Our medium term S&P 500 model does not know if the current correction is a long one or a big one (see weekly model update). Since we invest by our model, we are currently sitting on 100% cash as we wait for either type of correction to be completed. However, our guess (which does not impact our investment decision) is that this is probably a big correction instead of a long and shallow one. There are several headwinds that may push the U.S. stock market to new lows.
The S&P 500 has seen an increase in volatility this month. Volatility itself is not a bad thing. In fact, high volatility near the market top may be bullish because there's a chance that the market has decide to consolidate instead of correct. However, markets that crash and then remain volatile for multiple weeks is bearish. High volatility after a market crash (like the crash on August 24) means that investors and traders are very nervous. If someone or (a group of investors) sells a lot of stocks into the bounce, all the nervous investors and traders will dump their positions. Their frantic selling will cause the market to make new lows on heavy volume. Volatility usually subsides when the bottom is in because the market begins to rise steadily and incessantly. Low volatility shows that investors are confident in the rally. Thus, they will not be shaken out of their long positions at the first sign of trouble. With the S&P 500 swinging 30-40 points up and down each day, volatility remains high. Hence, it's likely that the S&P will make fresh lows.
The U.S. Dollar is in a Bull Market
Regardless of its multi-month correction, the U.S. dollar is still in a bull market. Bull markets that go parabolic typically do so in 3 distinct stages.
- Stage 1: The market rises steadily day after day. Some value investors scream "bubble!" when the market rises for many months. Their selling causes the bull market to enter into Stage 2.
- Stage 2: Heavy selling from investors who think that the market is "overvalued" causes a big significant correction. Any decline in the market seems to validate the value investor's belief that the bull market is over. But to the value investor's disbelief, the market soon makes new highs, proving that the bull market is far from over.
- Stage 3: The market rises rapidly. Unlike Stage 1, the market is no longer steady in Stage 3. It feels like panic buying. The market might crash one day, only to see the next few days push the market to new highs. This is the final stage of the bull market.
The U.S. dollar has completed Stage 1 and has almost completed Stage 2.
- The first stage of the U.S. dollar's bull market was driven by a strong U.S. economy. U.S. economic data was on fire in 2014 while the European economy tanked. (The Euro accounts for more than 50% of the U.S. dollar index). Stage 1 ended when the U.S. dollar almost reached parity against the Euro.
- The second stage of this bull market is almost complete. The U.S. dollar has been in a massive correction since March 2015. This correction has lasted 9 months, ranking it among some one of the longest corrections in the U.S. dollar's history. This means that the second stage will end any day now.
The U.S. dollar will soar when it enters Stage 3. The U.S. is entering into a deflationary phase that will last a few months. Recent CPI reports show that U.S. inflation has no intention of rising from the zero mark. Inflation cannot pick up unless commodity prices pick up. With oil unable to bounce significantly and other commodity prices behaving likewise, it doesn't seem like inflation will pick up in the next few months. In fact, commodity prices will probably continue to fall. Jim Rogers thinks that gold will fall to at least $960 before the commodities bear market can end. Since deflation is bullish for the USD, perhaps it's the deflation theme that will drive the U.S. dollar to massive new highs. A strong U.S. dollar is bad for the U.S. stock market since it will hurt U.S. corporate earnings. In this weak global economic expansion, no country wants to have a strong currency. Strong currencies hurt exports. The U.S. dollar has not appreciated in Q3, which means that it will not impact Q3 2015 earnings. I expect that the USD will impact Q4 2015 and Q1 2016 earnings.
David Tepper mentioned the impact that the refugee crisis may have on the Eurozone. Many of these "refugees" are economic migrants from Africa and other parts of the Middle East. The Eurozone is already enough of a mess. Their economy is limping on life support and political tensions are high. The added weight of a refugee crisis can only hurt Europe's economic and political landscape. These refugees will be a heavy financial burden to the European society. If Europe's economy craters under the weight of this additional burden, it may affect the U.S. economy and stock market.
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