a possible shutdown of the Federal Government in early December (funding and debt ceiling legislation need to be passed)? The Democrats are in the minority in Washington, but they still have power (to disrupt)!

3. Black Swans, by definition, are unknown exogenous events that can cause major disruptions in financial markets. Despite the daily reports from the media on Russian meddling in the U.S. elections of November 2016, not very many on Wall Street or in Washington are talking about potential disruptions to the financial markets from a major unforeseen cyber attack. Russia has proven it expertise in cyber warfare. And reports now suggest that North Korea is also among the best at this extraordinary new weapon of war!

4. Special Prosecutor Robert Mueller seems to be interviewing everyone close to President Trump right now in the ongoing investigation of Russia's interference in our November 2016 National Election. It's not hard to predict that something significant could come out of Mueller's investigation that will move the markets.
5. The U.S. Federal Reserve announced in September it would begin to reduce its $4.5 trillion portfolio of Treasuries and mortgage backed securities. It plans to shed $10 billion per month during the final quarter of 2017, then increase this pace by $10 billion every three months until it reaches a monthly rate of $50 billion. Fed Chair Janet Yellen said late Friday that the initial stage of this "liquidation" of the Fed's balance sheet was going well. With those comments, we now know for sure that the Federal Reserve has actually started on this path to reducing its balance sheet, but we don't have any idea how the markets will receive these planned liquidations over the coming months. "Quantitative Tightening" as this is now being called, is fraught with massive risks! If the Fed executes the sale of at least $10 billion in notes and bonds per month through year end and then another $20 billion per month through the first quarter of next year, $90 billion in Treasury securities will be sold by the Federal Reserve through March 31, 2018. In addition to these sales, the Treasury will need to sell approximately $330 billion in notes and bonds to fund the Government's budget deficit. The total is about $420 billion in Treasury securities sales through March 31, 2018. And if rumors are true that the ECB will taper its bond purchases by 30 billion Euro ($35 billion) per month in the first quarter of the next year, then the market will need to buy an additional $105 billion in sovereign debt in the 1st quarter of 2018 that it didn't have to buy during this same 3-month period in 2017. The current 10-year T-note yield is 2.38% as of Friday's close. The massive additional supply expected in this market over the next 6 months could easily force this key interest rate to near 3.0%! How will U.S. equity prices fare in an environment of 25% higher interest rates? It's not hard to forecast at least a 20% correction for the major stock market averages under this scenario!!
6. How much money is now tied to "short volatility" derivatives activity? I read a frightening research report this weekend from Artemis Capital Management that suggested this number could be as high as $1.4 trillion if all markets are considered (stocks, bonds, FX, etc. - see chart below). One of the biggest contributors to the Crash of October 1987 was "naked" selling of put options in the popular OEX Index Contract. The OEX was officially called the S&P 100 Index back then. More than several "retail" customers were short the limit of 15,000 contracts in "out of the money" puts that suddenly went "in the money". These shorts were forced to cover at the worst possible time Monday morning on October 19th which triggered an avalanche of selling in the underlying related S&P 500 futures as market makers tried to hedge. Short interest in VIX (volatility) futures is currently at or near a record high! I sometimes wonder if these "investors" understand that if there is a sudden correction in the stock market, VIX shorts will explode and cause massive losses (as stock prices freefall and index funds and ETFs get liquidated).

Courtesy: Research from Artemis Capital Management

With all the stock market records in the major indexes that were posted last week, does anyone think it is odd that the average stock on the New York Stock Exchange was only up 0.11% on the week, and on the Nasdaq Stock Exchange the average listed stock was actually DOWN 0.29% on the week! In the latest weekly edition of Barron's Magazine, the P/E ratio for the Russell 2000 Index is now 115 as calculated by Birinyi Associates using the trailing 12-month earnings for each component stock! Does this kind of valuation bother anyone?

And here is a fascinating chart by Dana Lyons (https://lyonssharepro.com/) which tracks the money moving in and out of the Rydex (Guggenheim) Bear Funds:

What's immediately clear from this chart is that almost no one is expecting any kind of meaningful correction in the U.S. stock market right now!

Is there anything meaningful happening in my proprietary computer trading system? I am glad you asked!

Despite record highs in almost all the major averages on Friday, weekly chart sell signals were officially triggered at Friday's close in the following key FAANG stocks: Amazon, NetFlix, and Apple. A weekly chart sell signal was also triggered in the Biotech ETF (symbol BBH). The broader U.S. stock market looks vulnerable to a major correction as downturns in key leadership equities already appear to be underway! Could there be a melt down on the near-term horizon? Has Icarus flown too close to the sun?

Biotech ETF (BBH)