Picking Up Pennies in Front of the Steamroller
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The Federal Reserve wants to raise interest rates. At this point, that much should be clear. But this doesn’t come without costs, or risks, and the premise of removing years’ worth of accommodation and easing has produced a real quagmire of a situation at the world’s largest national Central Bank.
As the Fed has talked up rate hikes over the past year, or perhaps more accurately, the prospect of ‘normalization,’ risk assets have sold off aggressively. This is precisely what we saw at the beginning of the year after the Fed laid out their expectation for a full four rate hikes in the calendar year of 2016. After spending much of 2015 bantering about a single 25 basis point move, the Fed set expectations exuberantly high for rate hikes in the New Year, and this is what led to our bearish call on equities ahead of Q1. But as global risk markets collapsed on the first trading day of 2016, that expectation for higher rates began to moderate as the sell-off deepened until, eventually; the bank did a backwards-shuffle on rate hike plans throughout the first half of the year in the effort of assuaging risk markets.
And it’s worked! At least so far, as the S&P 500 has rallied-up to another fresh all-time high in the most recently completed quarter. Likely, few would’ve expected this from the driver that got us there, as the response to the Brexit referendum seemed to elicit panicked buying from investors afraid of missing out on the next big Central Bank salvo in response to the referendum.
To be sure, the global stock buying bonanza hasn’t been driven solely by the Federal Reserve. In the recent quarter we’ve also seen a ‘bazooka’ of stimulus launched by the Bank of England in response to the Brexit referendum. In the quarter previous to that (Q1, in March), we saw the same from the European Central Bank; and in Japan it may just be a matter of time before we see even more stimulus launched from the BoJ as they try to head-off decades’ worth of deflationary pressure. And all of this is happening as Chinese regulators carefully attempt to manage the capital flows within their own economy.
So the biggest players in the world (global Central Banks) all seem to be vested in the same interest of keeping stock prices higher despite the fears of the unknown around what might happen when seven-plus years of liquidity and accommodation are removed by the inevitable prospect of policy normalization. This will likely keep stock prices supported, to some degree, as bearish moves in stocks can be offset by more dovish language from one of the ‘big’ Central Banks. This can also produce an asymmetric risk-reward ratio as price action may not have much room to run to the upside before resistance sets in; while also carrying the risk of a dramatic downside move should we see a flare of macro risk factors.
The probability of an extended down-side move (meaning S&P breaking below 1900, or a move of greater than 11.6%) is probably pretty low at this point, with the primary risk factors being the US Presidential elections in November followed by the December FOMC meeting. Each of these can produce sharp moves-lower in stock prices in the near-term, perhaps even testing support levels as deep as 2,040 or 2,000; but the ability of the Federal Reserve to offset that weakness with more loose and dovish language will likely continue to exist, thereby moderating the potential for an extension of losses.
So, while the S&P 500 stays above the 2,000 level, traders and investors can apply the same similar ‘buy the dip’ strategy that’s been in vogue on US equities for over seven years now. Look for price to move down to support, place a stop below that level of support; if it breaks, take the stop and don’t throw more good money after bad, and simply look to buy a deeper support level later on.
The bigger move, or the proverbial ‘steamroller’ mentioned in the title of this article is what happens when a risk factor flares that the Fed cannot offset with more dovish language and additional assertions of ‘looser for longer.’ There are a plethora of these potential risk factors, such as dislocation in bond markets around the world that have been contorted by seven-plus years of low rates and ‘emergency like’ accommodation: Or potential banking stress in Europe as many European banks face riskier and riskier economic conditions, exacerbated by a combination of low rates (compressing margins), lackluster economic activity (growth, inflation, exorbitant levels of unemployment), and increasing regulations removing flexibility.
Again, these are all lower probability scenarios; but for the trader hunting for the next ‘big’ move, the argument could be much stronger on the bearish side of the coin than bullish because, frankly, monetary policy and Central Bank stance has driven stocks to exorbitant valuations that may be difficult to support without even more accommodation, much less in an environment in which the Federal Reserve is trying to ‘normalize’ policy; and arguments for even more accommodation are likely a non-starter while the S&P 500 sits so close to all-time highs.
For those that do want to take a bearish stance on stocks, equities in Europe may be more vulnerable to such a theme as the ECB is already quite extended on the QE-front after their ‘bazooka’ in March; and they may have the least dry powder available at the moment amongst the ‘major’ Central Banks. Stock markets in Germany and France could be especially vulnerable, as each has been working on longer-term bearish formations and setups.
The third quarter ended on a benign note, which wasn’t surprising as September ranks historically as the worst performing month of the year. Going back over 60 years it’s the only month in which the average return for the S&P 500 is negative. As we head into Q4 we need to keep in mind that October ranks as the most volatile month. However, worth noting is that the rocky nature of October (or affectionately called, “Shocktober”) is often a result of a poor September spill-over, where selling intensifies into a capitulation low, and volatility spikes sharply as a consequence.
