In this continuing series, we've analyzed the fundamental drivers for the bullish run in equities and financials. In this analysis, we'll look to the charts to see how those fundamentals might impact price action for the S&P 500.
The fundamentals driving equity markets:
- The Fed and U.S. economic growth have had a substantial impact on equities, financials, and yields. Both growth and Fed hikes will be key factors in deciding whether this year will be an up or down market for the S&P and equities in general.
- If U.S. economic growth doesn't pick up as expected in the second half of this year, risk-averse investors may opt for Treasuries and gold instead of equities. However, if global growth increases (i.e. China) and as a result, U.S. exports get a lift, U.S. GDP growth might surprise to the upside.
- Fiscal stimulus and tax cuts for this year are very important for the rally to sustain itself. Although not likely to derail the equity bull-run completely, if legislation gets pushed out until next year, the S&P could see a correction.
The discussion over whether Trump policies will come to fruition have heated up lately, following the failure of the House of Representatives to pass healthcare reform.
Here's what Mr. Rubenstein of The Carlyle Group, a private equity firm with over $58B in equity capital under management, had to say on Trump tax cuts:
"The President will no doubt have some principles that he'll set forth soon and no doubt there'll be corporate tax cuts in those and repatriating money from offshore. I think that'll probably happen in the next week or two or three… but I think it'll take about a year before it gets done," said Rubenstein" - CNBC
- Treasury yields are a barometer for growth expectations and are likely to remain a key factor for equities going forward. If the 10-year yield falls, we may be thrust into a situation where short-term yields rise (due to the Fed hikes), and long-term yields fall, as investors expect lower GDP growth.
- If you need a refresher on how the two-year and 10-year yields can move separately, please click on my article: The 2 And 10-Year Yield Spread: And The Different Messages.
Any change in the fundamentals outlined above will have a lasting impact on equity investors who are long the S&P via the SPDR S&P500 Trust ETF (NYSEARCA:SPY), those long banks via the S&P Bank ETF (NYSEARCA:KBE) and the Financial SPDR ETF (NYSEARCA:XLF) and Treasury investors via the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).
Analyzing the charts to see how the fundamentals might drive S&P breakouts and pullbacks:
Channel lines and how they relate to the fundamentals.
As the market moves up and down, the volatility can be dizzying. Drawing channel lines can help us visualize the trend amid market volatility. Channel lines simply connect the key levels of lows and highs in the market, thus creating a visual representation of the direction of the trend.
It's this author's opinion these lines (often referred to as technicals) do not drive the market higher or lower. The economic and company fundamentals drive price action not the charts. However, investors use these channel lines to place buy and sell orders, and when these orders are triggered, the market can move rather violently. But it's worth mentioning again; the fundamentals have to move first for these orders to get triggered and for the move to have lasting power.
A look at the S&P pullback:
- The bullish rally for the S&P 500 since June of last year is highlighted with the blue trendlines creating an upward sloping channel.
- Following the Fed meeting on March 15th, the S&P broke lower, out of the June 2016 bullish channel. Stop-loss orders below the blue channel line were triggered exacerbating the downward move.
- The good news for the bulls is that the S&P has since rebounded. However, equities remain outside the blue channel. As a result, we may see the market trade sideways as it tries to get back to 2400 (bottom blue channel line).
- Also bullish for the S&P is that it remains in its long-term bullish channel (within the red lines) dating back to February 2016.
- The yellow lines represent the lows in the rally, and the S&P is still putting up higher lows in the long-term (yellow rectangles).
Until the S&P breaks below the yellow lines, the market remains in a bullish trend.
In managing portfolio risk, watch for volatility to spike as the S&P approaches and especially if it breaks below one of the higher lows. The areas highlighted in yellow will likely have sell orders to unwind long positions, and the triggering of those stops would exacerbate any downward move.
We can debate the merits and failings of technical analysis. And whether we utilize the analysis for our individual trading style or not, many investors including hedge fund managers use these key levels to place their sell orders (i.e. take-profit orders). Of course, the fundamentals drive the technicals and price action on the charts, but the enormous amount of capital flows from hedge funds are a significant driver of market direction as well.
How the last range-break, driven by fundamentals, pushed the S&P 9% higher:
The S&P retraced and consolidated from May to November last year. And following the Trump election, the market spiked out of the 9% range (consolidation) it was mired in, as shown by the yellow rectangle.
- Range-breaks can be quite volatile as investors place buy orders above the top of the yellow zone to capitalize on any spikes higher due to fundamental events.
- Once the break higher occurred, some investors waited for the next consolidation in late 2016 and early 2017, placing buy orders above the consolidation highs, to take advantage of the next fundamental move higher.
Following a range-break, the market can sometimes (not always) go the length of the range or in the case of the S&P, 9% to 2400.
- If you notice, the S&P unwind or take-profit orders (selling) kicked-in around 2400; well before the Fed meeting on March 15th (a fundamental event). The disappointment over the lack of Fed hawkishness drove yields lower and propelled the S&P lower as well; triggering more sell orders (see the break lower out of the blue channel).
- Again whether investors trade utilizing chart analysis or not, if the S&P approaches these target zones of the range-breaks (9% or 2400 in this case), take-profit sell orders and volatility is very common.
Why the S&P is currently in a 16% move higher, and 2450 is a key area, likely to contain sell orders and market resistance:
- At the risk of drawing too much on one chart, the yellow zone to the left of the chart shows the 16% pullback and consolidation from 2015.
- The break of the 2015 highs is very significant. If the S&P travels the length of the range or 16%, 2450 would be a likely target and resistance area where take-profit orders would likely exist.
- Of course, the fundamentals (mentioned earlier in this article) would need to drive the market higher to reach 2450.
- However, if the fundamentals begin to break down while the market is trading in the 2450-2500 area, we might see spikes in volatility as take-profit orders get initiated, and as a result, a correction lower for the S&P.
If the S&P breaks lower:
In the short-term, if the S&P breaks 2320, a test of 2250 is possible. However, look for any fundamentals factors in the market to determine if the downward move has lasting momentum.
Final Note on risk:
For long-term investors, these selloffs may not be an issue since they have time to wait for the market to rebound.
However, for retirees who live off their investment savings, who may not be able to handle a 10-20% correction in the market, employing risk management strategies around these sell zones is prudent.
More to follow on equities, financials, the dollar, and yields in the coming days and weeks.
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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.