When Stocks Go Parabolic

Ivan Martchev  |

iStockphoto, Camrocker

The fact that the market is overbought does not mean that it will immediately correct; it means that we need to remember how overbought it is – based on credible indicators – and monitor if it is getting more overbought. We had the same dynamic in January 2018, and we had a rather unpleasant February 2018.

To be fair, overbought readings now are not as extreme as they were in January 2018, but they are getting closer by the week. Two measures that jump out are the RSI readings and how far the index is away from its 200-day moving average. If you say that bulls live above a rising 200-day moving average while bears live below a falling 200-day moving average, by that yardstick, we are definitely in bullish territory.

Right now, we are about 335 S&P 500 points above the 200-day moving average, and back in January 2018 we were above by a similar amount, but the index was at a lower level then, so the spread meant more from a percentage perceptive (340/2532=13.4% vs. 335/2994=11.2%). I am rounding the index points and the precise level of the moving average, but you get the picture. We are 11% above the 200-day moving average at present, which is not as extreme as January 2018, but it is still pretty high.

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Any RSI (or Relative Strength Reading) above 70 is considered overbought. The S&P tagged the RSI-70 line in October 2017 and hugged it pretty closely until it took off to about 85 in January 2018. Some weekly readings were even more extreme. This time around, we are not as extreme, but we sure will be getting there if we continue the same rate of ascent as we have seen recently.

Keep in mind that there were imploding inverse volatility ETFs back in early 2018. The more the index went down, the more they sold the S&P futures, which causes the index to go down more and for the machines to sell more futures. If there ever were a hellish negative feedback loop for a computer program running an inverse volatility ETF, that was it. (For more, see Marketwatch February 14, 2018, “This is what happens when Skynet from ‘Terminator’ takes over the stock market.”)

A lot of those inverse ETFs that automatically sell S&P 500 futures have been shut down, even though at $4.4 trillion there is considerably more money in ETFs today, so the computerized trading that helps run that business in the aggregate is more pervasive. More computers trading stocks do not necessarily mean more stable markets, as the fourth quarter of 2018 clearly indicates.

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Still, there is one key difference between now and early 2018. The Federal Reserve is unwinding its quantitative tightening from 2018 right now at a rate that is rather disturbing, averaging $100 billion per month in balance sheet growth and over $400 billion in total balance sheet growth since it made the infamous U-turn in monetary policy at the very end of September 2019 (shown in the chart, above).

It may have been that accelerating quantitative tightening helped pressure stocks in February 2018, but exactly the opposite is happening now, which I suppose is the good news. In other words, in looking for a culprit in a hypothetical scenario that repeats February 2018, you cannot point fingers at the Fed.

Right now, the Fed has your back.

As Money Supply Growth Accelerates

One can go crazy looking at the various forms of money supply, but these are the basic definitions:

  • M0 (M-zero) only includes cash or assets that could quickly be converted into currency.
  • M1 includes cash, checking deposits, and traveler’s checks (if anyone uses those today).
  • M2 is a broader measure of money supply that includes M1 and easily-convertible near money.
  • M3 is a measure of the money supply that includes M2 as well as large time deposits, institutional money market funds, short-term repurchase agreements (the Fed does a lot of those), and larger liquid assets. M3 is no longer officially reported, but its individual components still are.

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So, the four M’s incorporate one another in that order and expand on the broadness of the previous M’s. Still, the narrowest definition of the money supply – called the monetary base and designated as M0 – includes only currency in circulation and excess reserves. Those are the very excess reserves that the U.S. central bank creates by growing its balance sheet, yet excess reserves are not part of M1, M2, or M3. It’s like electronic money minted out of thin air that only banks can access, which is where quantitative easing becomes a little uncomfortable, as it begins to look like an alchemy experiment in central banking.

If you look at M1, M2, or M3, all forms of money supply have accelerated over the past year. If you look at M0, even it has turned up because of the growth in excess reserves due to electronic credits applied at commercial banks accounts at the New York Federal Reserve, as the central bank pays for Treasury bills it takes on its balance sheet, as well as other repurchase agreement activity that has accelerated.

I believe monetary policy affects money supply growth, but it affects the different M’s differently. QE and QT directly affect M0, while they indirectly affect M1, M2, and M3 in addition to the stimulative effect on borrowing by lowering the fed funds rate.

So, if the money supply growth is accelerating, there is only one elephant in the room to pin it on – the Federal Reserve. And right now, all of the M’s (0, 1, 2, and 3) are supportive of the stock market rising.

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Equities Contributor: Ivan Martchev

Source: Equities News

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.


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