Dear Reader!
I’m sure you saw the Consumer Price Index reading for September – which is why I’m guessing you’re still not smiling!
Despite the fact that Fed rate hikes haven’t made a dent in inflation, the market rose on the news with vigor not seen since last March.
There’s a reason for the irrational buying exuberance, and it may not be what we’re all hoping for.
That means the sharp rally is probably a fake-out.
There are several reasons for the market to look like it has hit a bottom and is ready to rock on to higher ground, but the foundation it’s on is not solid.
So, don’t be fooled that we’ve hit rock bottom just yet, but take advantage of the short-term market movement ahead, and then look for signs for the next round of turbulence.
Here’s what to do…
THE MARKET HAS REASON TO RALLY
I don’t think it’s any great secret that bargain shoppers are eager for buying opportunities.
One such opportunity is an over-sold market. I mean, large selloffs create buying opportunities – and they have for a long, long time.
Since 1946 there have been 29 market declines of 10%-20% with an average recovery of approximately four months.
Since September 12, the market has dropped nearly 15% if we include the low on Thursday, when the CPI was announced for September.
Even in recessionary economic conditions, investing psychology would imply that even a 10% market decline feels like a correction worth taking advantage of, even if it’s only for the short-term.
A 15% market pullback creates a prime buying opportunity for traders, and short covering can create an illusion of market confidence.
Short-Selling Plays a Big Role at Times Like This
Short sellers are traders who borrow shares to sell and open positions, then, after the stock or ETF has declined in value a buy order is placed to close out the position.
But, since short selling requires stock’s prices to fall, there are times when stocks trend upward that short-sellers are forced into aggressive buying.
I mentioned above that after markets declined to the psychological correction levels of 10 percent or more, bargain hunters can engage in buying. In turn, this creates a panic situation for the people and institutions holding the millions of short positions in the market.
And then conditions are ripe for prices to rocket even higher. You see, as the market begins to rise, short-sellers become panicked, causing a buying frenzy – called a “short squeeze.”
Oftentimes a bottomed market will make its reversal with extra heavy volume on the buying days, but when short sellers are frantically covering, it can create an illusion that the worst is behind us.
But the data doesn’t lie.
As you look at the chart below, you’ll see that we encountered a candle on Thursday, October 13, that swallowed up the previous three down trading days of the market, and it was accompanied with volumes not seen since March.
(Bullish Candle Associated with Excessive Trading – October 13)
As short-sellers join the bargain hunters in a buying frenzy, investors can get confused into believing that the market bottom is finally here… when it isn’t.
Being informed about the greater economic situation, however, can help us to avoid the wolf in sheep’s clothing these rallies represent
Here’s the big picture.
The U.S. Economy is in Severe Turmoil
When the volatility of food and energy are stripped out, the annual U.S. Core CPI accelerated to 6.6% in September, 2022.
Despite the Fed’s efforts to aggressively hike interest rates to curb inflation, the new reading is the highest since 1982 and was also above the market’s forecast of 6.5%.
(Core CPI: September, 2022)
Steady and rising inflation rates with rising interest rates is a prime combination for a recession.
In fact, most CEOs believe there’s a recession on the horizon. When more than 1300 CEO’s at large companies worldwide were polled, advisory firm KPMG found that 91% of the U.S. respondents believe there will be a recession in the next 12 months – and not a short-lived one.
And since the Fed is not done with raising rates we can expect a widespread reduction in the workforce – so, rising unemployment.
Additionally, The Fed has lost credibility from some central bankers, and they know inflation must drop if their institutions will survive the economic conditions.
Essentially, there’s a growing belief that the economy must crash hard before it gets better, and the idea of a soft landing is nearly extinct.
All the data’s pointing that way.
The market may be poised for a bounce, or potentially a short-term rally, but the indications of a full reversal and recovery may very well just be a wolf in sheep’s clothing as we consider the bigger picture.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a range of strategies to make money in a strained market environment.
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