The bullet proof S&P 500 market fell 1.5% on Friday, and is down around 1.45% Monday morning after weekend reports that China is in a state of lockdown that's restricting 56 million people.
China appears not to have the virus under control yet, as we've heard statements that the virus has been contained, then travel bans, then school closings in major cities and then the move to extend the Lunar New Year holiday to Feb. 2.
The mayor of Wuhan waited till the weekend to reveal that 5 million people left Wuhan before the quarantine was put in place. The city was seeing large-scale human-to-human transmission and the death toll over the weekend doubled to 81.
At the latest count, around 3,000 people have been infected globally, and cases have showed up in the U.S., France, Switzerland and Australia as well as several other nations. China has just reported that markets will resume trading on Feb. 3, even though the Chinese A50 futures are down over 11% since this outbreak was reported.
Why is this a worry?
In 2003, SARS was a virus with a lower incubation period, the coronavirus has incubation period of up to 14 days. There are reports from various scientists that perhaps 100,000 people could have been infected so far. It is hard to tell, and no cure yet has been found, but it is viral and spreads like a flu.
China is the engine of growth for industrial and consumer expansion and given its link to world trade, there is no doubt this will put a damper on "economic trade" as we know it. Commodities such as copper, iron-ore, steel, and oil all will get hit. It is impossible to quantify the impact on demand, but suffice it to say that it will get a hit. The extent of it will depend on how fast the virus is contained and quickly stopped, and the economies helped by central bank liquidity support for markets.
Ironically, since 2019's fourth quarter, when trade wars were in full swing, 80 central banks have now been cutting rates and the Fed has expanded its balance sheet already to $4.15 trillion -- using all its chips in three months only because it feared President Donald Trump would get angry if the market fell by more than 1%.
The repo -- or repurchase agreement -- market crisis at the end of September got the Fed so spooked that it actually ramped up the balance sheet in three months what it took two years to reduce. Instead of asking what caused the repo crisis, the Fed nostalgic of September 2008, just reacted first and hoped to ask questions later, hoping the problem would go away.
Central banks around the world have been trying to stoke inflation and demand growth over the past few months. A globally synchronized effort in the fourth quarter of 2019, after the Fed's October statement revealed that it would not be too concerned if inflation ran above its 2% target even for a while. And with that confirmation the market started buying the reflation trade, for example, cyclically geared stocks including commodities, because it was convinced that for the Fed to raise rates, the bar is much higher. As we rallied copper all the way to $6,300 a ton from lows of $5,800 per ton and oil from $58 a barrel to $68 per barrel, around 17%. Energy and mining stocks rallied between 15% and 30%. We were beginning to price in an economic recovery, with a leap of faith, only to wait for actual economic prints like Institute for Supply Management and Purchasing Managers' Index to justify that bias. The economic data did stabilize, and with China pumping in liquidity in the markets, it seemed like it was just a matter of time before global growth would start to move higher from the lows of 2019's Q4, especially after the infamous "phase 1" trade deal was signed.
Low and behold as the market cheered the endless Fed liquidity and balance sheet expansion together with U.S. and China seemingly becoming best buddies and promising to play good in the playground, all institutional and hedge fund investors including speculative funds and retail investors were "all-in." The market was showing signs of a slowdown in momentum and breadth as it stalled for the last week or so failing to make new highs. Following January expiration of S&P 500 index options where all put protection expired worthless -- and investors were too complacent judging by the volatility (VIX.X) trading all the way back down to 12, the market was ripe for profit-taking.
Technically, we are breaking wedge formation patterns in the markets as they test their support, but also in the VIX that is squeezing higher now. These breakouts can happen quite fast as witnessed in the last year. The Fed's balance sheet also stopped growing over the past two weeks suggesting they had called a timeout to their "non-quantitative easing" QE. After all, the Fed pumping liquidity has been one of the main drivers of the S&P 500's rally over the past three months.
Profit taking is more an art than a science, in fact it should be a discipline. Regardless of whether investors have the appetite to go short, it is prudent to say, "thank you" after 25% gains and wait on the sidelines. The market was looking for an excuse to sell off, to come back to more normal levels, given most stocks were trading 8% to 10% above their closest moving averages. The coronavirus was the catalyst that sparked this sell off; catalyst or a self-fulfilling prophecy?
But the coronavirus brings with it its own set of worries, as this has effected the key engine of growth in the world, China. Investors, after having been in the "show me the growth" phase, will now most certainly not see that growth, at least in the next month or two. This is and will cause commodity stocks like copper and oil to be weak. This is not fundamental, it is a reaction pre-empting what can happen. Only when the dust settles can we start to look at "fair value" and dip our feet back in.
The Fed hosts its key January Federal Open Market Committee meeting Tuesday and Wednesday, where we shall wait to hear what it has in store for the markets regarding the repo operations it conducted and its "non-QE QE." Could we even see QE4? That is a possibility given how petrified the Fed is to see a relapse of December 2018 and September 2008. For now, it is best to be patient and sit on the sidelines, keeping powder dry to react once the time is right. And that will be the case, just after all the overextended technical indicators have had a chance to rebalance and come back to more normal levels.