The Santa Claus Rally is likely over

It was almost perfect timing that last Friday I posted my view to call for a year end rally to continue. That was the time when S&P was crashing hard in a few days to 2005 and most of people were pessimistic and some were even looking for an Aug-like 1000 points drop in the following Monday. As a contrarian trader, I figured that was likely a short-term bottom. With high VIX and oversold junk bonds, I argued that we could see a quick year end rally from there with declining VIX and even recovering HYG for high-yield bonds. Apparently we nailed it, as in the past 3 trading days, S&P jumped to 2065 with crashing VIX and also advancing HYG. What a difference could the short 3 trading days make!! Now it seems everyone is bullish and S&P has reached the pivotal 50 DMA with a 3% increase within days, which is quite overbought at the moment. VIX is back down to the 15 level. The question is whether this Santa Claus rally could continue. Well, anything is possible but I'm afraid the upside from here is quite limited, if any. The Santa Claus rally may have done its course and is likely ending. Tomorrow we may see another gap high day but that will probably the exhaustion of the final up move. If the market has a higher opening but lower closing tomorrow, it will be a clear signal that the rally is ended and next week will likely be a very choppy short trading week to close the year end of 2015.


In the past few months, S&P has largely been driven higher by very few high-tech stocks, most notably FANG stocks. But in the past couple of weeks, these FANG have very much lagging behind and have not really participated in the latest rally. This is another warning sign that S&P may face a very tough 2016. S&P may visit the 1800 level at some point in 2016 if it continues with its downtrend started in Aug. This may be consistent with the signal the junk bonds are sending. We will see as we move into 2016 soon.


Since I will be traveling in most of the final days in 2015, this will likely be my last blog for 2015. I sincerely wish all my friends a very

Merry Christmas and Happy New Year!

Junk bonds are sending an ominous warning

Junk bonds refer to those corporate bonds that are rated below investment grade. Its formal name is high-yield bond because it has to pay much higher yields due to being more risky with higher risk of default. That’s why people also call them junk bonds. In the past 6 years, junk bonds have been chased by fixed income investors as they cannot find better interest income from anywhere else in the zero interest environment. As such, it has almost become the Wall Street darling, a rather hot investment product for years. People simply forget about the risk associated with it; actually the risk is huge, especially when the interest starts to rise. In the last 2 weeks, junk bond investors got the first sense of what kind of risk they are facing: due to the plunge of junk bond prices within days, they got stuck when they wanted to sell as not like stocks, bonds are typically more difficult to sell. The situation was so severe, several junk bond funds, started with the largest fund Third Avenue, got blowup and could meeting investors’ request to sell. But believe me, this is just the beginning and actually junk bonds are sending some very ominous warning that go well beyond just the junk bond investors. It impacts the whole financial world.

 

According to last week’s Wall Street Journal, “Junk bonds are headed for their first annual loss since the credit crisis…..US corporate high-yield bonds are down 2% this year…”. According to Barclays, junk bond annual losses are rare and actually in the past 2 decades, there have been only 4 other instances with such losses. Two of them were followed by the recessions with market crashes, one in early 2000s due to Internet bubble and the other in 2008 financial crisis. In addition, more evidence for concerns also comes from the junk-bond default rate. For this year, the junk bond default rate is still less than 3% but it is estimated to jump to nearly 5% or more next year. Be aware, a rising junk-bond default rate has even stronger correlation with economy and more often signal a recession when the rate reaches a high point. As a matter of fact, in the past 3 decades, the junk-bond default only went above 4% three times and each time it preceded a recession that followed: 1991, 2001, and 2009.

 

So what does that mean for us? Well, if the history is any guide, we may be at an early stage of an economy situation that may lead to a recession later. Of course, it does not mean anything imminent and does not mean the stock market will crash straight from here. Actually the stock market may continue to be doing fine for a while before the recession finally hits us. I think this may happen in the next 12-24 months. Just keep this in mind with the understanding that risks in the stock market become increasingly higher moving forward. Accumulation of a good chunk of cash may be a good idea and do not bet too aggressively for speculation. Rather, buying good quality stocks at good valuation will be much better for your wealth! From now no, you may want to pay more attention to what the junk bonds are doing and easiest way to do this is via HYG.

Is the year end rally done already?

