Why A Stock Market Correction May Be Inevitable - Reminiscent Of August 2015

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, GLD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SLV, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTI, VTWO, VV, VXX
by: Markos Kaminis
Summary

My prior call for stocks to break out post the Fed's dovish pivot, and the recommunication of it, is now obviously null and void.

The Administration’s fresh tariff threat has drawn the ire of China, and its response this time is clearly threatening.

Capital flow factors make a stock market correction near inevitable for this August or September.

Stocks were poised to breakout thanks to the Fed's dovish pivot, at least once they got the signaling straight. Then, in one fell tweet last Thursday, stocks went from breaking out to correcting. For the stock market now, China's response to the President's new tariff threat looks to prove damaging. However, that has as much to do with the response as it has to do with the current market environment. Let me explain why today reminds me of the environment that led me to correctly predict the stock market crash of 2015.

Chart Data by YCharts

Stocks were rebounding on Thursday August 1, 2019, after having previously fallen on investor interpretation of the Federal Reserve's forward intentions. I discussed the issue in my timely call to sell the U.S. dollar at height published on Thursday morning. By the time the day was over, stocks had made an abrupt U-turn and fell 2.3% from peak to trough, based on action in the Vanguard Total Stock Market (VTI) security. The moves for the various sectors of the market varied somewhat, but they were all down significantly for the day and sharply so from their intraday highs. The intraday spread shows how the rally that was in progress was severely disrupted by an intraday event, in case you were not following in real time.

Market Sector Security

Intraday Peak to Trough Aug-1

August 1 Change

Vanguard Total Stock Market (VTI)

-2.3%

-0.9%

SPDR S&P 500 (SPY)

-2.3%

-0.9%

SPDR Dow Jones (DIA)

-2.3%

-1.0%

Invesco QQQ Trust (QQQ)

-2.9%

-0.5%

iShares Russell 2000 (IWM)

-2.9%

-1.4%

The Tweet that Tanked Stocks

President Trump tweeted on Thursday, August 1, 2019, that the United States would be initiating new tariffs on China at a rate of 10% on $250 billion more goods exported into the U.S. This is above the $300 billion of goods already being taxed. He later spoke with reporters on the subject, adding color and clarity to the reasoning behind the move. In retrospect, we should have all seen it coming after the latest trade negotiations seemed to bear no fruit.

While the President makes some good points about how China and companies within it have been bending and breaking rules to our detriment over a long period of time, the move to further tariff China still threatens to cause a correction in the U.S. stock market, if it is pursued. The President hopes to spur China into the trade deal he wants, but I expect China will not respond like one of the real estate mogul's indebted contractors from the past might have from a weak bargaining position.

China is a proud nation that does not rank itself based on the secondary size of its economy or the trailing might of its military hardware. And it is a communist country, where no election can displace the leadership, and through control of its media, it can play this story how it likes to its economically impacted populace. And, importantly, it can inflict pain on the United States and damage its leader's reelection status; and it knows that. This is a big reason why I am worried.

China's Response this Time will Probably be Painful

I do not expect China to offer reciprocal tariffs this time around, if it is even capable of it. Rather, I anticipate that China, knowing what is expected of it, will act in another way that might inflict real damage to the United States economy in real time.

Back in August 2015, China allowed its currency to depreciate somewhat significantly, and it played a role in raising the volatility of security markets globally. The U.S. stock market dropped roughly 11% over the course of a week, and especially sharply on one given day, partly helped by the destabilizing catalyst. However, the market also fell because of another factor that is in place again today. I will get to that in a moment.

When I first started writing about trade war risks, I outlined them carefully but ruled the most dangerous weaponry out "for now." Well, the day has finally come when I believe China will resort to asymmetrical trade warfare. China can no longer counter the United States' tariffs tit-for-tat, and its actions thus far have not impacted the U.S. or swayed its leader. The U.S. economy is still humming, with GDP just reported at 2.1% for Q2, and the U.S. stock market is trading near its all-time high. If China wants to get the American president's attention, it knows it must do something more.

