We know the Fed will slow QE only if economic data shows stronger growth. While this would normally be a positive for stocks, the bull market that began in 2009 has largely been artificially manipulated by central banks in their money printing party to lift all asset classes, including stocks, higher, so the threat of slowing QE is enough to put a damper on the bull. Think of QE as morphine. It's highly addictive. When you take it away, the patient who's got cancer has nasty withdrawal symptoms.
While it may take months before the economy shows enough strength to trigger a tapering in QE by the Fed, the market should find its footing if history is any guide. That said, there may be short term issues created by the aggressive selling as we saw last week. Investors fully margined in stocks that suddenly lose value can accelerate the selling. Thus selling can accelerate in the short term.
History shows it takes "three steps and a stumble", ie, 3 interest rate hikes, to derail a bull market. That said, this is a very rough rule of thumb as there are plenty of cases where this aphorism does not apply. And certainly, these QE times make for a highly unusual market environment between the junk-off-the-bottom led rally in 2009, to the flash crash of 2010, to the generally trendless markets of 2011-2012, and finally the lackluster QE3 rallies in the first quarter of 2013. Nevertheless, stocks may not feel this sort of long term selling pressure for a number of months as a slowing in QE may take at least this long to materialize. However, the Fed's recent mention of a possible slowing of QE is enough to make the market nervous and sell ahead of the actual slowing. This selling can be swift and sharp, but also is often spurred by short-term liquidity issues, which creates volatility to where the market sells off then bounces back sharply.
Consequently, the MDM may move to a CASH signal. Friday's bounce was anemic. Further, June buy signals have a particularly bad track record in both IBD and MDM. Price/volume action in the major indices and leading stocks remains under pressure with the NASDAQ Composite and S&P 500 both trading under their respective 50-day moving averages, and the VIX has spiked to its highest level this year.
Adding to the pressure is China's Shanghai Composite index which plunged 5.3% to 1,963.24, led by bank stocks. It was the first close below 2,000 since December, and the percentage drop was its worst since a 6.7% fall in August 2009. The drop was due to concerns that Beijing may be reluctant to ease a liquidity crunch in the Shanghai interbank money markets. Consequently, short-term interbank interest rates in Shanghai hit record highs last Thursday.
“The worst of the liquidity crunch may now be behind us, but we believe interbank rates will stay at elevated levels until at least the second week of July,” said Standard Chartered China economist Stephen Green.
“The longer this policy lasts, the more concerns about banking-sector stability will be raised. It may also cause slower credit growth in the second half,” he said.
While MDM is giving more room for minor market corrections due to the market finding a floor as a result of the "QE bid," it is also picking up more selling pressure here thus may switch to a cash signal. It finds in this QE-challenging environment that it could also quickly switch to a sell should the pace of selling continue to increase. However, it could also quickly switch to a buy once it senses the market finding a floor and thus bouncing from oversold back to a QE-induced uptrend.