After a strong but narrow bounce in the indexes on Monday, the sellers are active again here on Tuesday morning. The rebound on Monday was mostly due to oversold technical conditions and did not extend to smaller caps. The Dow Jones Industrial Average was the big winner as there was some movement into stocks that were viewed as less expensive.
The selling on Tuesday morning is due primarily to poor economic news out of China and is a reminder that maybe the economy isn't as robust as many market players have hoped. Exports from China dropped by the most since early 2020 when Covid first hit and imports also contracted. This combination pushed down the Hang Seng by 2% and also hit mining, oil and commodity stocks that are levered to Chinese economic growth.
This news is also reversing bonds. Bonds have been under pressure and yields have been rising recently as there has been increased optimism about the economy. The bullish narrative recently has been that inflation is going to contract and there will not be any notable economic slowdown in the near future. The bears have been convinced that the lag impact of monetary policy eventually would cause a recession, but that theory has been torn apart by the consistent strength in the indexes this year.
Bonds are jumping this morning as the safe haven trade is back on after the poor data in China, but this movement raises the important issue of whether estimates about the US economy have become too optimistic. If China is experiencing a significant slowdown, won't it also spill over into the US at some point?
There is a report this morning from Goldman Sachs' prime brokerage unit that bearish hedge funds were forced to close out short positions in June and July at the fastest pace since 2016. That action is what helped to cause the euphoric finish that hit the market at the end of July.
Now that significant shorts have been covered, they are no longer a market positive. It is ironic that this occurred just as the market is heading into the seasonally slowest time of the year and after earnings season is largely concluded.
From a technical perspective the market is very vulnerable here and the bounce on Monday did nothing to change that. If anything, the bounce probably helped to create a false sense of comfort that may have helped to trap some bulls who hope that the powerful momentum from July is not yet dead.
It is a good time for elevated caution as the market sorts out what is happening with bonds and deals with shorts who may be looking to re-establish positions that they were forced to cover into the recent top.
