The Market Needs A Correction Before Heading To Its Final Peak

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Includes: FEZ, SPY, VXX
by: Dzhafer Medzhakhed

Summary

A very likely March rate hike will put downward pressure on stocks.

Debt ceiling negotiations will force reality back into the mind of market participants.

Safe haven flows into the USD will most likely decrease in May, negatively impacting US stocks.

The stock market is now ripe for a 10%-15% correction.

Following the strong signaling by Fed officials that a rate hike is coming, the Fed funds futures have reached levels very close to 100% for the FOMC March meeting. At this stage, only a catastrophic job report would stop the Fed from increasing the interest rates to 1%. An increase in interest rates has both a bullish and a bearish effect on stocks. The bullish effect is more short term: a rate increase is a confirmation by the Fed officials that the economy is doing well; it is some sort of “green light” on the outlook for the economy. This stimulates confidence and adds to the rally in stocks. The bearish side is more long term: a higher interest rate will cause the dollar to become stronger, which will make US exporters less competitive worldwide. In addition, higher interest rates will also play against share buybacks and increases borrowing costs for all companies. It adds pressure on the less financially sound companies, most of which are not part of the big indices (S&P500, DOW, NASDAQ). A higher interest rate is a challenge to US companies to continue growing earnings while having less favorable conditions.

The effect of the first rate hike back in December 2015 was very visible and the stock market fell in January by more than 10% from the December highs (concerns about China being the explanation). The effect of the second rate hike that occurred in December 2016 has been hidden behind the post-election euphoria. We are getting closer to a period where the euphoria will start fading while a second rate hike will be added. This means we should easily see a market correction of at least 10%, probably more.

US Interest Rate Historical Chart

By looking at the long term history of US interest rates, we can see that there is a trend line emerging. From this trend line, we can expect that the US interest rates still have 0.5% to 1% upside before meeting solid resistance and most likely starting a reversal as in 2008 (housing bubble) and in 2001 (dot-com bubble). This is one reason why we believe that we will see a correction, not a change in trend.

Apart from the effect of a fed rate hike, there is also the debt ceiling debate that will start to affect the markets in the coming weeks. The market may assume that the previous conflict around the debt ceiling was solely related to the fact that congress was republican and the president a democrat. This would assume that there are no conflicts between the republican congress and president Trump. This is obviously not the case and on top of that, on these budget matters, there are divisions within the GOP party itself. If all of Trump plans (tax cuts, infrastructure plans, military budget increase) were to be implemented without adjustment to the current spending levels it would lead to a budget deficit of 5% to 10% of GDP. This strongly contradicts the conservative position of many GOP leaders of holding down government debt (at least stopping it from growing). We expect Trump stimulus plans to deflate when getting down to the real numbers, adversely affecting the so-called “Trump reflation trade” (out of bonds and into stocks).

Finally, we do believe that part of the current stock market rally is related to safe heaven flows from Europe. The French presidential election is causing some investors to be very nervous, fearing another Brexit event, which would be far more catastrophic to the European Union. The market underpriced a Brexit event and a Trump presidential win, while now the market is probably overpricing a LePen win in the French presidential election. If LePen is not elected, we shall see a euro rally, which will reduce the current safe haven flows from the euro area to US bonds and US stocks. In our view, there are several fundamental differences between LePen and Trump, that makes it more much difficult and unlikely for Marine LePen to win the elections in the same way Trump did:

- Trump built a positive image decades prior to entering the presidential race. His conflict with the media developed only during the course of the presidential campaign. While the Le Pens, both father, and daughter, were always cataloged by the French mainstream media as the leaders of a fascist movement from the onset.

- Trump won the republican primaries and campaigned as a republican candidate. He had the support from well-known GOP politicians like Rudy Giuliani and Chris Christie. Le Pen has no support from the French establishment and is running on the base of the Front National, the political movement founded by her father.

- Trump had the finances to play the game while Le Pen needs to rely on financing, which weakens her independence and her authority.

- Most importantly, Trump brought to the voting booths people that were not regularly voting and that came to vote especially for him. Le Pen will have the opposite effect: both left and right will unite against Le Pen in the run-off election, and many people not regularly voting will come to vote especially against her.

This is why in our view, in the beginning of May, the dark clouds created by the French presidential election will dissipate and a rally in the euro and the European stocks will occur taking away some of the funds invested in US stocks.

From a trading perspective, there are several possible approaches:
- One can go long VIX derivatives (VXX). Our cycle analysis suggests that during the first two weeks of April the probability of a market correction is highest. We, therefore, expect the VIX to double in the beginning April while the downside will be very limited.
- Shorting the SP500 (SPY) is a more risky move but can be considered for those with more advanced trading skills. One can also short the SP500 and buy European stocks (FEZ).

Disclaimer: This article is in no way a recommendation to buy or sell any of the financial instruments mentioned. We are not responsible for any trading decisions or investments you make based on this article. Trade at your own risk.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short SP500 futures

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