Even though we aren’t immediately in a risk-off environment as the month/quarter begins we still can’t rule out the notion that market conditions won’t get hairy to start, as seasonality doesn’t turn positive again until we move into the last two months of the year (which are historically the two most bullish months of the year, on average).
Keeping it simple, first things first – the trend is up and will continue to be such until certain developments take place. We will start by giving the benefit of the doubt to the general trend along with the Feb trend-line and horizontal support in the vicinity of 2134/00.
But if weakness sets in below noted support, risk skews downward towards 1991 and another potential challenge of the bull market trend-line could unfold if selling becomes aggressive.
Bottom line: As long as the trend and support holds we will remain in the cautiously bullish camp, but should the market trade below noted levels of support our bias will turn accordingly.
S&P 500: Weekly
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During the second quarter, the DAX managed to break above the trend-line running down off the April 2015 highs, giving hope to longs’ that the index may turn higher and begin playing catchup to the world’s strongest stock market – the U.S. However, as we turn towards the final stretch of the year the DAX is struggling to find buyers to sustain its move off the post- Brexit lows.
The index found support in mid-September at the backside of the broken trend-line off the 2015 high; if the DAX is to sustain a bid it will be important for the index not to trade aggressively back below the sloping line of support. A sustained move higher will require a move back above the August high at 10802. If it can manage to do so, then the upper parallel of the trend-line off the Feb lows will come into play and then nothing to the left is visible until around 11400.
On the flipside, if the DAX does indeed trade back below the 2015 trend-line, it will expose the August low at 10092 and psychological 10k mark. A break below those levels postures the market poorly as 2016 draws towards a conclusion. Support will come in by way of a lower parallel of the Feb lows and then a parallel running back to 2011.
Bottom line: As long as risk sentiment remains buoyed and support levels hold, it will be tough to fight an upward tone, even if the DAX isn’t sporting the most bullish looking chart. If risk aversion hits markets, then we are likely to see the German index act as one of the leaders to the downside.
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If there is a market out there which presents as the most challenging to get a good feel for, it’s the FTSE 100. Following the post-Brexit spike lower and rip higher, the remaining six weeks of Q3 have provided limited directional indications worth leaning on. We will turn to general risk appetite for our cue as to where the FTSE may be headed with key technical levels in mind.
If global markets hold a bid, look for the FTSE to attempt breaking to new yearly highs above 6955 and challenge the record high at 7127, set back in April 2015.
With broad risk aversion the first level of support is the September low at 6654, beyond there nothing substantial shows up until the 6427/87 area, then the trend-line off the Feb lows.
Bottom line: The FTSE is a tough read, so we will take our cue from broader market sentiment and react accordingly to market levels as they approach.
FTSE 100: Weekly
Created in Tradingview
Japan’s benchmark index continues to struggle to gain any traction following the sharp drop to begin the year. An attempt to recover was made in the spring, but failed, resulting in the Nikkei trading back to yearly lows. A second attempt to rally ensued during the summer months, but once again Japanese stocks are failing to find sponsorship as the Nikkei struggles to overcome trend-line resistance off the August 2015 peak.
As long as the market stays below the trend-line off the 2015 peak and below the September high at 17156, the bias is tilted neutral to lower, with potential to carve out another lower high and trade back towards the yearly low at 14864 with broad risk aversion. Conversely, a weekly closing bar above the 2015 – present trend-line and the 17156 level will be reason to turn somewhat positive on Japan, with the April high at 17,613 as the next level of resistance. (The DAX and Nikkei have been highly correlated over the past year+ and even more so over the past 3 months (+84%); a break above the 2015 trend-line would be akin to the bullish trend-line break experienced in the DAX during August.)
Bottom line: The Nikkei looks ready to flop, but general global risk appetite may not allow it to do such, and may even help push the index above noted resistance. If broad sentiment does sour look for the Nikkei to make good on another lower high, act as a global leader to the downside, and challenge yearly lows or worse.
Nikkei 225: Weekly
Created in Tradingview
Shanghai Composite (Bonus Chart: Keep an eye on it.)
It’s been quiet on the Chinese front since the early year disruptions rattled global risk sentiment, and the expectation is that we haven’t heard the last from China. The big question is, when? If China’s stock market begins selling off aggressively, its message of instability could once again spill over into other major global stock markets. The ‘line-in-the-sand’ we have our eyes on is the trend-line extending back to late January; as long as it holds, then reasons to be concerned are muted, however; if it breaks it would be the first step towards indicating another leg lower is unfolding.
Bottom line: We are looking to the Shanghai as a potential ‘canary in the coal mine’ for global markets should support break and sellers begin aggressively pushing the index lower.
Shanghai Composite: Weekly
Created in Tradingview
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