S&P 500 Index: 1812 Overtures

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Includes: BCS, CNY, CS, DB, EWU, FXB, FXE, HYG, JNK, KRE, LYG, OIL, RBS, SPY, UBS, UUP, XLB, XLE, XLI
by: Eric Parnell, CFA

Summary

Not surprisingly, the U.S. stock market has been slammed since last Friday in the wake of the ‘Brexit’ vote.

A bounce back to the upside may be likely in the coming days.

But the market is starting to send signals that a much further decline may be looming in the near-term.

A retest of the lows from early 2016 may soon follow in short order.

Not surprisingly, the U.S. stock market has been slammed since last Friday in the wake of the 'Brexit' vote. And while a bounce back to the upside is likely in the coming days, the market is starting to send signals that a much further decline may be looming in the near-term. In short, a retest of the lows from early 2016 may soon follow in short order.

Opus

The initial response by the U.S. stock market to the 'Brexit' vote has actually been fairly orderly to this point.

Friday's -75 decline on the S&P 500 Index (NYSEARCA:SPY) represented nothing more than a give back of the +42 point run up that took place in the four trading days leading up to the outcome of the 'Brexit' vote in the U.K. (NYSEARCA:EWU) on Friday along with another roughly +30 points that had been picked up by the market since late May. In short, if investors felt like the U.S. stock market was doing OK a month ago on May 20, they were essentially back to the same place by June 24 on the S&P 500 with the 'Brexit' reaction.

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And while stocks continued to decline on Monday, at least some liquidation pressures had to be anticipated coming out of the weekend given that so many institutional investors got caught way out of bounds with portfolios levered to a 'Remain' outcome. While further declines may follow through the remainder of the trading day, the S&P 500 Index bottomed at 1991 by 11:00 AM EDT and has stabilized in and around 1999, which not coincidentally was the initial post 'Brexit' vote bottom in the S&P 500 futures market during the very early hours of Friday morning.

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The VIX was supporting the notion of a potential short-term bottom in stocks on Monday. Despite the fact that the S&P 500 Index was trading by as much as -45 points lower during early morning trading, the VIX was not screaming to the upside but instead was also marginally lower and trending to the downside as the day progressed.

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As a result, the U.S. stock market may find its footing and even start to rally in the coming hours during the early part of the trading week. And knowing that global central bankers are lined up with their respective monetary policy pop guns to fire and relentlessly jawbone provides investors with an added degree of reassurance in the coming days.

But this is the short-term good news. The outlook for the intermediate-term out over the next few weeks is decidedly more troubling for stocks.

E Flatting Major Problems For Stocks Going Forward

Let's begin with the fundamentals for stocks. In a word, they are lousy. And they just got worse thanks to the 'Brexit' vote on Thursday. For those of you that follow my articles on Seeking Alpha, I may have mentioned that corporate earnings on the S&P 500 Index have been in decline for some time having fallen for six consecutive quarters on an annualized as reported earnings basis including double-digit declines in each of the past three quarters. And not missing out on this latest opportunity to beat this topic to death even further, not only are earnings already projected to fall again in the second quarter, but the outlook is not likely to be helped either by the business uncertainty resulting from the 'Brexit' decision but also the potential for a further rising U.S. dollar (NYSEARCA:UUP) relative to the British Pound (NYSEARCA:FXB) and euro (NYSEARCA:FXE) in the coming months. And with stocks still trading at a premium valuation of over 23 times trailing 12 month as reported earnings even after the fact that more than 110 points have been hacked off of the S&P 500 Index, this suggests that stocks are on highly unsteady footing for further pressure on the earnings outlook.

The technical picture is also troubling. Over the past two days, the S&P 500 Index sliced decisively through critical support at its 400-day and 200-day moving averages. These are not trivial breaks, for the last two times the S&P 500 broke below these key support levels, the benchmark index found itself trading into the 1800s before finding a bottom. This includes the most recent decline at the start of the year that had the S&P 500 Index breaking below both its October 2014 and August 2015 intraday lows before hitting a bottom at 1812 in mid-January and retesting these lows in mid February at 1810 before finally rallying.

