After U.S. equity markets posted the longest streak in history without falling more than -3% from 2016 to the beginning of 2018, we have now seen two corrections in 2018. A correction is defined as a peak-to-trough decline of -10%. A few short weeks ago, the S&P 500 was trading around 2930. Friday’s session saw the benchmark index trade down to 2628. The October correction has been driven by technical traders. Rising interest rates, China Trade Wars, and fears of an earnings slowdown are all old news items. The only real reason for the selling is that the algorithmic trading programs pumped up equities, forcing all fund managers in (lagging the benchmark is career risk). Once the major of portfolios were fully-invested, sell programs went into effect. As technical supports and moving averages broke down, more and more investors threw in the towel. Several high-profile earnings announcements (disappointing slightly the consensus) added fuel to the fire. In this Commentary, we share our vision for the equity trade going into year-end.
Macroeconomic news this week was less robust than we have been used to. Regional PMIs slipped more than expected. The Chicago Fed Activity index fell to 0.17 in September from 0.21. The Richmond Fed Index fell to 15 in October from 29. The Kansas City Fed Manufacturing Index slipped to 8 in October from 13. Markets may be anticipating weaker ISM PMI indexes next week. More weak housing data also contributed to the gloom. September New Home Sales plunged another -5.5% in September (-0.6% expected). Pending Home Sales also dropped more than expected -3.4% y/y in September (-2.6% expected). Finally, our first look at Q3 GDP came in at 3.5%, down from 4.2% in Q2 (although economists were looking for 3.3%). We need to remain alert to manufacturing survey data, which is the most forward looking. The October jobs report, announced next Friday, should not been looked, if positive, as support for the markets. Jobs data lags the stock market by typically 9 months.
The correction, while inevitable from the levels reached this summer, came as a surprise to most investors. The four major benchmark indexes (S&P 500, Dow, Nasdaq, and Russell 2000) had all broke to new highs, continuing the pattern of higher highs this cycle. Moreover, with the S&P 500 trading as high as 2935, most traders were preparing their silly S&P 500 “3,000 hats”. In essence, the indexes fell from highs, which is unusual. Typically, we see a move down followed by consolidation and/or an attempted rebound before the cascade selling occurs.
In any case, we are not ready to declare 2935 as the S&P 500 cycle high. We were convinced that last January was the final blow-off top. Yet the indexes all managed to re-take record highs over the summer. So we won’t be as dogmatic about expecting a cycle top now. Year-end rallies have occurred just about every year since 2009 and a Republican win in the House could spark excitement about Trump’s new middle class tax cut.
A 300+ point drop in the S&P 500 seems like a lot, for those expecting a rebound. The problem is that the exaggerations we saw to the upside will play out again as the markets fall. We would not be too aggressive buying because of an assumption that “equities look cheap” relative to levels this summer.
We are NOT ready to call a temporary bottom yet. The reversal Friday, with the S&P 500 down -60 points early in the session before coming back to positive territory, saw traders fade yet again the recovery into the Friday close. That in itself is not a good sign. One technical condition that looks potentially encouraging is a short-term positive divergence on the RSIs. However this divergence still needs to be confirmed. We need both price and the RSI to turn up right now to get a buy signal.
To confirm that 2935 is the cycle high on the S&P 500, we’d need to see a bounce fail stop below 2800 (the upward extent of the massive October 16 rally). We would be comfortable shoring on a down move after an S&P rally that fails to over-take 2800.
The Nasdaq hi-flyer stocks have been weaker that the broad market, for a change. The Nasdaq-100 broke its 200-day moving average (in yellow) on the first surge down. We see again a potential positive divergence on the oscillators. But it is best to wait for price to stop falling.
By far the weakest of the indexes is the Russell 2000 small cap. It’s hard to mistake the break in trend-line support and the 200-day moving average. We could be seeing a slightly higher low on the oscillators after this week. Again, not the time to sell but not the time to back up the truck and buy.
This week we enjoyed having over 50% in cash. No major trades to report this week. We’ll be holding on to
what we rode down in October and hopefully sell into strength on a market rebound.