Will A Trade War Take Down The U.S. Stock Market?

What is the biggest risk?

The U.S. stock market is under pressure on concerns over US/China trade talks.  Last week stocks attempted a recovery, but a breakdown in trade talks has increased selling pressure this week.

Given the circumstances, U.S. stocks have held up well.  The topic is not new; the market has had time to consider various scenarios.  Overall, a restriction in trade is bad for the U.S. and China.  Interestingly, so far, the stock market seems to be taking it in stride.  In terms of the major U.S. stock indexes, the selling has been less volatile and on lower volume than we saw last fall when the Q4 correction began.

After a strong rally through April, the stock market is due for a rest.

More importantly, perhaps, is the action of many leading stocks.  They remain in very constructive price patterns and are not showing evidence of widespread panic selling.  When leading stocks start to crumble the likelihood of a deeper and prolonged correction increases.

In terms of the stock market performance for the balance of 2019, it may come down to how well U.S. companies have prepared for an extended trade war.  We have already heard from companies like CISCO who has become less reliant on manufacturing in China.  Other manufactures have been reported to be making adjustments to their supply chain out of China as well.

With the push to bring manufacturing back to the U.S. through reduced regulations and tax incentives, U.S. manufacturers in China have more flexibility to deal with the current trade challenges.  For some companies, however, the investment made in China is a long-term commitment.  For those companies and the global economy in general, we can hope for a speedy resolution.

The big worry is whether U.S. companies will suffer an earnings recession due to restricted trade with China.  This is the biggest risk to the U.S. stock market and if one is expected to develop, expect a deeper correction.

China’s move to devalue the Yuan may turn out to be a net positive for the U.S. by reducing import costs, potentially taking some of the sting out higher prices from tariffs.

We should prepare for economic pain.  China is a leading supplier of some rare earth minerals used in high-tech components and materials; expect China to restrict access by U.S.companies in China as well as exports to the U.S.

If there was a time for the U.S. to address our concerns with China trade, it is now.  With tax incentives to onshore corporate money and the healthiest developed economy in the world, the U.S. is in a strong position.  Our economy is on a mild acceleration path whereas China remains on a decelerating path.

The following charts are examples of leading stocks from my Watch List Indicator that are holding up well given current market concerns.  Interested in learning more about my Watch List Indicator? Email me at info@dightmancapital.com.

No specific investment recommendations have been made to any person or entity in this article. Investing involves risk including the loss of capital. Conduct your own research before making any investment decision, or work with an adviser like me.  Call Kelly at 877-874-1133 to schedule a phone call.

Q1 2019 Market & Economic Review

U.S. stocks experienced a strong rally in the first quarter of 2019.  The biggest performance driver came from the Federal Reserve pausing their interest hikes.  Between 2017 and 2018 the Fed raised the Fed Funds rate approximately 8 times and until recently expected to continue raising rates into 2019.  The sell-off in Q4 was largely attributed to the Fed moving too fast with interest rates combined with lofty stock valuations and a mild slowdown in economic activity.  The Fed is also in the process of reducing their balance sheet by selling back the bonds they purchased during their QE program.  They reached a level of $50 billion per month but have since slowed the program dramatically and expect to put it on hold soon.  The Fed actions suggest that while the U.S. economy continues to improve, it remains in a fragile state.

Economically we are experiencing a mild slow-down as reported by Doug Short of Advisor Perspectives in his “The Big Four Economic Indicators”.  For example, January Real Income experienced a sizable decline, but that was after 8 months of growth and followed December’s increase of 1.06%.  Real Sales in February also dipped and 4 out of the last 11 reports have shown declines.  Industrial Production appears to be pausing, with a combination of 2 shallow declines and one small increase during the last three months.  Employment remains the shining star, but February almost reported a decline.  Here’s a look at recent numbers (several reports for March and one for February still need to be updated).

In a report by State Street Global Advisors, they reported confidence of North American investors shows a slight improvement while confidence for European investors declined further.  In the U.S. investors appear skeptical.  In Europe they are faced with BREXIT and a host of other challenges, including violent protest in Paris.

