My sentiment indicator is bearish and the FTSE 100 is rallying, this has created a bearish divergence. This divergence is a common feature of bear market rallies. The decline should resume but it will depend on the behaviour of the S&P 500. As you can see the S&P has retraced a large portion of the previous decline (nearly 61.8%). I said there was a risk the S&P would produce a huge rally because people are still buying the dips.
Furthermore there is always the possibility the Fed will intervene as they did in previous crisis. People know this and they bought the dip in the knowledge that if they are wrong and the market falls further, the Fed will come to the rescue and the market will rally. Buying after a large decline appears to be a safe bet. Of course you need to have the courage to buy at the bottom, it’s like catching a falling knife.
It is possible the Fed already intervened without telling us, I read that the Fed balance sheet expanded during the recent decline, this suggests the Fed has been buying bonds to support the bond market. If so, this is big news because it is the opposite of what they told us they were doing. They said QE was over and they are now reducing the size of their balance sheet which means selling bonds. If they are still buying bonds they are still doing QE.
This would explain why the S&P has surged this week. At this stage and if the Fed does a u-turn, I think people will lose confidence in the Fed, it is bearish for the stock market. Doing QE this time would mean the last QE did not work, so why would it work this time? This would spread fear that the Fed is losing control and investors would not trust the Fed anymore, stock markets would sell off as a result.
The dollar and bonds are going down, this is negative for stocks, either the Fed does nothing and bonds and the dollar continue to fall and the stock market goes down, or they start QE again and investors panic and the stock market goes down again. Either way stocks will go down, the Fed will be powerless to rescue the markets. However, it is possible the initial reaction, if the Fed announces QE4, will be a rally as QE is associated with good news.
If the Fed comes to the rescue and the stock market rallies this will provide an opportunity to go short. As I said the central bank will be powerless to stop a bear market, if bonds and the dollar continue to fall, stocks will decline.
