Unsurprisingly, the past week’s news was dominated by….the trade war with China. We learn of a significant development after the Friday market close. China reportedly decided to scrap planned trade talks with the U.S. and is unlikely to sit down with Washington until after November’s mid-term elections. In addition to new tariffs on $200 billion of Chinese goods set to go into effect September 24, the U.S. State Department sanctions against China’s defense agency and its director on Thursday contributed to the ultimate decision to cancel the talks. The decision to call off a planned delegation next week comes as President Donald Trump signals he’s prepared for short-term pain for the U.S. economy by ramping up the trade war, in the pursuit of what he sees as the long-term gains from taking on China. In an equity market trading off the “trade war”, this is an inauspicious development for next’s week’s equity trade. We’d expect China and U.S. index to gap down Monday morning.

The macro news was mixed last week. Retail sales disappointed (-0.1% in August) although Michigan Sentiment jumped to 100.8 for September’s preliminary read from 96.2 in August. Two regional PMI’s came out and were mixed (Empire Manufacturing fell to 19.0 from 25.6 while the Philly Fed improved to 22.9 from 11.9. Interestingly, the Leading Economic Index slowed to 0.4% August from 0.7% the prior month (and below the estimate for 0.5%). The LEIs are a decent indicator of recession (although the moves are more coincident with GDP. For the moment, nothing to worry about as the LEI y/s change is still high at +6.4%, as shown below.


New Highs All Around…But Is This A Break-Out To Buy?

The U.S. indexes rolled on last week, with Dow Jones finally breaking about the January 2018 high. The S&P 500 also hit new highs. We saw no reason other than panic buying: we are not in earnings season, macro data was lackluster last week, and the threat of trade war escalation looms. Here is our current read on charts (as charts seem to be the only thing that interests traders at the moment).

The Dow broke above it January high and held into the Friday close. With the goofiness in the index trade, we are always expecting a fake-out and reversal down (however this has only occurred once in the past two years, in Jan/Feb of 2018). That said, we need to wait for the reversal down to get bearish. We expect the Dow to trade below 26,620 (January 2018 high) this week, especially after the news that China will not negotiate until after the U.S. election. There is a gap up between the Wednesday and Thursday sessions on the Dow cash index: 26,464 to 26,519. If the Dow dips into this zone we can start to evoke the fake break-out scenario.

The S&P 500 keeps moving up in a saw-toothed manner. We do have an identifiable lower trend channel support line to watch. If the S&P 500 starts closing below 2900, we’ll exit this channel. Only a break of the prior low at 2864 would open the possibility of an intermediate down-trend. Still too soon to anticipate a top, although it would seem a top is getting close. We are guessing traders first want to see the S&P 500 post a 3,000 reading before selling.

The Nasdaq-100 is lagging for the moment, something we have not seen in a long time. Friday’s lower close contrasts with the Dow and S&P 500 highs. Serious selling won’t occur until 7350 is broken on a closing basis. We also see the other high beta index, Russell 2000 small caps, lagging as well (not shown).

Europe is enjoying a nice dead cat bounce. The DJ Stoxx 600 is shown below. And that is all this rally is, a dead cat bounce. No reason to buy European equities, especially with the sideways trading range. If the Stoxx 600 gets above 388, we’ll take interest.

We mentioned that we saw no earnings or macro news to justify the rally last week. However we did see higher rates, which is bad for the economy but short-term good for stocks. Simply because money is following out of bonds and needs to go somewhere. The U.S. 10-Year rate is getting up near cycle highs at 3.06%. At some point bonds yields will get too attractive and money will leave stocks and go back into bonds. Recall that the S&P 500 is yielding 1.81%. Any event that makes safe-haven instruments more attractive that risk assets will trigger a reversal of flows. Perhaps the China refusal to negotiate will be that trigger….?

Trade Recommendation

This week we put on a simple options trade. With Nasdaq weakness continuing into Friday, we bought October 19 monthly put options on the QQQ. The reason is that we need to control risk within a bubble product. We chose a $178 strike (Friday’s close was at $183.71) and bought the puts at $1.30 ($130 per contract). This a bet that the recent Nasdaq underperformance is signaling future corrective price action. We are giving this trade three weeks to play out. If we see a couple of large down days on the QQQs, we will cover by selling puts at a lower strike, recovering our paid premium and leaving us a free bearish put spread out to October 19.


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