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S&P 500 Bull Market - It's Reflation Vs. Deflation

October 7, 2020, 10:52 AM Monica Kingsley

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Upbeat news, upbeat, anywhere you look - such was the mood yesterday until Trump announced end to stimulus talks, and stocks fell like a rock within minutes. Going from my open long trade's profitable 3420 to its overnight bottom at 3330 before recovering black into the black at well over 3370 at this very moment.

Headline risk happens, and works both ways. A few days ago, I got a question as to my Q4 trading strategy, to which I replied that for internal publishing reasons, I would be quite likely using more limit orders as of now than subscribers were used to from me, which means less short-term trades.

But coming back to headlines working both ways, and how that relates to my currently open trade. Would it have made sense to lock in open profits during the second half of yesterday's regular session? No, because the break above Feb highs (as seen on the daily chart later on) was well underway with the market internals supporting it to go on.

And that's the key also today - the market internals examination. Do they still support the stock bull run - was yesterday's slide as much a flash in the pan as Trump's corona test? The question will be elegantly answered right after I present your with the daily chart.

Let's dive in and check whether the setback fits my yesterday's words on bull markets climbing a wall of worry:

(...) There will be many more instances such as this hiccup - and stocks will be more than willing to look past. Mark my words, this bull market isn't going to end in 2020 - but perhaps it'll become finally broadly recognized as such still this year to the dismay of still much more numerous bears compared to the bulls. Sorry, no gloom and doom, no calls for a market crash, though I expect turbulences to go on till elections are over and done with.

S&P 500 in the Short-Run

I'll start with the daily chart perspective (charts courtesy of ):

Right as stock prices were returning above the Feb highs, the Trump stimulus news hit the wires. Sure it has made the candle look ominous at first sight, but is this reversal to be trusted? Raise your hands if you believe that there won't be a stimulus deal in the end. I view such hardball tactics as part of horse trading. Who blinks first, if you will.

That's why I am not reading too much into yesterday's plunge, and because of these dips likely having a very limited shelf life and the above described publishing limitations, I'm not letting them shake me out of profitable trades that make sense from both short- and medium-term perspective.

Credit Markets and the Fed

High yield corporate bonds (HYG ETF) didn't give up as much ground as stocks yesterday. While the volume was heavy, the price print says that this is no reversal. In other words, risk-on has further to run - and stocks with it.

And that brings me to the Fed and its actions to counter the deflationary corona shock. Aggressive rate cutting, balance sheet expansions and backstops. Similarly to the Great Financial Crisis of 2007-2009, the forces of deflation and inflation are battling it out - but this time, the newly created money doesn't stay on the commercial banks' balance sheets, it flows more into the real economy instead..

Is the pace of new money creation (the word reflation better describes the Fed's efforts) faster than the rate of its destruction? Let's dive into Danielle DiMartino Booth tweet that I ran into at Tom Luongo's Gold Goats 'n Guns:

It's common knowledge that the Fed's mission is to fight deflation tooth and nail. And as I have been saying over the summer, the central bank's interventions have worked, reinflation goes on, and stocks benefit - see the Jun 05 article called Reaping the Early Benefits of Inflation in Stocks.

Long-term Treasuries (TLT ETF) is another chart you see me feature quite often. I don't see a flight to safety here, and yesterday's upswing is actually a disappointing one (not for its upper knot merely). Yields are rising, which is conducive to the economic recovery - there is no flight to safety here.

In the 1980s, government bonds used to be called certificated of guaranteed confiscation - thanks to the galloping inflation outpacing bond rates. With Treasury inflation-protected securities (TIPS), the investor at least stands some chance against this invisible tax.

The TIPS chart (TIP ETF) shows that the credit markets aren't really questioning the Fed - there is no breakdown but I see the Fed's resolve to step in as likely to get tested shortly. Remember, the Fed is active here, and aims to send a message that inflation expectations are rising - on Aug 07, I pointed out that gold is frontrunning that in my article S&P 500 Bulls Meet Non-Farm Payrolls.

But the point is now that the Fed's inflation-is-here message hasn't progressed much in the last two months, which is why I see the central bank as likely to act and counter the above chart's sideways patch.

Just look at this 10-year Treasury yield's chart ($TNX). It's kind of a mirror view of the above - when bond yields rise, regular Treasury prices fall. And as the 10-year Treasury yield is approaching yesterday's open (the high of the red candle), it's a pressure on real yields to rise - which is not the development the Fed would prefer to see (debt servicing costs are another argument here).

In short, inflationary expectations aren't where the Fed wants them to see (remember the new 2% target redefined as an average inflationary reading instead of a one-off one), and we can look for the central bank to do more of the same if it hadn't worked out so far totally marvelously as the TIPS soft patch shows.

The other key takeaway is that the Fed hasn't lost control over the markets, far from it. Its actions aren't seriously questioned.

And the S&P 500? As I wrote already before, stocks love few things more than money printing - asset price inflation - before inflation starts to bite. Yes, the bull market is alive and well - and financials (XLF ETF) will prove that by performing better over the coming weeks and months.


Summing up, I look for stocks to recover from yesterday's setback in a heartbeat. The credit markets are painting a convincing picture, with the risk-on sentiment having an upper hand. The Russell 2000 and emerging market stocks remain strong, and so does copper. The dollar again didn't get pretty much anywhere. Once technology returns to trading with strength, the S&P 500 would be seriously boosted. As for now, a very measured grind higher in the 500-strong index remains a safe bet for the days and immediate weeks ahead.

Thank you for reading today's free analysis. If you would like to receive daily premium follow-ups, I encourage you to sign up for my Stock Trading Alerts to also benefit from the trading action described - the moment it happens. The full analysis includes more details about current positions and levels to watch before deciding to open any new ones or where to close existing ones.

Thank you.

Monica Kingsley
Stock Trading Strategist
Sunshine Profits: Analysis. Care. Profits.

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