In my last post, I asked if the massive reversal we were seeing after having just entered bear market territory was actually just a dead cat bounce (a market condition during which a sharp reversal in value is experienced after a period of precipitous declines). Well, if we are just cat bouncing, we should know soon enough. From an historical precedent perspective, and current technical perspective, if this is not a true recovery the bounce will have just about run its course.
From what I can find, it appears that a typical dead cat bounce from the initial entry – or very near approach – into bear market territory falls between about 9%- 14%. As of this morning, the S&P 500 has advanced 9.9% from its December 26th lows.
This advance has been attributed to a wide range of factors ranging from Treasury Secretary Mnuchin settling nerves, to the Federal Reserve seeming and suddenly sounding more dovish, to newfound international trade optimism. In reality, however, not much of substance has changed. In fact, other than a strong recent jobs number, many data points from around the world continue to indicate economic sluggishness at best. What’s worse, even the good data point of strong jobs might put the Federal Reserve in a difficult position balancing its path to controlling potential inflation and avoiding financial market turmoil.
For now, unless the Federal Reserve explicitly states that they will temper their efforts to normalize the balance sheet or actually cuts rates, or if some earthshattering news comes out of the U.S./China trade negotiations, I am going to stick to the dead cat bounce theory.
A purely technical backdrop might also lend some credence to the cat bounce theory. One popular set of tools that technical analysts utilize are the Fibonacci Ratios. I won’t go into how these are derived – although it is a super interesting topic that I encourage anyone to look into – but these ratios are utilized as the basis of Fibonacci Retracement Ratios. Whether the ratios themselves are significant, or if it is just traders all looking at the same ratios that make them significant is kind of irrelevant. What is relevant is that, after big moves, these retracement ratios consistently provide at least some support and/or resistance. I will call it stickiness, for lack of a better term.
What is directly relevant to my cat bounce theory is that, after a nearly 10% rally in the S&P 500, we are just now tickling the first of the most popular of these retracement ratios, 38.2%. If this line in the sand proves too much to overcome, history might suggest that things could get much worse from here. After all, the general theory among technicians is that a move is not considered reversed until it can overcome the Golden Ratio reversal of 61.8%. As can be determined from the chart below, we are a long way from the Golden Ratio.
Not only do we have a way to go before we can declare our drop into bear market territory reversed, but, because of the velocity of the movement getting us up to this point, other technical indicators are beginning to flash overbought signals across progressively longer intervals. This might mean that not only is the buying a bit overdone in the very near term, but we may be in for a rough ride for weeks and months to come.
Financial markets are amazingly sensitive to sentiment. I would argue that markets can be irrationally sensitive to sentiment. Unfortunately, at the end of economic cycles, markets can get a little sentimental. Proceed with caution, as sentiment has a tendency to shift much more quickly than reality might warrant.