Sell signal finally triggered, stock markets sell off

What a week last week was for stock markets, and especially for one particular indicator. The Bank of America Bull/Bear indicator, which the week before last came within a whisker of the Sell signal, last week went above it, for the first time in five years.

And what happened? Investors sold, of course. They sold furiously. The Dow Jones index was down 2.5% or 666 points, prompting some people to speak of the devil. The S&P 500 closed Friday down 2.1% and the Nasdaq fell 2%.

The bond market was what spooked investors; the yield on the 10-year U.S. Treasury bond climbed to its highest level in four years, approaching the 3% psychologically important level.

But there were plenty of signs of overheating. Last week, before Friday’s selloff, there were “massive” inflows into equities, worth $25.7 billion, according to data from Bank of America Merrill Lynch. The year is still young, and yet, so far $102 billion went into equities.

This pushed the Bull/Bear indicator to 8.6 from 7.9, triggering a contrarian sell signal for risky assets. A move above 8 is a sell signal. Investors should only move back into risky assets once the indicator drops below that level again.

Bull/Bear index

The Bull/Bear indicator triggered a sell signal for the first time in 5 years.

The analysts at Bank of America Merrill Lunch forecast that the decline will take the S&P 500 to 2,686 by the end of the quarter from the current level of 2,762. The average peak-to-trough decline is usually 12% in the three months that follow the triggering of the signal.

The selloff is not confined to stock markets only. The decline in 10-year Treasury yields is usually around 58 basis points once the signal is triggered, according to their report.

It remains to be seen if Friday’s selloff marks the end of the equities bull market, which is the second-longest in history, or just a “healthy” correction.

The economic backdrop does not suggest a bigger decline should be on the cards: interest rate increases are still likely to be gradual, economic growth is ticking along nicely and the US fiscal reform should help boost companies’ earnings in the short term.

Over the long term, clouds are gathering on the horizon. Tax cuts are nice, but they will balloon the already wide US budget deficit. Inflation is still tame, but if oil prices stay at this level or increase further, they will spill over into other prices. Higher interest rates may offer battered savers some relief, but they will cut into borrowers’ spending power.

This selloff may or may not be the end of the bull market. But it is the end of easy money.

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