Meep! Meep! Have the Financial Markets Hit a Wile E. Coyote Moment?

10/09/2014 9:51 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

With Thursday's market plunge, the big question that remains is not how much damage has been done but how much still lies ahead, and for MoneyShow's Jim Jubak, an even bigger question is have investors and traders lost their faith in central banks?

I'm certainly not one to laugh at 335-point drops in the Dow Jones Industrials, or 2.1% declines in the Standard & Poor's 500 index (SPX), or another 2.7% plunge in the already hurting small-cap Russell 2000 index.

But the Standard & Poor's 500, to pick the broader big-cap index, is still, at 1928.21 Thursday, only 4.5% below its September intraday (and all time high) of 2019.26. And the index is still up 4.3% for 2014 to date.

The big question isn't how much damage has been done, but how much damage still lies ahead. Friday is likely to see a challenge to the 50% retrace of the April to September rally at 1916 on the S&P 500. We could get another Friday rally after the selloff of the next two days, but I doubt that 1916 will hold for long and I believe that we're on our way to test 1900. That 1900 level would still mark only a 5.9% drop from the September high.

What worries me right now are signs that the financial markets, investors, and central banks are about to experience a Wile E. Coyote moment. If that's true, then we're looking at a drop below 1900 with the increased possibility of a real 10% correction of the kind that we're haven't seen since 2011. Corrections are normal-S&P Capital IQ calculates that they happen on average once every 18 months or so-but it's been so long since this market has experienced one that a 4.5% drop can feel like the end of the world. (As an indicator of that, the CBOE Volatility Index or VIX climbed 25% today to the highest level since February. The VIX looks at demand for options on the S&P 500 so it's a reasonable proxy for fear in the big-cap market.)

I can live with 5% down, especially if it gives me some buying opportunities when traders and investors overreact to earnings reports that don't meet expectations. But 10% or worse-especially if it the market then muddles along at that lower level for a while-would require some more portfolio adjustments.

So what's a Wile E. Coyote moment?

Any fan of Roadrunner/Coyote chases has seen this moment over and over again. Wile chases the Roadrunner to the edge of a cliff and then beyond. For a while, everything is fine as Wile's legs keep churning along and he pursues the Roadrunner through thin air. But inevitably, Wile looks down, notices that he's running without a cliff, and stops running. Count the beat-1, 2, 3-and then Wile plunges to the canyon floor far, far below.

The financial market equivalent would be that moment when investors and traders-who have believed that central banks could drive asset prices higher by stimulating economies by printing money-start to question the ability of the Federal Reserve, the European Central Bank, the Bank of Japan, and others to print their way to economic growth. The Fed is, for the moment, headed to the sidelines with the end of its program of asset purchases in October and the first interest rate increase likely sometime around the middle of 2015. (Neither of these moves involves reducing the size of the balance sheet the Fed has built up through its asset purchases since the financial crisis.) That leaves the game-and the doubt-to the European Central Bank and the Bank of Japan.

It's pretty clear from the reaction to the European Central Bank's sketchy plan for asset purchases, announced on October 2, that many investors and traders doubt that the proposed level of purchases will be enough to give a boost to growth and inflation. In the weeks since the news, doubts have only increased so that now it's not unusual to find market commentary by some institutional guy or gal saying that the ECB isn't going to be able to push up growth or inflation. At the moment, it's not clear to me if the majority opinion is that the current plan won't accomplish that goal or that the European Central Bank can't achieve that goal no matter what plan it proposes.

The situation is different but similar in Japan, where the early hopes for Abe-nomics have turned into pessimism about the government's ability to create growth or increase inflation. In hindsight, the government's decision to go ahead with the increase in the national sales tax in March to 8% from 5% has turned out to be a huge mistake. The tax increase stalled what was a promising economic recovery and has led to a shift from optimism that Japan would finally exit its decades of no growth/deflation to pessimism that the Bank of Japan and the Japanese government can do something this time. The possibility that the government will go through with the second half of the tax increase this month has just increased the sense of deja vu all over again. The Japanese government has consistently shot itself in the foot by doing something to truncate every promising recovery of the last ten to 15 years. And the growing belief is that the Abe government will do it again.

All this is important because the power of central banks to push economic growth higher-to a great extent-depends on faith among investors and consumers that central banks can devise policies with the power to produce that end. It's faith in the power of central banks that more than anything else has produced the current long rally in asset prices.

That faith can keep markets elevated for a long time just as Wile E. Coyote can run on air just because he believes he can. If that faith in central banks is rewarded with results-asset prices do go up because investors and traders believe that central bank actions will produce that movement-then that moment when Wile looks down and starts his plunge to the canyon floor can be delayed for a long, long time.

The question right now for this market is have investors and traders lost their faith in central banks.

Are they starting to look down?

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