Is the current bear market rally signalling over-optimism?

Marius Paun | London, UK | Senior dealer | Thursday, 30th April 2020

We had the FOMC meeting yesterday and the Chair Jerome Powell pledged to keep interest rates near zero saying the unemployment rate is likely to rise 10% above March level (around 4%). The Fed also reaffirmed its commitment to do whatever it takes to prop up the US economy to the ‘absolute limit of our powers’.  All signs that the real economy looks under serious stress.

The US Labour Department’s previous jobless claims report released last week showed that in total 26.5 million American filed for unemployment benefits during the prior five weeks. That number now exceeds the 22.4 million jobs added to the US economy since November 2009 when American employment started its recovery after the Great Recession. Today another 3.84 million workers have filed for benefits bringing the total now to around 30 million. Problems in the labour markets are accompanied by a slump in economic activity as Gross domestic product data released yesterday showed a contraction of 4.8% in the first quarter. When the final revision will be in, the extent of the damage is expected to look a lot worse.

Let’s also remember the extraordinary measures taken in the past 6 weeks. In mid-March, the US Fed cut interest rates to 0.25% from 1.75% before the coronavirus pandemic. It then pledged unlimited asset purchasing to support the markets dubbed ‘QE to infinity’. In addition, the Fed started buying corporate bonds and exchange-traded funds for the first time. Around the beginning of April, the US Congress approved the $2.2 trillion stimulus package meant to support the real economy.

On the other hand, the Dow Jones rose over 530 points, or over 2.2%, yesterday to close at 24,633. Interestingly, on this occasion, it was not the Fed’s reassuring comments which led the rally, but rather developments in the biotech after Gilead Sciences reported positive results linked to its drug Remdesivir, coveted as a possible Covid-19 treatment for the past few weeks. Dr Anthony Fauci, who leads the National Institute of Allergy and Infectious Diseases, expressed optimism that Remdesivir ‘shows a clear-cut positive effect when treating the virus’. The Dow Jones is up 12 % in April which represents its best month since 1987.

So why the optimism in the financial markets?

To start with, the markets appear to have been inspired by news that “the infections curve” around the world seems to be flattening. In other words, infection rates are levelling out. However, more importantly, according to a Goldman Sachs report, it’s all that money printing which led to one of the strongest rallies in history, going back to 1970.

Between 2008 and 2016 the US Federal Reserve’s balance sheet expanded by $3.6trn. But just last month another $2trn of the stimulus was announced. ‘Don’t fight the Fed’ goes the saying – all those tech and e-commerce stocks rebounded so quickly because there was a wall of cash flooding the markets. If investors believe the Fed will do whatever it takes why be on the other side? Right now, deflation seems to be the immediate concerns (although when the world finally re-opens for business the narrative might change very quickly) and no chance the Fed will change its easing course. Investors can easily see the valuations are high but are they meant to keep buying bonds when yields are so low?

As impressive as the last month rally may look, there are plenty of investors and/or analysts saying this is just a bear market rally. They expect a retest of the mid-March lows possibly by late summer. The first reason; it’s not that easy to restart the economy, it’s not like igniting a car engine. The second argument would be that despite the Fed’s aggressive policies to support the economy and the financial markets the lockdown has done perpetual damage for many industries: travel, entertainment, pubs, clubs, sports and so on. It will take a lot of time to get back to the demand levels seen before Covid-19 and the world will look different; it will be a completely new normal.

At the time of writing a decline was underway in Dow as economic data continues to disappoint.

The chart indicates an all-time high of 29,585.15 on February 12th. As the coronavirus pandemic spread worldwide, a violent selloff followed to a low of 18,165.75 reached on March 23rd. That’s a 39% drop in less than 6 weeks. Notwithstanding this, we also had a meaningful rebound, beyond most expectations, as the current market price is 24430, 34% above the recent low. The short-term moving averages crossed above the longer-term one and both are now pointing upwards.

If bulls can keep the momentum going then look for a retest of resistance around the psychologically important 25,000 handles which held its ground this morning. Overtaking that could trigger another surge with next resistance seen at the 61.8% Fibonacci retracement at 25,221. If the aforementioned resistance holds it could signal the sellers are growing more confident. There is plenty of support within the 23,500 -24,000 range.