September's Stock Market Environment

Key Points

• We analyze the market environment to look for risks to the stock market.
•  A strong U.S. economy has brought the S&P 500 back to its all-time highs.
• The greatest risks to the markets come from monetary and fiscal policy.

The U.S. Economy

The U.S. economy remains strong in 2018. 201k jobs were added in August, while wages grew 2.9%, the fastest rate since May 2009. This month’s report is not likely to change the Fed’s rate hike path, so investors remained calm after the numbers came out. 

Additionally, U.S. industrial production is at its highest ever, after surpassing the October 2014 highs. Furthermore, the Atlanta Fed is currently predicting third quarter GDP growth of 4.4%. The slack in the economy continues to tighten ten years into this bull market.

The big metric to watch is inflation. Fed governors are starting to worry about “prolonged inflationary pressures,” and most investors are expecting rates to rise two more times this year. 

Core PCE, the preferred inflationary measure of the Fed, reached its 2% target in August. With wages rising the most since 2009, investors and the Fed will need to watch inflation closely. Stronger inflation could force the Fed to hike rates faster than expected.

It took extraordinary measures to pull the economy out of the Great Recession, and an enormous amount of liquidity. Now, the Fed is hiking interest rates and lowering their balance sheet in whats been called “Quantitative Tightening.” 

Under normal conditions, tightening monetary policy hurts the financial markets. Today is different though. It took these extraordinary measures to get the financial markets to where they are, and now that it is being reversed, the markets are likely to struggle.

Another exogenous risk to the financial markets is the trade war with China. President Trump is threatening another $467 billion dollars of trade with tariffs. This would tax almost all of the goods imported from China, which will inevitably affect many U.S. based companies. 

Nobody wins in a trade war, and the effects of one are extremely difficult to predict while it’s occurring. However, if Trump has his way, the U.S. could benefit from restructured trade pacts in the future. For now, it looks like there will be short-term pain and hopes for long-term gain.

The Charts

Dow Jones Industrial Average

The index has been in a a channel since 2009, and it is currently sitting at the top of the range. It had broken out of this range in January this year, but failed to stay above the trend line. 

This may be worrisome because the index could revert to the mean, and fall from here. However, looking at the past few years we can see the index had stayed along the resistance for some time, before falling. 

When we look at other indicators, we see the index is strong. Momentum is strong, as the RSI and MACD indicators still show signs of a solid trend. The volume indicators also confirm the uptrend, and breadth shows there are plenty of stocks moving up with the index.

For now, we can expect the index to continue along its gradual path up. The resistance from the upper channel is likely to keep the index in check, unless some large catalyst can push the index past it. One such catalyst could be a favorable trade deal with China, but that doesn’t seem to be happening anytime soon.

The Nasdaq Composite

The Nasdaq Composite has had some trouble recently. The MFI indicator reached the overbought level, and the index has since fallen. However, the MACD indicator still shows good momentum. 

Even in the face of volatility, the index has remained in its uptrend. Volume indicators show that there are still bulls to push this index up, but breadth is starting to weaken. 

While the ADP line confirms the trend, less stocks within the Nasdaq-100 are staying above their 50-day moving average. This could be a sign of further volatility, but with the rest of the indicators still showing strength, this is just something to keep an eye on. 

S&P 500

The S&P 500 is arguably the strongest looking index. While the other two large cap indices have seen some trouble over the year, the S&P 500 has been dictating the show. 

The index has maintained its uptrend all year, and the market rebounded each time the price reached its 200-day moving average in February, April, and May.

The long-term chart also shows a strong uptrend, as the index has stayed within the center of the channel. Unlike the Nasdaq Composite and Dow Jones Industrial average, which are candidates for a mean reversion, the S&P 500 has maintained its uptrend without over exuberance. In addition, breadth and volume indicators confirm the trend, and tell us it is still strong.

The Russell 2000

Earlier this year we considered the Russell 2000 the strongest index. It broke out of its triangle pattern first, and the economics supported the argument. 

Small cap stocks should benefit more from a trade war because tariffs are usually designed to help domestic businesses. Now, as President Trump raises the level of tariffs against China, this index could perform better relative to the large cap indices.

Conclusion

The biggest risk to the markets are monetary and fiscal policy. Monetary policy is tightening, and that is never good news for the stock market. As the Federal Reserve normalizes monetary policy, investments are going to take a hit, and so will the economy. 

The Federal Reserve is actively removing liquidity from the economy, and making it more difficult for businesses and people to use cash. As liquidity dries up, stocks start to suffer because rather than using cash to buy investment assets and push prices up, the money is used in other parts of the economy.

Plus, as interest rates rise, borrowers are less likely to borrow, meaning there is less potential economic activity taking place. This will take time to play out, but as monetary policy tightens, we grow closer to the next recession and bear market.

Fiscal policy, on the other hand, could affect the markets and economy at any time. The trade war with China is ratcheting up, and eventually it is going to spill over into the economy. If the dispute between the U.S. and China lasts a long time, it is going to hurt the profits of companies. 

Either they will have to soak up the extra taxes placed on imported items, or consumers will. Either way, the supply and demand curve will shift, and there will be what’s known as a “dead weight loss.” This loss occurs because neither the supplier or demander receives it. Instead, it goes to the government. 

For now, investors are not showing signs of worry because the stock market technicals are strong. The charts show a continued uptrend, and indices that have strong momentum in their moving averages and prices. 

Breadth analysis tells us that there are a lot of stocks moving up with the indices, and volume analysis tells us that the bulls are stronger than the bears.  All three of the large cap indices share these characteristics. 

Small cap stocks and the Russell 2000 also show strength. The index continues to trudge higher, and they may be seen as a relatively safer investment because tariffs should help smaller domestically focused companies.

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Submitted September 10, 2018 at 04:19PM by BR-Technicals https://ift.tt/2NuuFGA