In this past weekend's newsletter, I discussed in detail the "Post-Trexit" market action as the pre-election certainty, a "Trump Catastrophe," turned into a "Make America Great Again" rally. To wit:
"Last week, I detailed the various levels of overhead resistance to any rally that must be defeated to reinstate a more bullish market.
- The downtrend resistance from the previous highs is colliding with the previous support level which now acts as important resistance.
- The 50-dma is also trending downward adding further resistance to price advances in the near-term.
- An important 'sell signal' has been registered at fairly high levels and current remains intact.
The post "Trexit" rally that started on Wednesday took out the first two levels of resistance with some ease. However, the 'sell signal' remains intact with the market now back to extreme overbought levels.
The good news is the market is holding above the downtrend resistance line currently which puts all-time highs as the next logical point of attack if this bull market is to continue.
However, as we step back to a longer-term (weekly) picture we get a little clear picture about the overall directional trend of the market."Click to enlarge
"I like weekly charts because the "noise" of daily volatility in price action is removed. As shown in the chart above, the "sell signal" remains intact but the reflexive move has only taken stocks back to retest the underside of the longer-term bearish "downtrend" line.
This suggests, the current move may be near its limits and the short-covering frenzy seen on Wednesday and Thursday of this past week is near completion."
Importantly, while the Dow hit new "all-time" highs this past week, other major indices did not.
Furthermore, when we dig down into the S&P index itself, we find the very limited nature of the advance, the "great divide", as shown below
Interestingly, the same sectors which "ran like a scalded ape" following the election were also rising prior to Election Day, which suggests the markets were already placing bets on a "Trump" win. However, the limited breadth of the move was evident from the large number of both new highs and lows simultaneously registered in the market. This was noted by Dana Lyons last week:
"The first is the fact that both the number of New Highs and New Lows set 3-month highs yesterday. If that sounds odd, it is. In fact, it was only the 2nd day ever in which each set a 3-month high. And since 1970, only 18 prior days saw New Highs and New Lows set as much as a 1-month high.
As the next data point shows, the level of New Highs and Lows is elevated on an absolute basis as well. To wit: Yesterday saw both the number of NYSE New Highs and New Lows account for more than 5% of all issues traded. That is another rare occurrence, with just 11 precedents since 1970."
"As one can see on the chart, all of the prior instances occurred in fairly close proximity to cyclical market tops (the jury is still out on the late 2014 occurrences). Thus, unlike the prior table, in a way, S&P 500 returns following these occurrences have been unanimously poor - at least over a 2-month time frame."
"As the table shows, the return in the S&P 500 has been negative 2 months after all 11 occurrences. And it wasn't just the 2-month period that was poor. Median returns are negative across nearly all time frames from 1 week to 2 years. The 2-year result is perhaps the most eye-opening after the 2-month. The market is not typically down over a 2-year period so to see 7 of the 8 instances lower is a rare result."
The Dollar / Rate Headwind
Adding to the weak underpinnings of market breadth is also the strong rise in the US dollar and benchmark interest rates in recent months.
As stated many times previously in this blog, roughly 40% of corporate profits are impacted by the rise and fall of the US dollar. While there are many hoping the 18-month earnings recession is finally over, the strong rise in the dollar negatively impacts corporate profitability.
Of course, it is not JUST the rise in the dollar impacting corporate earnings, but also the end game profit manipulation as the effectiveness of cost-cutting, layoffs, share buybacks and other accounting gimmicks used to boost earnings at the bottom line found its limits.
Furthermore, the negative impact of the strong dollar is being coupled with a surge in labor costs from the onset of the Affordable Care Act, as I have warned about many times in the past.
As shown in the US dollar chart above, continued pressure on earnings is leading to a rise in the price/earnings ratio. At some point, valuations WILL matter. (Read this.)
Adding to the headwinds of a continued bull market is the strong rise in US interest rates back to their long-term downtrend line. As I discussed this past weekend:
"As Jeff Gundlach stated last week:
'I do think this rate rise is about 80% through. If yields rise beyond 'critical resistance' levels, including 2.35% on the 10-year note, then things are in really big trouble.'
He is right, higher rates negatively impact economic growth. But in BOTH CASES, the outcome for bonds is EXCELLENT.
The chart below shows the long-term trend of the 10-year Treasury going back to 1978 as compared to its RSI index."
Whenever the RSI on rates has exceeded 80% (red dashed lines) it has preceded a subsequent decline in rates. In other words, strong rises in rates negatively impact economic growth and earnings. Rates then fall as the economy slides towards weaker or recessionary environments.
As with the dollar, rising rates, due to the impact on economic growth and consumption, also impacts corporate earnings and stock prices. To wit:
"While the punditry continues to push a narrative that 'stocks are the only game in town,' this will likely turn out to be poor advice. But such is the nature of a media driven analysis with a lack of historical experience or perspective.
From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of 'risk,' when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower."
Click to enlarge
"This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.
In other words, I get paid to hedge risk, lower portfolio volatility and protect capital. Bonds aren't dead, in fact, they are likely going to be your best investment in the not too distant future."
In the short term, the markets can act completely contradictory to logic as the rebalancing of portfolio exposures (both long and short) leads to sector and market dislocations.
Over the longer-term time frame, the markets will come back to focus on economic and fundamental realities which remain fragile currently. As noted by Lawrence McDonald just recently:
"Granted, the economic impact of policies introduced by Donald Trump will not be seen for many months or years. Nevertheless, we can look to other market events to get an idea of what we might expect in equity and currency markets over the near term, while the markets are still absorbing the news."
"Admittedly, two examples of vote-related surprises (2000 uncertainty post-election, and Brexit) and associated market movements and volatilities, along with the example of how the market may view one of Trump's signature issues (NAFTA agreement in Jan 1994), are hardly comprehensive indicators of what we might see in markets over the next few months; and of course, the economic impact of trade and other policies may not be known for months or years.
But we believe the uncertainty and associated market volatility we have seen in the past may well come to pass again, and market volatility may become the order of the day, as the US transitions to a substantially different style of administration from the past eight years and new policies are put into place."
Could the policies eventually turn out to be a benefit to economic growth? Sure. However, as Dr. Lacy Hunt recently stated:
"Markets have a pronounced tendency to rush to judgment when policy changes occur. When the Obama stimulus of 2009 was announced the presumption was that it would lead to an inflationary boom. Similarly, the unveiling of QE1 raised expectations of a runaway inflation.
Yet, neither happened. The economics are not different. Under present conditions, it is our judgment that the declining secular trend in Treasury bond yields remains intact."
This is the most important point. Over the intermediate to longer-term time frame, when considering economic and fundamental underpinnings, the consequences of aggressive equity exposure are entirely negative.