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Does this mean that a retest of the January and February lows is in the cards in the coming weeks? Fundamentals certainly support a stock market trading well below these levels, so from this standpoint it is certainly possible. And current technical readings suggest the market is indeed broken. For unlike the last two spells when the S&P 500 Index already had the look of an oversold market when it started cascading to the downside, this time around it appears to have some space to the downside with momentum and money flow readings that are still flat to positive.

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A number of other reasons why I already hated stocks this summer prior to the 'Brexit' vote are also suggesting that a much more precipitous drop for the S&P 500 Index may lie ahead in the near-term.

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For example, the value of the Chinese Renminbi (NYSEARCA:CNY), which has been highly correlated to the S&P 500 Index in recent years, has fallen off a cliff relative to the U.S. dollar recently. In the process, it has plunged to levels that effectively match its previous lows from early January 2016, which was a bottom that preceded the eventual lows in the S&P 500 Index a couple of weeks later at 1812 on the S&P 500 Index. The fact that the weakening of the Renminbi can also be reflective of fundamental concerns such as the growth potential for China's competitors, the potential for building challenges within the China economy, and the potentially destabilizing capital flight out of the country suggest that this relationship between the Renminbi and the S&P 500 Index is not without merit.

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Another worrisome sign is oil prices (NYSEARCA:OIL), which are showing increasing signs of definitively rolling over after not being able to break out above $50 per barrel in recent weeks. The recent rally in oil prices was highly supportive of the stock market bounce from mid February through the recovery in energy (NYSEARCA:XLE), materials (NYSEARCA:XLB), industrial (NYSEARCA:XLI) and selected regional banking (NYSEARCA:KRE) related shares as well as the high yield bond market (NYSEARCA:HYG) where energy makes up roughly one-sixth of the entire market. Thus, if oil continues to slide lower, it has the potential to drag both stocks and high yield bonds (NYSEARCA:JNK) back down with it. Clearly, the uncertainty resulting from the 'Brexit' result and the associated impact on the U.S. dollar is not a help for oil prices.

Perhaps the most disconcerting sign of brewing troubles is coming from the European banking sector. If the financial crisis taught us anything, it was the interconnectedness of the global banking system. So when the stock prices of major systemically important banks in any part of the world start fast tracking their way toward the low single digits, it is a definitely a cause for concern and worth monitoring.

From the list of eight major European banks that are publicly traded in the United States, we find that several institutions have broken decisively to the downside. Leading among these are U.K. based Lloyds Banking Group (NYSE:LYG), Barclays (NYSE:BCS) and Royal Bank of Scotland (NYSE:RBS), each of which broke decisively to new lows on Monday that are well below readings from earlier in the year.

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This is not just a U.K. based problem either, as banks from across Europe including Deutsche Bank (NYSE:DB) in Germany along with Credit Suisse (NYSE:CS) and UBS (NYSE:UBS) in Switzerland have also broken to fresh new lows.

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This is a situation in particular that warrants close attention. For while there is no reason to think that we are anywhere close to a circumstance like the set up we had in 2008, if we enter into a situation where a number of systemically important financial institutions across Europe start to come under stress, it may not be a defense of 1812 on the S&P 500 that we are soon observing but something much lower instead.

Looking Ahead

The U.S. stock market has managed the early days of the post-'Brexit' period in a fairly orderly way. And a solid bounce higher may soon be in order in the coming days. But investors should not fall victim to complacency under such an outcome with the belief that calm has returned to financial markets and the next leg higher is right around the corner. Capital markets have presented a number of signs of accumulating stress under the surface, thus having the S&P 500 Index now making overtures that a retest of the lows at 1812 in January and 1810 in February on the benchmark index may soon be in order.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.