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Dow Collapses as ‘Psychotic’ Rally Pauses. What Happens Next?

Last Updated September 23, 2020 1:59 PM
Ben Brown
Last Updated September 23, 2020 1:59 PM
  • The Dow Jones Industrial Average (DJIA) faded lower on Tuesday after a storming rally that saw stocks recapture most of March losses.
  • Skeptics maintain that this rally is ‘psychotic,’ driven by emotions and Fed liquidity.
  • But a fresh boom in margin trading suggests the market still has room to go higher.

It’s been called the most hated rally in history, but the stock market has almost fully recovered from the March massacre. After three straight weeks of gains, the Dow finally took a breather on Tuesday, falling more than 200 points in morning trading.

Some investors are still struggling to reconcile the booming stock market and the torrid economic backdrop. Speaking to Bloomberg this morning, Paul Gambles at MBMG Group called the rally ‘psychotic’.

Our biggest concern is trying to understand what this rally is based on … This is all entirely psychological. It’s as if the market’s had some type of psychotic episode.

But that doesn’t mean it can’t keep pushing higher. A breaking Reuters report suggests that margin trading is back  – a clear sign that investors are taking on more risk to capitalize on this rally.

Dow slides as much as 400 points

The Dow fell as much as 400 points after the opening bell, though by 9:37 am ET it had recovered to losses of 252.57 points or 0.92%.

Now trading at 27,319.87, the DJIA’s fall comes ahead of the Federal Reserve’s two-day policy meeting  which begins on Tuesday. The central bank is likely to hold course despite the strong jobs report last week.

Chairman Powell is expected to keep U.S. Treasury purchases ticking at $100 billion per month and mortgage-backed securities purchases at $80 billion.

dow jones industrial average, djia today
The Dow Jones fell by triple digits on Tuesday after a breakneck start to June. | Source: Yahoo Finance

The S&P 500 was down 0.84%, while the Nasdaq dipped 0.45% as the Wall Street party took a breather.

Where will the ‘psychotic’ stock market rally end?

Even the most cautious investors admit that they have no idea where this rally will end. Yesterday, hedge fund manager Stanley Druckenmiller said he was “humbled” by the rally as he sat on the sidelines.

And despite declaring the market ‘psychotic,’ Gambles also admitted he had no idea when the rally will end. But there are canaries in the coal mine, he said, with dollar weakness hinting at a global slowdown and speculative stocks like Tesla hitting all-time highs.

That usually precedes something pretty ugly.

Not to mention, the stock market is now trading at its most expensive valuation since 2001, relative to forward earnings.

s&p 500 forward guidance
The S&P 500 Index is rallying despite a sharp downward revision to 12-month earnings guidance. | Source: FactSet

More money is coming into stocks from the sidelines

Despite the over-valued prices, traders are still trying to play catch-up on a rally they missed. According to a Reuters report this morning, margin trading (borrowing money to increase leverage on stocks) is rising again.

Retail and institutional margin lending rose to $525 billion in April, up from $479 billion in March.

It’s a sure sign that investors are taking on more risk as stocks push higher. And it’s more than just retail FOMO. Institutions are being forced to get involved in this rally, or they risk massively underperforming their rivals.

Add this to the unprecedented liquidity sloshing around the markets  and stocks could conceivably push higher from here. As Jeremy Siegel at the University of Pennsylvania put it:

The amount of liquidity that’s been put into the economy by the Federal Reserve and the government… This is a liquidity-driven rally.

Is the Dow Jones in a new bull market?

As bizarre as that might sound after the fastest and most aggressive selloff in history, some analysts on Wall Street are hailing a new bull market. In his weekly market update, Morgan Stanley CIO Mike Wilson, who has been resolutely optimistic (and correct) from the depths of March, says the new bull market is here .

Index prices, the equity risk premium, market breath, and early cycle leadership are all following the same pattern we witnessed at the 2009 bottom during the Great Financial Crisis.

Dr. Ed Yardeni at Yardeni research said he’s not even sure it ever was a ‘bear market.’ Instead it was just a continuation of the bull market since 2009 . This rally is the ‘mother of all melt-ups’ as he put it, and may not slow down yet.