Bearish Strategists Are About 6 Weeks Early

Major equity indexes are poised near potentially formidable resistance levels

Senior Vice President of Research
Aug 6, 2018 at 8:48 AM
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"For the third time in five months, a trade war topped the ranking of tail risks in Bank of America Merrill Lynch's fund-manager survey. Some economists have forecast that a full-blown trade war with China and other trading partners could send the S&P 500 down as much as 20%."
-- Business Insider [subscription required], July 23, 2018

"Markets in Asia plunged overnight, wiping more than $220 billion off the region's stocks as a fresh round of trade war fears sent investors seeking cover. The move came after the White House confirmed that President Donald Trump asked U.S. Trade Representative Robert Lighthizer to consider hiking duties to 25 percent as early as next month."
-- Bloomberg, August 2, 2018

"China Threatens to Impose Tariffs on $60 Billion of U.S. Products"
-- The Wall Street Journal [subscription required], August 3, 2018

On CNBC's Squawk Box last Monday morning, I was asked by co-anchor Michelle Caruso-Cabrera if I thought the Fed was the biggest risk to the market, as a guest expressed earlier that morning. I agreed with that assessment, basing my opinion on quantified evidence on how the equity market has behaved in the short term in the immediate aftermath of Federal Open Market Committee (FOMC) decisions since the current tightening cycle began in 2015.

Obviously, my opinion contrasts with that of fund managers, who cite a trade war as the No. 1 risk to the market and economy. Perhaps their opinion is influenced by the constant stream of media headlines and discussions about the negative implications of a trade war with our trading partners.

Judging by the action last week, I stand by opinion that it's all about the Fed, as the U.S. equity market rallied -- even amid fresh headlines about bigger tariffs on Chinese goods and China's retaliatory moves. The equity market action last week suggests to me that: 1) the market is discounting that a trade war will not occur; or 2) a trade war will not have the negative implications for the market and economy that many fear.

While individual companies and sectors of our economy may feel the impact of trade wars and tariffs -- either positively or negatively -- a takeaway from last week and the past several months is that a full-blown trade war is much more a risk to the Chinese economy and its stock market relative to the risk that it poses to the U.S. market. The Shanghai Composite Index (SSEC - 2,740.44), for example, did not fare so well last week amid the trade headlines, dropping 4.6%. Moreover, this index is down 23% from its January closing high, while the S&P 500 Index (SPX - 2,840.35) is only 1% below its 2018 high.

"In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1-3/4 to 2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation."
-- Federal Open Market Committee (FOMC) statement, August 1, 2018

"The arrival of a new trading month on Wednesday, Aug. 1, also brings a big event for investors from a macro perspective -- the Federal Open Market Committee (FOMC) policy decision... equities... have performed better in the immediate aftermath of a decision by the FOMC to hold rates steady versus a rate hike."
-- Monday Morning Outlook, July 30, 2018

The trade headlines did create intraday noise last week, with the SPX testing the round 2,800 century mark during a Thursday morning pullback. But ultimately, market participants again applauded the FOMC's decision to hold rates steady, with the SPX ending the week above its pre-FOMC decision day close of 2,816.

Per the table below, displayed in last week's commentary, the SPDR S&P 500 ETF Trust's (SPY - 283.60) best days have occurred in the month following a decision by the FOMC to hold rates steady as opposed to raising rates.

spy returns after fed meetings 0727

The probability of the market being higher one month after a decision to hold rises slightly to 83% when retail investors' expectations are tempered, as they are now. For example, the American Association of Individual Investors (AAII) survey for the week ended Aug. 1 showed slightly more bears than bulls. In other words, retail investors in this survey are net bearish ahead of the most lucrative time for bulls following Fed decisions since December 2015. And as displayed last week, when investor expectations are neutral-to-cautious, as they are now, the expected SPY advance rises to 2.2% from 1.4%.

It isn't only the retail investor that is cautious. In late July, strategists from Goldman Sachs, Sanford Bernstein, and Morgan Stanley recommended that investors be on guard for a serious pullback. Goldman is worried about a liquidity-fueled sell-off, as they still don't see spreads in S&P 500 E-mini futures as "back to normal" following the extreme illiquidity that preceded the February correction. Morgan Stanley is warning that a correction worse than February is looming, citing the loss of leadership in technology and cyclical stocks recently and the inability of value stocks to rally on strong earnings reports. Strategists from Sanford Bernstein summed up the price action concerns about value and cyclical stocks as a symptom of rising correlations between all investment factors, which ratchets up systemic risk for active investors.

One scenario is that this caution represents buying power in the immediate days ahead, especially with the SPX trading around multi-month highs on the heels of the Fed's "pause" last week. Another potential scenario is the strategists being correct about the risks, but early on the timing. With an expected rate hike at the September FOMC meeting, which will likely coincide with a ramp-up in midterm election uncertainty, perhaps their case for a pullback becomes stronger roughly six weeks from now.

Speaking of caution, the 10-day equity-only, buy-to-open put/call volume ratio rose again last week, and is currently above 0.60. The last time this ratio was above 0.60 was in the spring, which preceded an impressive rally.

Amid the potential short-term tailwinds from the Fed's hold last week and a sentiment backdrop that could supply buying power, there is resistance immediately overhead on multiple equity benchmarks that could slow or hinder a rally.

Resistance on the Invesco QQQ Trust (QQQ - 180.08), the large-cap technology exchange-traded fund (ETF), is at $180, which is 50% above its 2000 peak. The SPX could incur resistance at its January closing high of 2,872 -- which I mentioned above is only about 1% above its Friday close.

Meanwhile, smaller-cap indexes, such as the Russell 2000 Index (RUT - 1,673.37) and S&P MidCap 400 Index (MID - 2,000.04), continue to struggle with round-number resistance at 1,700 and the 2,000 millennium mark, respectively. In fact, per the chart below, the MID has been fighting the 2,000 level since its first test of this area in January. And with respect to the RUT, the 1,690 area is a round 10% above 2017's close, which presents another short-term technical challenge for RUT bulls.

mid daily with 2000 resistance

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