Jesse Livermore famously warned his readers that “the stock market is designed to fool most of the people, most of the time.” Yet “All through time, people have basically acted and re-acted the same way in the market as a result of: greed, fear, ignorance, and hope – that is why the chart patterns recur on a constant basis.” This axiom has withstood the test of time, and the recurring pattern of a Bear Raid followed by an equally quick recovery rally has been played out on numerous occasions on Wall Street.
Such has been the case during the first quarter of 2016. The year started off with the Dow Industrials plunging -2,000-points lower to hit the 15,450-level. That was surprising, because according to a Barron’s and Bloomberg Poll; taken in Dec ’15; virtually every Wall Street strategist expected “No End to the Bull Market,” and predicted a +10% gain for the S&P-500 index and would end this year at the 2,220-level. Instead, by Jan 20th, it plummeted -12% lower to the 1,820-level, and completely contrary to expectations. (A year earlier, the pros predicted the S&P-500 index would rally +10% in 2015. Instead, it ended -1% lower).
What investors have witnessed over the first 12-weeks of 2016, was a classic “Bear Raid” or sudden, sharp panic attacks that frighten many investors into selling their shares in order to avoid losses to their retirement accounts. During a “Bear Raid,” quick footed short sellers seize upon news items, such as financial turmoil overseas, (in this case, the -20% plunge in the Chinese stock market in January), or exploiting largely unexpected, or “Black Swan” events that are far outside of the realm of probabilities (such as the slide in Nymex crude oil prices to $26.50 /barrel, – a 13-year low).
The objective of a “Bear Raid” is to make windfall profits within a brief time period through short sales. If the Bear Raid is successful and the target stock (ETF or index) plunges, short sellers can buy the shares cheaper on the open market. These shares would be used to replace the ones that were borrowed earlier and sold at a much higher price, with the short sellers pocketing the difference as a profit.
Bear Raiders cannot afford to wait for many months until their short strategy works out. They must act sooner, usually after a few weeks, and move to cover their short positions, before other investors see the beaten down market as a bargain. If operating in a centrally planned market, where the central bank is actively intervening to prevent sharp downturns from getting out of hand, the Bear Raider knows the gains from the short sale trade will eventually be reversed, and usually within short order. Once Buy-side investors begin to realize they’ve been hoodwinked, and scared out at the market lows, – they begin to pile back into stocks again at higher prices. What usually follows is an eventual recovery of all the previous losses that were engineered by the Bear Raiders.
Such was the experience of the Dow Jones Industrials index, where it formed a “W-shaped” double bottom on Jan 20th and Feb 11th, and then rebounded in a parabolic fashion, over the next five weeks, to end the quarter where it began, around the 17,500-level. The first quarter saw a lot of volatility, and one of the most interesting behaviors, was the US-stock market’s strong correlation with the price of crude oil. Q’1 saw the price of crude oil tumble from a starting point near $38 /barrel, to a 13-year low at $26.50 /barrel, where it also formed a “W-shaped” double bottom pattern, before rebounding towards $40 /barrel in the final five weeks of Q’1.
A key reason for the correlation between crude oil prices and the gyrations of the stock market, is the fear that many oil and gas companies could be pushed to the verge of filing for bankruptcy, if the price of crude oil lingers below $50 /barrel, which is considered to be the break-even point for companies in the high cost shale oil business. The Wall Street Journal suggests that the total debt of US oil and gas exploration and production companies, that is at risk of default is more than $200 billion. Last year, 36 oil exploration and production companies defaulted on $17.5-billion of secured and unsecured debt. In a recent interview with Bloomberg, Fitch’s Eric Rosenthal paints a very disturbing picture: the rating agency senior director predicts that about $40 billion worth of energy debt will likely default in 2016.
Currently, the energy sector accounts for more outstanding debt in the $1.8-trillion high yield “junk” bond universe than any other at 19%. When combined with metals/mining, the two most distressed sectors account for 25% of the high-yield bond universe. With $13 billion of defaults already tallied this year, and coal companies are the most prone to default this year, any sign of a recovery in base metal and crude oil companies has been greeted with a big sigh of relief in the US-stock market. Already, a post Feb 11th rebound in commodity prices, led by crude oil, copper, gold, and iron ore, has fueled a +12% rebound in the junk bond market ETF’s, and in turn, enabled the complete recovery of losses from the initial phases of the “Bear Raid” on Wall Street that took place in the first six weeks of Q’1.
Blocking the Dow’s advance at the 17,600-level last week, were warnings from six Federal Reserve officials, citing their collective willingness, to vote for a +25-bps increase in the federal funds rate to 0.625% at the April 27th meeting. Atlanta Fed chief Dennis Lockhart, regarded as a centrist, said, “There is sufficient momentum evidenced by the economic data to justify a further step at one of the coming meetings, possibly as early as the meeting scheduled for end of April.” Even a perma-dove such as San Francisco Fed chief John Williams – told Market News International in an exclusive interview that “he will be advocating for another interest rate hike as early as the April meeting or, failing that, at the June meeting – provided the economy continues to do as well as it has been.”
It is unclear just what he means by the economy doing well,” unless of course, the Fed’s mandate has nothing to do with the US economy and everything to do with the price level of the Dow Jones Industrial index. In other words, with the Dow trading around the 17,500-level, expect to hear more hawkish talk of a Fed rate hike in the weeks ahead.
“Bear Raids” have been a part of the US-stock market’s folklore for more than a decade. Throughout history, investors have blamed short sellers for some of the worst crashes in the world’s financial markets. Jesse Livermore was said to have pocketed $100-million in profits from shorting the stock market during the Crash of 1929. Before his death, Livermore wrote a book titled, “How to Trade in Stocks,” in which he described the dynamic of a “Bear Raid” as follows; “The theory is that most of the sudden declines or particular sharp breaks are the results of some plunger’s operations. The excuse for losses that unfortunate speculators so often receive from brokers and financial gossipers serves merely to keep you from wisely selling short. The natural tendency when a stock breaks badly is to sell it. There is a reason — an unknown reason but a good reason; therefore get out. But it is not wise to get out when the break is the result of a raid by an operator, because the moment he stops the price must rebound,” — Jesse Livermore, “Reminiscences of a Stock Operator.”