The Dangers Hiding in the Market’s Huge Rebound

The Dangers Hiding in the Market’s Huge Rebound

REUTERS/Shannon Stapleton

Investors are probably grabbing at their necks, suffering from some serious whiplash as stocks have rebounded powerfully in reaction to Wednesday's Federal Reserve policy statement.

The Dow Jones Industrial Average soared 421.28 points, or 2.4 percent, on Thursday and is now just 200 points or so from setting a new record high. The S&P 500 also gained 2.4 percent and is up 4.5 percent over the last couple of sessions, the best two-day pop since November 2011.

Related: Why Big Oil Needs a Bailout in New OPEC Price War

But there's a problem: Not only is the rise likely predicated on confusion over the wording of the Fed's statement, but stocks have separated from other asset classes such as crude oil and high-yield bonds, suggesting that the market has gotten ahead of itself.

^SPX Chart

^SPX data by YCharts

The Fed's commitment to be "patient" in the pace and timing of its rate hike campaign in 2015 was accompanied by a non-dismissal dismissal of the "considerable time" language that investors had been comforted by for months. Long story short: The Fed will likely tease its first rate hike at its April meeting, with rates actually being raised at the June meeting for the first time since 2006.

Moreover, Fed officials dismissed recent market volatility, the risk the collapse in crude oil represents to the economy via the energy sector, and troubles in foreign economies. Those were all pretty hawkish positions in an announcement that was otherwise viewed as being more dovish than expected.

Related: Why America’s Energy Renaissance Has a Long Life

But, as Bloomberg reported, the machine trading algorithms that dominate the stock market probably didn't catch the nuances of the Fed's statement — more or less that "patient" was replacing "considerable time" — and aggressively bid stocks up after simply scanning the statement for the inclusion of the words "considerable time," based on the pre-statement assumption that it was going to be either one phrase or the other.

In other words, the algos may have gotten punk'd.

JNK Chart

JNK data by YCharts

The problem is that the timing of the Fed's first rate hike is tightening. Also, as shown above, the junk bond market — concerned about the risk of rising energy-sector defaults — remains under pressure. And the weakness in crude oil that precipitated the Dow's 5 percent-plus drop from its high earlier this month has resumed. Brent crude futures fell to $59.27 a barrel Thursday, even as a Saudi oil official said that a rise in supply from non-OPEC sources paired with a slowdown in the global economy are largely behind what he called a “temporary” drop in prices.

The Dow has also separated from the yen carry trade — a currency pair trade that stocks often follow on a tick-for-tick basis — as well as emerging market stocks.

I don't know how long the disconnect between the Dow and other markets will last, or whether the machine traders really did get duped by the wording of the Fed's announcement. What I do know is that this market is more dangerous and high strung that many realize.

For now, I prefer to watch that chaos unfold from the sidelines.

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