Bill Cara

Why stocks are selling off and what to do about it. -Bill Cara’s View Sept 18, 2015

Why stocks are selling off and what to do about it.

As equity prices sell down today, bond prices are rising. Why the move from stocks to bonds? Is it simply the result of a growing concern among traders that corporate earnings are weakening, which calls for the lowering of equity prices based on traditional equity pricing models?

My sense of the market reaction to the Fed holding rates flat for now (i.e., due to persistence of global economic weakness) is only partly what is going on in capital markets presently.

I think most traders believe that the Fed must eventually raise rates in order to get the private sector to start financing the government debt so that capital market prices (i.e., stocks and bonds) can return to a long-term normal pricing model. Maybe the Fed’s thinking is that starting to do so now (October was favored by analysts) would be to cause the US Dollar to rise, which would be harmful to the country’s export trade and add to the government deficit. If so, by postponing a rate hike, the Fed would be hoping that other factors would lead to a recovery in global economic growth in the interim. Then, with global growth on the upswing, the US Dollar would not likely gain relative strength among the major currencies, and the resultant stability in currency rates would enable the Fed to start raising rates at that point.

There would be a weakness in that argument.

As the Fed begins to raise rates, even by +0.25%, there will be a shift from bonds to equity holdings. However, continued postponing of this move, as seems to be the case today, in all likelihood would just shorten the timeframe and increase the amplitude of the move when it does happen. For example, if the Fed pushed rates quickly and much higher than +0.25% at a time, the result would be a major sell-off in bonds and an unsustainable soaring of equity prices. China might cease their selling of US Treasuries, preferring to wait for the next Bull cycle to try to get a better price, but the equity market would also quickly develop a blow-off top, similar to what happened in China earlier this year.

Based on experience in Fed Watching, I have a sense that the Fed will delay the rate hike, then panic and hit the accelerator on rates in order to stem the sales of Treasuries by the Chinese. That sudden Fed move would then lead to a massive but short rally in equities that I have been anticipating since first writing about the possibility in 4Q2014.

Bottom line: If any time in the next 3 to 12 months you see a substantial rally in equity prices not supported by earnings growth, start lining up your sell orders. It would only be a matter of time before a crash. The ensuing Bear market in US and European stocks would then look something like the Shanghai index did earlier this year, which was a sharp drop of some 35 to 40% in a matter of a couple months.

In a fast moving market, timing is a matter of guesswork for most traders. So, even if you were to miss the first 10% of a decline from the market’s peak, you would be far ahead in the end.

I recommend keeping a list of the technical support levels of each of your holdings and of the Dow 30 stocks. I would be selling these holdings as and when support levels were being crossed on the downside.  Don’t listen to stories. Do let the market help you make your decision.

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