As stocks report disastrous fourth-quarter earnings and finish up on the day, one begs to ask "Are we at the start of a bull market?" One can be forgiven for thinking a bottom of sorts is in place, given the rally witnessed these past few weeks, instigated by Fed Powell speech on January 4, highlighting "patience" in hiking rates this year. Make no mistake, they were just playing catch up to where the rates market had priced in future rate increases; the Fed is merely buying itself time as they face a binary outcome ahead.
Just one word defines the price action of the past few weeks -- liquidity. If one were to take a look at the correlation of central bank balance sheets and S&P 500 price action, there is a direct correlation -- implying that once central banks increase liquidity in the system (by expanding their balance sheets, as an example), the market benefits directly as money flows into the system overall. After all, this is the reason why the markets and most asset classes had been so inflated over the past decade; quantitative easing.
Low and behold, once the Fed embarked on its quantitative "tightening," asset classes started to deflate. Contrary to popular opinion, this has been one of the cornerstone reasons for asset price inflation over the past decade.
There is no debate that macroeconomic data coming out of both the U.S. and China has been disastrous, even recessionary in some cases. China is stuck between deleveraging the economy away from all the debt, only to be faced with a severe slowdown that can undo all their hard work. They are stuck between a rock and a hard place and are trying to engineer some sort of a smooth process. A Trade War with the U.S. certainly puts a spanner in the works.
As markets fall, central banks turn more dovish and start echoing words of protectionism to calm investors. Mnuchin's words were a great example after the market collapsed in December.
Over the past week, China has injected about 1.1 trillion yuan worth of liquidity in the market. Yesterday, the market saw the biggest one day injection of 560 billion yuan of liquidity injected into the financial system via open market operations. The figures this week were 20 billion yuan on Monday, 180 billion yuan on Tuesday, 560 billion yuan on Wednesday, followed by 380 billion yuan on Thursday.
Chinese New Year is earlier this year, on February 4, and Chinese markets will be shut for almost a week around then. The PBOC annually injects liquidity into the system to offset this holiday and any pre-tax payments and maturing of MLF funds. This all adds to the credit impulse and supports the market, short-term.
Interestingly enough, Chinese markets have not reacted to this week's injection at all, as they are flat even on Thursday. What gives? With no resolution to the Trade War impasse between the U.S. and China, investors have no choice but to focus on the weakening trend evident in Chinese data.
S&P 500 Break-Through
One factor that helped the S&P 500 break through 2600 on the upside in the last few days was speculative funds (CTAs -- otherwise known as momentum funds) covering their all-time short positions they have had on since the end of December. As computer algorithms go, they have to follow their signals, so when liquidity pushes markets higher, they have to chase it and cover their shorts.
This break above 2600 could be a red herring. As much as people like to believe fundamentals are unimportant and it is all about following the trend, one cannot ignore fundamental analysis altogether. Trends are important, but they assist in accentuating the fundamentals, not offsetting them.
Most asset classes have been flat to boring all of January. It is only equities that are behaving crazily -- rallying up and down 10% over the past few weeks. Outside of something sinister, this liquidity boost seems to be temporary. Once the sugar rush is over, equity shall return to its path of least resistance. For now, that is down. After the squeeze from December lows, it is tee'd up perfectly to perhaps retest the lows of December. At least that is what the fundamentals are saying.