Regarding all the talk about the Yield Curve inversion, we remain in an extremely low interest-rate environment which may reduce the predictability of a future recession a yield curve inversion has had in the past.  The other factor to note is the long lead time between the inversion and the start of a recession (16 months since 1976).

We are at the very beginning of Q1 corporate earnings season.  As of last Friday, 25 companies have already reported quarterly earnings.  Overall the market expects a decline in earnings compared to a year ago.  However, as of April 5th industry analysts project a 8% price increase for the S&P 500 over the next 12 months according to FactSet.  During the last 5 years analysts have overestimated their 1-year price target by 1.5%.  The more constructive takeaway here may be the directional move versus the magnitude of the move, especially give the gains produces in Q1.

There are two developments currently working their way through the political process that could have a positive impact on the market.  A favorable resolution to trade negotiations with China and talk of an infrastructure bill, potentially ready for a vote this summer.  Positive developments in these two areas would go a long way toward helping the economy get back onto a stronger growth trajectory.

Overall, I feel pretty good about the economy and markets.

Inspiring Podcast by Great Investing Minds

Check out this podcast by one of our top investment providers, ARK Investment Management.  In Episode 9 of FYI (For Your Innovation) you are going to hear from three people.  The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist).  During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer.  A truly inspiring, power packed podcast, on investing in disruptive innovation.

Now We Need A Follow-Through Day

True, some of the largest single-day stock market gains come during bear markets.  December 26th, 2018 marks the first time the Dow Jones industrial average gain 1,000 point in a single session.  Experienced stock market investors know, one big up day does not mark the end of a downtrend.

Investors should also note, Wednesday’s advance was the first day of a rally attempt.  If stocks can stage another meaningful advance in the next 7 trading days, preferably on day 4 through 7, the worst of the selling may be behind us.  Rally attempts followed by follow-through days are no guarantee, but they often signal the start of a new uptrend.

Source: Investors Business Daily

There were other signs of optimism in Wednesday’s big advance.  Stocks from retails, software, internet and consumer spending led the market’s upside.  Growth stocks are preferred over mature, defensive sectors when leading the market out of its first bear-market correction in seven years.

The ratio of advancing stocks to declining stocks delivered wide breadth, another positive.  Nasdaq winners outpaced losers nearly 4-to-1.  On the NYSE, winners led by 5-to-1.

Also of note, there is a tiny but growing group of quality growth companies forming attractive chart patterns.  These companies feature strong fundamentals, especially in terms of sales and earnings growth.  Often, they are smaller, younger companies introducing new products and services.  It is one of the more encouraging signs given the renaissance of innovation and entrepreneurship underway, something we have not experienced to this degree since the 90’s.

If stocks can hold levels this week and deliver a strong rally on any day next week, that would deliver a perfect follow-though day and improve the odds of a new rally as we enter 2019.

Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

The Grind To Lower Valuations

Let’s think about the future for a moment.  After all, that is what the stock market is doing constantly.  Up to this point in 2018, the stock market has had a very positive view of the future.  Why wouldn’t it?  Corporate sales and earnings growth have delivered in the strongest economy since 2008.

In addition to an economy that is strengthening, we are also experiencing an innovation renaissance.  Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs.  If you spend any time following science and technology news, rarely a week passes without a new scientific announcement.  Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990.  The future did not look very bright.

The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds.  Many commentators point to the increase of debt by corporations as a major risk for the economy.  So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.

At some point in the future we will see another credit event like the sub-prime debacle of 2008.  That is the nature of a credit-based global economy and it will likely trigger a deep recession.  Perhaps we are on the verge of such an event but the high-yield market does not seem to think so.  It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.

Stockcharts.com, Dightman Capital

If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.

I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S.  But I digress, that is the past.  What is more important is will these policies allow the U.S. economic expansion to continue?

In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight.  I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession.  There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.

Excellent Technical Analysis Example

There are a lot of technical indicators used by stock investors.  Some screens are so filled with colors, lines and data it tough to make heads or tails from what you are looking at.

