Key Points
- This commentary is based on analysis you can find here.
- Market breadth is weakening, and key levels have been broken.
- Demand for stocks is weakening on multiple fronts.
You can read the blog post here: https://www.brtechnicals.com/the-market-environment-october-2018/
The Market Environment
When stocks peaked in January, it came off the back of a historic 2017. After the election of President Trump, a weight had been lifted off the shoulders of investors, and they were ready to buy stocks. The global economy saw “synchronized growth” and had very high expectations.
Stock markets around the world were growing at a pace that history had never seen before. The lack of volatility was proof investors had high expectations and high sentiment. Towards the end of 2017 and the beginning of 2018, the “fear of missing out” trade came to be.
This is the final stage of a sentiment trade, because investors were buying assets based on fear of missing returns, rather than using sound judgement and due diligence. This is a sign of a top because these investors are the last group to finally invest, leaving no more buyers out there.
Finally, the sellers took over, and in February 2018, we saw the first signs of volatility in more than a year. The sell-off was exacerbated by VIX short sellers covering their positions, but the market eventually found a bottom.
Even with the quick drop, investors still had hope that the recent tax-cut legislation would pull the market back up, and it did. The tax-cuts were going to bring record earnings to the stock market, so investors started to buy stocks again, and it was justified because prices had fallen.
Soon, everyone was focused on the earnings reports, and we started to see winners and losers among companies. Now, investors had become more selective in where they were going to put their money. Our prediction that it would become a stock picker’s market came to fruition.
Along with our prediction of a stock picker’s market, came the idea that the market was going to struggle to make new highs, or if it did, they would be slight. The reason for this was because of how the market behaved leading up to the drop in January, and the economic environment we were in.
Simply put, there isn’t enough cash in the economy to push stocks much higher than the January peak. The lack of volatility in 2017 tells us that expectations were so great that investors continued to buy stocks throughout the whole year. If you hadn’t purchased stocks when expectations were this high, than you aren’t going to.
Without new investors adding cash to the stock market, prices are going to struggle to grow. Also, given the stage of the economic cycle we are in, the economy is going to struggle to find new investors to add to the stock market.
Moving from 8% unemployment down to 4% brings many workers into the labor force, and it also creates many new investors into the stock market. More people have jobs, and they are able to save and invest. Moving from 4% to 3.7% is not going to provide the same effects.
In addition, the Federal Reserve is draining liquidity, and raising interest rates. When this happens, dollars are used in other parts of the economy other than the stock market. When there is high liquidity in the system, people are able to store it in there savings and in there portfolios.
It is easy to get money from other sources, such as credit or loans, so instead of selling assets to raise the funds they need, they just borrow it. But when interest rates grow higher, and cash becomes more scarce, individuals start to tap into investment portfolios and savings, leaving less cash available for the stock market. Plus, higher interest rates makes other investment vehicles more attractive.
The stock market has grown as much as it has because bonds were unattractive during Quantitative Easing (QE). Investors that rely on income from bond payments, needed to find that income elsewhere. This meant they either needed to move up in the risk spectrum or look for dividend paying stocks.
Dividend paying stocks became the goto, as it provided the income they needed, but also grew their principle because of a 10 year bull market. Now that interest rates are on the rise, bonds are becoming more attractive, and investors are going to pull cash from the stock market to move back to the bond market.
Today, we are seeing the beginning of the stock market’s struggle. While we first noticed weakening momentum in August, the first confirming sign of danger was when the Russell 2000 broke its 200-day moving average. Small cap stocks are typically seen as a leading indicator of the overall stock market.
These stocks are more volatile than large caps, so investors buy these when they believe the market is going up, and they sell these first. On the same day the Russell 2000 broke its 200-day moving average, the S&P 500 confirmed a failed breakout. This wasn’t too alarming, as there was another support just below the breakout support.
However, the trendline was violated the next day, along with the 200-day moving average. The close below both of these levels is another significant blow to the health of the stock market. While this occurred, indicators fell, and they fell fast. The RSI moved well below the oversold level, and MACD fell into negative territory.
While typically these moves signal the market fell too fast and is ready for a reversal, it may also tell us something much more significant. The extended drop in RSI tells us the bears have taken over. Over the last two years, RSI has fallen to oversold, but investors quickly pushed it back up. This is the first time since 2015 that is has fallen a significant amount below the oversold threshold of 30.
Also, while the RSI is in oversold, that does not mean stocks are done falling. In an upwards trending market, the indicator can stay at overbought levels for an extended period. The same can happen in a downtrend. Since the trends have been broken on multiple indices, at multiple levels, this has turned an oversold RSI into a confirmation indicator, rather than a mean reversion one.
Thus, these indicators are confirming a bearish breakout, not a reversal. The stock market is going to struggle for the foreseeable future. While a recession may still be six months or more away, the technical and economic analysis point to less demand for stocks.
Key levels have been broken, and stocks are not only showing signs of weakness, but also momentum to the downside. Now is a time to hold cash.
Submitted October 18, 2018 at 06:03PM by BR-Technicals https://ift.tt/2ykrmJh
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