The NASDAQ Is About to Blow

Touching stock market graph on a touch screen device.
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There’s this cool, quirky and slightly scary sci-fi drama that’s just been released on Netflix called Stranger Things. Set in the 1980s, the US Energy Department, in the course of doing some crazy experiment on a kid, unwittingly releases a monster from an alternate reality.

I know, I know…but it is called ‘Stranger Things’.

Anyway, this monster wanders into the real world — lured by the scent of blood — and drags its prey back into this weird, toxic, alternate reality.

As a Back to the Future nut, I’m a big fan of alternate reality shows. And while Stranger Things is entertaining (helped by some pretty good acting…especially from the kids involved), it’s no Back to the Future.

But today’s Daily Reckoning isn’t a movie review. I bring it up because of the parallels with what is going on over at the Fed — another government agency that has clearly screwed up.

The only difference is that the government agency in Stranger Things, the Department of Energy, knew they had a problem. As far as I can tell, the Fed has no idea that it has unleashed a monster of its own.

The Fed appears to operate in an alternate reality of its own. It’s trying to play the role of God. Or at the very least, it likens itself to the Popes of the Dark Ages, convincing everyone that it has the ear of God, and that we must all bow down to it.

Overnight, the Fed wheeled out another speaker. This time it was Lael Brainard. Clearly spooked by the savageness of Friday’s market selloff, Brainard made the case for only gradual rate increases (has there been any other case?). From Fortune:

On Monday, investors, following a speech by Federal Reserve governor Lael Brainard, raucously toasted the idea that an interest hike was a no-go for September. The punch bowl, however, may be less full than it seems.

After hawkish statements from Fed Governor Daniel Tarullo and Boston Fed President Eric Rosengren, suggesting the Fed was ready to up interest rates, helped send the Dow Jones down by nearly 400 points on Friday, all eyes were on Governor Lael Brainard on Monday. She took the opposite view, presenting a case for raising rates very gradually.

Translation: The Fed won’t raise rates in September. But they still hope to do so in December.

But as shown by Brainard’s response to Friday’s price action (and we’ve no doubt she spent the weekend reworking her speech), the Fed has little to no tolerance for market volatility. So if they tell the market a rate hike in December is likely, and the market sells off savagely, do we get a rate hike in December?

Probably not. Monster: 1 Fed: 0.

Central Banks Creating Monsters

Anyway, it’s not just about the Fed. The Bank of Japan (BOJ) is causing all sorts of problems, too. They meet on 20–21 September (the same time as the Fed’s next meeting) and the market expects to hear something decisive about monetary policy.

Despite many years of monetary insanity, there is no inflation, or any decent economic growth, to speak of in Japan. The Bank’s credibility is pretty much shot to pieces. Its strategy has failed completely.

The concern is that the BOJ will wake up to what everyone already knows. That is, that QE doesn’t work, and that something else needs to happen.

That means the huge amount of free money flowing from the BOJ might be about to stop. Or at least come from another direction. That’s why Japanese government bonds look a little battered right now. In fact, you could say they are the canary in the coal mine.

As you can see in the chart below, Japanese government bond (JGB) prices reversed sharply in late July, on a disappointing update from the BOJ. A further fall below the recent lows could well signify the end of the great Japanese bond bull market.


Source: Optuma
[Click to enlarge]

Such an event would hardly be bullish for the rest of the world. If the bubble is indeed bursting, Japanese banks and pension funds would be in all sorts of trouble. Japanese households would also suffer losses, and may just call in the sizeable assets they hold in other global markets to cover the losses.

Of course, this wouldn’t be the first time someone fretted about the Japanese bond bubble bursting. After all, it is the original ‘widow maker’ trade. That is, plenty of people have blown themselves up betting against the bubble.

I’m not suggesting you do it, by the way. I’m just pointing out that the reversal which occurred in late July looks pretty ugly, and further falls from here would not surprise. And further falls in bond markets could lead to further falls in equity markets.

Specifically, I’m thinking of the tech heavy NASDAQ index. This long term chart does not look at all healthy. It’s a monthly chart that shows the bubble top in 2000, followed by the collapse and reflation back to the 2000 highs.


Source: Optuma
[Click to enlarge]

But the NASDAQ has struggled to move beyond the 2000 high. It appears to be a significant point of resistance for the market. This could well be a major top forming in the NASDAQ again.

I say that because tops can form in a few ways. One, like the 2000 top, goes parabolic. Such a move is always followed by a correction. In this case, it wasn’t a correction. It was the tech bubble bursting.

In cases of prolonged tops, you often see a period of sharp selloffs and sharp rallies. That is, a lot of volatility, but not much overall increase in the index. The NASDAQ rallied to a marginal new high in July 2015, followed by a sharp selloff.

It then tried to rally back to the high and failed, selling off sharply again before rallying to another marginal new high following the Brexit announcement. That new high occurred on the promise of more central bank stimulus, which is now under question.

So I think the NASDAQ looks vulnerable around here. An inability to hold around the highs suggests the probability favours a move sharply lower.

In short, the Fed may have saved the day today with some more jawboning, but some key markets look vulnerable at this point. I think we’re in for a rough few months. So prepare for it and keep some cash handy, as there will likely be some good buying opportunities to emerge from the carnage.

Cheers,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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