I have been expecting a year end rally in the last 2 weeks of the year. Starting from Monday and following the FOMC announcement on Wed for a rate hike as expected with dovish comments from the Fed Chairwoman (Yellen), the market went up crazy and had recouped all the losses occurred last week. S&P jumped 70+ points within days, hitting its 50 day MA. This is an action clearly too fast too soon. Reasonably we cannot expect the market simply going up straight without a pause. A pull back should be within the expectation. But last 2 days heavy selloff has been quite intensive and today, S&P dropped down to 2005, losing all its gain from early this week. What a crazy market!!  The question is if there is still a year end rally? It is anyone's guess but I personally still believe we will continue to see a rally in the last few days of the year due to 4 reasons:

• We are still in a seasonally bullish time period, which has been consistently so for many years
• Today's panic selloff has made the market quite oversold, which in almost all the cases will lead to a strong rebound, baring black swans emerging over the weekend or next week.
• Junk bonds have led the stock market for quite some time. The hard selloff of junk bonds in the past week or so is again preceding the current stock market selloff. But at the moment, junk bonds are quite oversold as well (see the HYG chart below). I will not be surprised to see a rebound for HYG towards its 50 DMA (red line). If so, it will again support the idea for a stock market rebound leading to a year end rally.
• Finally, we did not see a runaway of the volatility as VIX was much contained and did not shoot up to the moon during the rather intensive market selloff. And the call/put options for VIX in the next 2 weeks are relatively even. This suggests traders are not expecting a much higher VIX (which is often associated with lower stock prices) in the near future.

So if anyone who dares to buy today during the panic selling, they may likely be rewarded handsomely next week, unless something devastating occur unexpectedly.

JO is back to trade again

A few months ago, I talked about trading for the coffee ETN, JO. I recalled it was around $20 or so and was poised for a pop-up. It was a good timing as JO indeed went up almost immediately after that for a quick 10%+ gain in just a few days. Nimble traders could have made a good quick money by taking the profit promptly. Since then, JO has come down again and wobbling around $18-20 for months. But I think another tradable opportunity is coming again for JO now. In the past few weeks, JO has quietly set up a bullish inverse H&S. It is showing an uptrend with higher highs and higher lows, which is supported by a strong positive divergence in MACD. Friday's sever market decline has also brought down JO quite a bit but it is right sitting on its uptrend line. Technically if JO can keep above this level I think it is ready for a quick move to the upside. If we are lucky enough, it could be another 10%+ return in the next few days or weeks. But remember to take such quick profit off the table swiftly as this is not a trade for long-term. However, if JO breaks down from here and closes below 18.50 (below the last low), the idea for its immediate next leg up is wrong and it is better to exit.

The Santa Claus rally is just around the corner

For many years, it has been a consistent phenomenon that the year end usually comes with a general market rally. However, this is usually preceded by a severe market selloff in the first half of Dec, followed by a strong market bounce in the last 2 weeks of the year. Last year, this was exactly like that when the market sold off very hard with VIX jumping from 15 to 25 within the first 2 weeks. Then the market went high significantly starting in the mid Dec as if everyone suddenly turned from being very bearish to bullish at the same time.  While the history does not always repeat itself, it often follows the same pattern. I think we may likely witness the same Santa Claus rally this year, following the same SC rally pattern as last year. As I said to friends at the WeChat groups in the last few days that I was expecting S&P should drop hard to 2030 or lower before a perfect SC rally could finally start, we got the hard selloff today and S&P indeed broke down the 2030 level and went down as low as 2008. Today's VIX also jumped hard to 25, which was around 15 just a few days ago. Technically speaking, the market is quite oversold at the moment and is due for a good bounce. Of course, the wild card is the FOMC next Wed when Jen Yellen is expected to announce a rate hike, first in almost 10 years. While it is widely expected and should has already been priced in, the market is still very uneasy about it as it may be worried about some negative surprise in their announcement. But personally I would bet such a surprise, if any, would be more in favor of the market than negative to it. The US economy is still very fragile in its recovery and the world economy is in a total mess. I don't think the FED will be taking any risk to announce something that could be perceived as very negative to the market. Therefore, I'm betting that the 2015 SC rally will occur as well, maybe starting next week, barring any black swan shows off.

Of course, I cannot know if today's hard selloff will mark the bottom before this rally, as there is still a chance some further selloff may occur before the FOMC next Wed. Buying some today as long positions but be willing to buy more early next week if further selloffs indeed happen is my game plan to play with the Santa Claus rally!