Reciprocal Means We Get Hurt Too this Time

I am sorry to say that I believe the trade war will now escalate to a new stage, and that stage will be damaging to both the U.S. economy and securities markets. I started this article last Friday, believe it or not, and am very sorry today that I had not finished it then; I need to get back on Twitter. China is already responding in the manner I expected.

China reportedly is halting all purchases of U.S. farm goods. China also hinted at a stronger measure, and one I am looking for to disrupt global securities markets and impact the U.S. economy. The People's Bank of China set its daily reference rate for the yuan below 6.9 for the first time since December. On that news and the news of the halt in crop purchases, pressure came hard against the yuan, driving it down 1.3% to below 7. The yuan was at one point down 1.9% to a record low level.

Equity markets weakened dramatically globally on the apparent shift in China yuan policy, which symbolizes an important escalation in its trade war with the United States. While markets fell globally, China shares held up relatively well that day on an expectation that the government would support its shares.

Chart Data by YCharts

Since the spark, the United States labeled China a currency manipulator. China's central bank later reassured markets that it was not, and would not, use currency as a weapon. It backed its statement with a better fix for the daily reference rate, and since these moves, the currency and other financial markets, including the U.S. stock market, have stabilized. All of this is reminiscent to me of late evenings some four years ago, as I watched Asian markets from my home in the States.

Recalling My Correct Stock Crash Call of August 2015

It was 2015, and China was allowing the yuan to devalue. Equity market volatility was building, and pressure was eventually released with a sharp market correction in the U.S. Not by coincidence, those events unfolded in August of 2015, the start of seasonal weakness in the U.S. This seasonal weakness is not an issue of chance or dumb luck either. There are serious fundamental capital flow factors at play that lead me to once again make a market correction call, like the one that I presciently made in August 2015.

Why Stocks are at High Risk of Correction

Stocks are up significantly for the year-to-date period, with the SPDR S&P 500 (SPY) year-to-date return at 19% as of August 2, 2019.

Market Sector Security

YTD Return

Vanguard Total Stock Market (VTI)

+19.2%

SPDR S&P 500 (SPY)

+19.1%

SPDR Dow Jones (DIA)

+15.3%

Invesco QQQ Trust (QQQ)

+23.8%

iShares Russell 2000 (IWM)

+15.8%

This means that significant paper profits are stored up in portfolios, including those of institutions. Many of those institutions will close their fiscal years over the course of the next month or two. Thus, portfolio managers have every incentive to lock up profits in this highly volatile and risky period in order to protect their performance. In order to do so, they must sell stock. It's that simple. Selling begets selling and fear leads to panic which leads to market correction.

The events unfolding with China are simply the spark to start the fire. While they certainly threaten global economic growth, the future remains somewhat uncertain. Developments could unfold for the favor of a trade deal, and yet stocks could unravel by 10% before that day comes. In fact, I believe as much as a 40% market correction is possible in today's market environment.

How to Protect Yourself

Investors buying into my thesis can protect themselves by raising cash levels, which offers the least risk of its own, save for the fact that I expect the U.S. dollar to depreciate on U.S. economic concerns and perhaps an emergency Fed rate cut in the interim. If an investor would hope to seek to profit on this thesis, they can add counter asset/security risk while attempting to profit on market disruption by purchasing gold and silver, or relative securities like the SPDR Gold Trust (GLD) and iShares Silver Trust (SLV). For higher security risk, and only for short-term use by sophisticated investors, one might add to holdings of the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX). Otherwise, a counter index security like the ProShares Short S&P 500 (SH), or for a riskier bet, the ProShares UltraShort S&P 500 (SDS) will serve as a hedge to portfolio risk; though they are obviously not long-term holdings. Several of these securities have already seen significant demand and are thus drawing a more expensive price premium today. Thus, buyer beware. Long-term investors, say with plans to hold for a decade or more, might not act at all, but not glance at portfolio statements over the next few months if I am correct. To enhance performance, or attempt to, you can raise cash and purchase after the dust has settled. Stocks should be rising again into or after the close of the year. I'll be updating my column along the way and hope to highlight that moment in time as well.

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.