Sometimes, a good metaphor is the best way to describe what’s going on in the stock market.
We were having a hard time coming up with the perfect metaphor to use to compare to the current state of things (it was sort of like … oh, never mind). Luckily, strategist Michael Purves of Weeden Co. dropped one in our inbox that works pretty well.
“The markets are in tug of war right now,” Purves wrote. On one side of the rope, the macro conditions such as a weaker dollar, reduced expectations for interest rate increases and oil stabilizing in the $40 range are pulling the market toward all-time highs. On the other side, he said, corporate earnings and the economic conditions that underscore them “are weak and potentially getting weaker.”
This maybe helps explain why, except for when it fell out of bed last summer and again in the winter, the SP 500 seems to be stuck in that same range it’s been in for more than a year: 2,100 or a little above on the upside and 2,050 or a little below on the downside. But like any good tug of war that seems to be at a standstill, you have to wonder if even a little nudge on one side or the other could send the whole contest lurching in that direction.
To consider what could potentially do that, let’s consider the work of another strategist and rudely insert it directly into Purves’s metaphor. Marko Kolanovic, the sagacious quantitative and derivatives strategist at JPMorgan Chase, studies systematic strategies of hedge funds to determine how they will react to changes in market momentum and volatility. Money managed by these types of funds has grown in recent years, bolstering their influence on the market.
One of the most important inputs for many automated traders is simply momentum, or what the cool kids call “momo.” Is the market trending higher or lower compared with various dates in the past? To put it simply and metaphorically, these funds set their sails in the direction the market winds are blowing, and by doing so they may actually help the wind blow more strongly in that direction.
The market has been mostly flat over the last year, with that 2,050 neighborhood acting as sort of the center of gravity. The SP 500 closed Friday at 2,057 but dipped its toes into waters below 2,050 on the final three days of the week.
As Kolanovic points out, that means 12-month momentum is negative. In other words, the SP 500 is trading below where it was a year ago:
Same thing with six months ago:
Three-month momentum is OK, because the market was in the middle of its worst-start-to-a-year hissy fit in February:
But one-month momentum flirted with turning negative last week:
A rise above the 2,100 level, if it were sustained for a few days, could have caused trend followers to buy and help push the market a bit higher from there, Kolanovic told Bloomberg TV last month. But that hurdle proved to be too hard last month. The index closed at 2,100.80 on April 19 and 2,102.4 on April 20 but then decided it was more comfortable below the 2,100 threshold.
Now trend-following funds, according to Kolanovic, could be looking for confirmation of negative short-term momentum. And one-month momentum could turn negative soon even if the SP 500 doesn’t drop further simply because it was higher in the previous month. Should market swings widen, it could cause selling from other systematic funds that depend on volatility as the most-important signal.
This is why it’s worth paying attention should the SP 500 start dipping into the 2,030 to 2,050 level again. That’s where momentum is decisively negative and, to use Kolanovic’s technical jargon, it could “turn things ugly.”
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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