Why The Latest Surge In Stocks Is Different And May Signal A Big Drop

I have said several times recently in these pages that I believe a correction is coming and that it could be fairly large. Of course, to this point that has not been the case. After flat-lining for a month or so, the S&P 500 has resumed its surge, gaining about 5% in the last week and a half.

I have no interest in becoming the “perma-bear” who works on the broken clock principle and jumps out yelling “told you so!” when the market drops 10% (after gaining 25% since the prediction was made), but the nature of the most recent gain in the stock market has made me even more convinced that a retracement, or maybe worse, is imminent.

You may have heard that in dealing rooms it is commonly believed that when retail cash comes into the market, it is the strongest sign there is that things are about to turn. That is both insulting and arrogant, but as someone who worked in dealing rooms around the world for decades I can assure you that neither insults nor arrogance are in short supply in that environment.

Unfortunately, though, in addition to insulting and arrogant, it is also usually true, at least in one sense.

When retail money becomes the driving force behind a move, it simply means that that money is being noticed by traders, rather than the big trading desk and institutional cash that they usually pay attention to. Typically the retail money has been there to some extent all along, but what draws attention to it at the end of a move is that the flow of institutional wealth has slowed to a trickle, and it is institutional cash that really drives markets.

There is evidence that the stock market is at that point now, but to understand why, you have to understand a few things about institutional money.

First and foremost it is just about always fully invested. Fund managers are paid to manage these huge pools of money and, in order to justify their massive salaries and bonuses, returns have to be maximized. To give some flexibility, though, money not invested in stocks or other risky assets is usually kept in Treasury bonds. Treasuries are safe, but still offer a return and can readily be sold to move money into the more risky stock market.

When risk is being added, therefore, it can be seen not just by a rise in the stock market but also by a fall in Treasury prices. When prices of bonds fall as the result of selling, yields rise. Treasury yields therefore usually move in tandem with stocks when the big money is moving. You and I, on the other hand, tend to keep our “spare” money in cash. When it is retail money that is driving stocks there is therefore no concurrent move in yields.

With that in mind take a look at the two 6 month charts above. The first is for 10 Year Treasury yields and the second for the S&P 500. As you can see the post-election move in stocks up to early December coincided with a similar upward move in yields as funds, institutions and trading desks sold bonds to buy stocks.

Since then, however, the 10 year yield has stabilized, having peaked just below 2.6% on December 16th. There are other things at play here and it is not a simple tick for tick relationship, but to me that is a sign that the flow of institutional cash into stocks has slowed.

When retail money is driving a move, the assertion that it is the beginning of the end is offensive to many retail traders who work hard at what they do. Unfortunately it is also usually true. The evidence now suggests that we are at that point and when that is combined with somewhat stretched valuations a large correction, or even more, looks on the cards.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

Read Martin's Bio