It is helpful to remember there are only two data inputs.  Price and Volume.  Price determines the trade direction and volume establishes conviction.  Focusing on these two variables and adding a simple relative strength indicator can yield a great deal of information about the potential near-term price action.

Take the example below.  This is a high-growth tech stock that has delivered outstanding returns to investors over the last couple of years.  This stock when public in 2015.

Marketsmith, Dightman Capital

In weekly chart above we can see three different basing patters (identified by the green dots and curved line).  Two of these bases were consolidation types and the middle base was a cup w/handle type (the handle slopped upward which is a potential concern).  The most telling part of the current late stage base (also a warning) can be seen when comparing it to the prior consolidation base of about a year ago.

Notice how the current base is downward sloping (current price is near the bottom of the base range).  The base this stock produced over a year ago featured the price staying more in the middle and then upper range.   You should be able to see an upward sloping trend just looking at it.  The current consolidation is producing the opposite, a downward slope.

Below the price bars you see the blue relative strength (RS) line. The RS line measures the price performance of a stock with the price performance of the S&P 500.   If the line is trending higher it is outperforming the market.  For growth investors often a new high on the RS line is a bullish buy signal.  It is extra bullish if this line hits a new high ahead of the price.

In this example, the RS maintained an upward slope during the first two bases.  Now it is starting to exhibit a downward slope.  The red lines over the RS were drawn to show the change in slope.  Notice how in the first base the slope of the RS line initially weakened.  This is normal and to be expect as a stock rests.  It is possible the stock above will still move higher and the RS line will turn higher.  But, if the price of this stock moves below the bottom of the current base consolidation, that would increase the probability this stock is going to see weaker price performance in the near-term.

Should Investors Prepare For More Market Declines?

The stock market experienced swift and deep downward action last week. Part of the market selloff points to typical action by institutional investors and looks very similar to the February decline. This type of trade action includes Option Gamma Hedging strategies, where traders profit from increased sensitivity to an option’s price change measured by gamma. Much of this type of selling is believed to be behind us.

You also have the Trend Following crowd, once indexes made a strong move below the 50-day moving average selling and short exposure increased, which aggravates moves to the downside.

This week Volatility Sensitive Strategies (investment allocations that shift between cash and the S&P 500) and Risk Parity Strategies are expected to be active. Some trading desks suggest there’s around $355Bn allocated to this category of trading. Stock exposure for these strategies is believed to already be down to around 65% from 100%. Another 15% reduction is still expected.

Goldman Sachs reported good flows into their Corporate Buyback desk but as you can see in the chart below (Stockcharts.com & Dightman Capital), it was not enough to establish firm support. Trading volume on Friday was significantly below recovery rallies earlier in the year and selling volume for S&P 500 stocks was significantly higher.

The Tech Premium, the higher cost an investor is willing to pay for tech exposure versus other areas of the stock market has faded a bit and may have further to fall. One area contributing to the compression in tech stocks involves international growth. There is concern international market are going to fall into recession before they kick into a higher growth mode. Rising Costs are also weighing on tech. While top-line growth is steady, margins are being compressed as costs, like wages, are rising.

On the geopolitical front, Trade Talks with China should be quiet (but probably won’t be) leading up to the November G-20 meeting but Saudi trouble and the Price Of Oil is a new issue for the market to digest. Brexit talks are not progressing well with many obstacles remaining so that may be causing traders in Europe to sit on the sidelines.

Q3 Earnings ramp up this week, so we will know more about the health of corporate finance throughout the week. Disappointing results or poor guidance could send stocks lower.

A scenario is developing which could push stocks further into the red in the coming days and weeks, or at least mute any recovery.  More downside for the stock market would provide cover for The Fed to become more dovish and slow interest rate hikes. This would likely be a welcome development for stock investors but in the meantime, we may see a bit more pressure on stock prices. From a longer-term perspective this looks like it may end-up being a buying opportunity on the strength of the U.S. economy, a renaissance in innovation and low interest rates globally.