Stocks and Bonds

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Today I walk you through this week's price action on the S&P 500 and give my perspective on the Fed's corporate bond ETF buying program - and I do so in the words of this week's Mitchell Market Reports (each emailed by 6:45 am ET on the day listed) and a few charts that help to tell the story.

The Anatomy of a Market Call - S&P 500

"I expect that we will see better selling develop on any retest of the 2954 high. While it's natural to expect the 200dma to be revisited after such a strong bounce from crisis level lows, the slow momentum study is showing divergence, meaning it has turned down from overbought extremes and has moved lower even as the SPX traded higher last week."

This bearish divergence suggests that momentum in this recent bounce from channel lows is running out of steam" The Mitchell Market Report - Monday, May 11

The S&P 500 went on to fail up at 2945 on Tuesday, May 12 and to rotate -6.05% lower to the Thursday, May 14 low at 2766, taking out channel support (purple) in the process. SPX also traded below the 30 day moving average (dma) for time since early April although it never closed below it last week.

"This negative price action raises the importance of resistance at 2954. It also threatens further deterioration down below channel support to test the 30dma (2797) as support." - The Mitchell Market Report - Wednesday, May 13

As the chart to the right displays, the SPX saw downside follow-through on Wed, May 13 that took it down to 2793. At that time, the 30dma was at 2794. The index traded lower to 2766 at the open on May 14 only to reverse sharply higher to close at 2852.

"The S&P 500 has leveled off at the recent recovery highs and is exhibiting consolidative characteristics that should leave it moving sideways in a range between 2954 and 2721 as investors and traders await clarity on how the reopening vs surge risks is playing out." -The Mitchell Market Report - Wednesday, May 13.

The Fed's Upstart ETF Purchase Program

On May 11, "The Federal Reserve Bank of New York today announced that the Secondary Market Corporate Credit Facility (SMCCF) will begin purchases of exchange-traded funds (ETFs) on May 12." The Fed later reported it bought $305m in corporate ETFs in the first two days of the program.

Perspectives from the May 12, 2020 Mitchell Market Report"

"The New York Fed announced yesterday that it will begin buying ETFs backed by corporate debt today under the Secondary Market Corporate Credit Facility (SMCCF) https://nyfed.org/2SY2Bg7 . It seems to me that the reasons for and the benefits of such buying have already accrued since the program was announced on March 23.

To be sure, the credit market is functioning in a much healthier way since that announcement after nearly seizing up in the days before the Fed and Treasury came together on that program. The new issue market had shut down altogether prior to the concurrent announcement of the Primary Market CCF.

Since then, there has been record underwriting in new issue investment grade corporate debt. According to Bloomberg, "Supply is running 89% ahead of last year’s pace" with a 2020 YTD tally at $883.2b.

CNBC has reported that the Fed, through Blackrock, will buy approx $250bln of the $750bln allotted to the program. This will most likely flow into investment grade ETFs. The iShares iBoxx IG Corp Bond ETF (LQD) is up +19.5% from the March 9 low in anticipation of this flood of buying.

In a Monday night report, Bloomberg noted the investment management agreement with Blackrock says “Purchases will be focused on reducing the broad-based deterioration of liquidity seen in March 2020 to levels that correspond more closely to prevailing economic conditions,” Well, that has already happened, hasn't it?

The agreement also states “Once market functioning measures return to levels that are more closely, but not fully, aligned with levels that correspond to prevailing economic conditions, broad-based purchases will continue at a reduced, steady pace to maintain these conditions,” (via BBG).

Now, I know that the credit market is functioning much better in anticipation of getting this infusion of liquidity. However, conditions have improved just knowing that the Fed will step in. They have also improved because the nation has moved through the worst of the virus and because the economy is beginning to reopen. Time heals all wounds.

The Fed is right in toeing into the program today. It is also proper to employ just a third of the leverage available. Frankly, the total program, contemplated and unveiled in the depths of the market turmoil, may not be needed. After all, as noted two paragraphs above, with market functioning already improving, "broad-based purchases will continue at a reduced, steady pace to maintain these conditions"

In other words, the purchases will be scaled back before they even start given market conditions."

This chart plots the Bloomberg Barclays US Agg Corporate Avg OAS. You can see the option-adjusted spread widened about +270bps from late February to the March 23 high as liquidity dried up in the corporate bond market as the pandemic swept across the nation. It was also on March 23 when the Fed announced the Primary and Secondary Market Corporate Credit Facilities. The spread tightened in -161bps well before the Fed began to purchase IG ETFs on May 12 (Tuesday). Not only that, look how flat the OAS has been over the last three weeks, evidence of the curing of the market dysfunction.

The chart to the left is LQD - the iShares iBoxx investment grade corporate bond ETF. It bottomed down -30pts from the high on March 19 and is currently up +22.5% from that low. Obviously, the bulk of that recovery came in anticipation of the Fed's ETF purchases. The corporate bond market is much more orderly now after finding stability long before this week's ETF buying program started.

No doubt, the Fed will keep buying; it has to now so as to not disappoint those who have bought in advance of the operation. If the Fed doesn't follow through, it would lose credibility. The odds that the purchases amount to anywhere near the $750bln available under the SMCCF are anytime soon are slim. That's not to say the Fed won't eventually get there because it may need to if what has so far been a liquidity crisis mutates into a corporate solvency crisis. The Fed will use this program judiciously and appropriately as market conditions warrant.

This article is part of my LinkedIn Newsletter Series: Indicators and Insights – Perspectives on the Top Financial Market Movers with a View of What's to Come.

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This report represents the opinions of its author. It reflects market and financial information that we have obtained from third party sources; we believe it to be accurate, but we make no warranty to that effect and are not responsible for any inaccuracies in the information presented. Nothing in this report constitutes personalized investment advice to any reader or a solicitation to effect or attempt to effect transactions in securities. All investments involve risk. Past performance may not be indicative of future results. Due to various factors, including changing market conditions, the opinions set forth in this report may no longer reflect the current views of the author. The author is not an investment adviser, law firm, or accountant, and nothing in this report should be construed as investment, legal or accounting advice. Additional information is available upon request. Copyright (c) 2020. All Rights Reserved. The Mitchell Market Report,LLC