On August 15th (Direct from Dudack “Another 90% Down Day”) we pointed out that the 91% down day on August 5th had been joined by a 94% down day on August 14th. This was not a surprise since 90% down days are a sign of underlying panic and panic days tend to appear in a series. Panic days often occur on heavy volume and as a result the combination usually creates a washed-out market. In sum, panic 90% days represent risk and opportunity. The reversal of panic is typically identified by a 90% up day. And historically, one 90% up day has signaled that the lows have been found and downside risk is minimized.
Long-time investors know that markets have the ability to frustrate and vex. Indicators do as well. On August 16th NYSE upside volume (volume in advancing stocks) was 89% and the downside volume was 10%. Was this good enough to define the bottom? Typically, a reversal day will have a much higher percentage of volume in advancing stocks; but since downside volume was only 10%, we believe that August 16 qualifies as a significant extreme day. In our view the downside risk in the market is limited to the SPX 2800 level, or roughly the low of SPX 2840.60 made on August 14th.
However, this does not mean that the market is about to have a dramatic advance. There are enough cross currents in the global financial world to contain the market in a neutral trading range for the intermediate term. The boundaries of this range are expected to be the recent all-time highs and the recent lows.
Events in Europe such as Brexit (October 31, 2019) and the resignation of Italy’s Prime Minister Giuseppe Conte are major threats to the European Union and these risks are expected to keep investors cautious. Plus, these developments are combined with China’s decelerating economy, Germany’s economy shrinking in the second quarter and the EU growing at a barely positive 0.2%. In our opinion, European risks are greater than the threat of an escalating trade war between the US and China. Neither the Chinese nor the US economy can truly afford a trading war. However, 19 central banks have joined with the Federal Reserve to implement some form of monetary policy in order to stem the potential weaknesses seen around the globe. China recently unveiled interest rate reforms which are expected to lower corporate borrowing costs. Australia’s central bank has cut rates twice and is discussing further stimulus measures. Mexico’s central bank surprised many by cutting rates last week. The Group of Seven summit will be held in France this weekend and the topics will undoubtedly center on trade friction, slowing economies and monetary policy. In addition, investors will focus on this week’s release of July’s FOMC minutes looking for signs of the timing and size of the next rate cut.
The confusion and angst seen among equity investors is understandable given the number of strong crosscurrents battering the financial markets. The weakening economies of China and Europe were discussed and these stand in stark contrast to the US economy which has surprised economists in 2019 with its resilience. The GDP growth rates of 3.1% and 2.1% in the first and second quarters of this year were consistently above consensus estimates and most economists, including the FRB and IMF, were looking for growth under 2% in both quarters. However, the push and pull between the US and global economies makes forecasting future growth difficult, particularly in an environment in which political risk (Brexit, Italy, trade) is high.
The pessimism expressed by many economists may be a result of the crosscurrents within the US economy. The dichotomy between a resilient US consumer and a weak manufacturing sector is perplexing. July’s total retail sales rose 3.4% year-over-year (YOY) and were led by nonstore retail sales which soared 17.4% YOY. These robust nonstore results suggest that Amazon Prime Day was strong. Retail strength was broadly based in July with only a few spots of weakness such as sporting goods and hobby stores, vehicle dealers and drug stores. See page 3. Some of the weakness in US manufacturing stems from July’s soft auto sales. See page 4. Motor vehicle and parts production declined 0.2% in July, after two consecutive monthly gains; though this segment of industrial production was 3.7% higher on a year-ago basis. Nevertheless, production in nonauto manufacturing decreased 0.4% in July and was 0.9% lower on a year-ago basis indicating that weak industrial production was not due solely to flat auto sales. Part of July’s industrial production weakness emanated from Hurricane Barry which triggered a sharp decline in oil extraction in the Gulf of Mexico.
The dichotomy between US and global economies or the contrast between the US consumer and industrial production does not explain the contradiction between the stock market and the bond market. Equities have been at or near all-time highs, reflecting a strong economy while bond yields have dropped to record lows, predicting a recession. After several intra-day inversions in the Treasury yield curve many analysts have begun to worry about a US recession. In our opinion, low bond yields have several sources, but most of them come from outside the US borders. For example, July inflation data shows headline CPI rising at 1.8% YOY, final demand PPI increasing 1.7% YOY and the personal consumption expenditure deflator rising 1.4% YOY. More importantly, import prices fell 1.8% YOY in July and export prices fell 0.9% YOY suggesting that deflation pressures may be seeping into the US economy from abroad. See page 5. Given these statistics and with inflation well below the Fed’s target of 2%, it is not surprising to see bond yields decline. Equally important, even after the fed funds rate dropped to 2.13% this month, the real yield is a positive 30 basis points and gives the Fed room to lower rates. See page 6.
In our view, it is global bond yields that are driving US Treasury yields lower. The weakness seen in the European economies is creating a flight to safety and the Euro Zone 10-year benchmark yield is currently minus 0.689% in line with the German bund. The Swiss sovereign yield is minus 1.00%, the Japanese 10-year government bond yield is minus 0.243% and the UK 10-year gilt yield is positive 0.45%. In this environment it should not be surprising that the 10-year Treasury bond yield is 1.55%. See page 8. In sum, risks are primarily coming from outside the US and though these risks should not be ignored, it should also be noted that most central banks are taking action to ease monetary policy. This may also explain why the financial media is reporting that President Trump is considering lowering the payroll tax rate.
The most important aspect of the market’s technical condition is the 89% up day on August 16 which suggests the worst of the equity decline has been seen. Yet it is also important to note that sentiment indicators never showed excessive bullishness or anything that implied a major top was forming. In fact, the week ended August 7, AAII bullish sentiment fell 10.7% to 27.7% and bearish sentiment rose 24.1% to 48.2%. Bullish sentiment is currently 23.2% and bearish sentiment is 44.8% which is neutral for this indicator. See page 13. On the other hand, the ISE Sentiment Index turned positive in early August – a sign that option traders are defensive. In sum, we remain long-term bullish.
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting
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