An October to Remember
Volatility makes a comeback - what does this mean for US equities?
|Shane C. Murphy||Oct 27, 2018|| 2||1|
The S&P 500 closed the week -3.5% as increased volatility and bearish sentiment continue to dominate the marketplace. With nearly all major market sectors finishing lower this week, it’s difficult to discern exactly where investors are putting their money. All key indices are trading well below their 200 day moving average, leaving traders to speculate on whether or not we are in the beginning of a bear market. On the positive side, we did see relative strength come out of two sectors that tend to under-perform within a rising rate environment; Consumer Staples and Utilities. With that being said, I do not believe the recent carnage in the market is a direct result of the Federal Reserve’s stance on interest rates. With September’s inflation numbers underwhelming estimates in a number of key areas, I believe we can expect little to no surprises from the Federal Reserve over the next 6-8 months.
The Fed is hawkish, they have been hawkish on rates all year long - nothing has changed, estimated hikes remain the same. The greatest economists very rarely can predict (if ever) changes in inflation, but what investors can bet on, is the Fed’s overall position on the economy, and how it will react to specific jolts or fizzes in economic data. I believe the recent correction was primarily caused due to a breach of key technical levels, a declining enthusiasm for continual economic upside (despite the data telling us otherwise) and lastly Geo-politic tensions coming to a crossroads with the PRC. US stocks finally re-correlated themselves to the Global Equity Market, and I believe there are 2 key technical levels we must keep close watch on. One is Crude Oil, the other is within the Russell 3000 Index.
The Light Crude Oil Futures weekly chart can be seen below
Double top formation (blue circles) this is one of the most common reversal patterns. If we see a confirmation move below $62 per barrel, it could mean the end of the bullish up-trend in Oil.
RSI divergence (two red lines) Notice as the highs of the price chart proceed to get higher, the highs on the RSI (bottom chart) proceed to get lower. This a bearish divergence and could lead to a sharp drop in price of the underlying commodity.
Ascending Broadening Wedge chart pattern; this is a bearish chart pattern, a break below the current trend line (black) along with an increase in sell volume, could push the price of Oil back below $56 per barrel.
What does this mean for inflation? Well economists believe (although weakened over the years) there is a direct relationship between the price of Oil and Inflation. CPI or the consumer price index; an economic indicator used to measure inflation, is positively correlated to the price of Oil. Meaning if the price of Oil declines, CPI will read lower and inflation will decline (however narrowly). It is estimated that a 50% reduction in oil prices would reduce expected inflation by 27 basis points per year, or about 2.7%, over 10 years . This may not seem like much, but in the grand scheme of things it can impact the global economy in a big way.
What does this mean for US stocks? Historically, a large decline in Crude Oil prices does not bid well for the US stock market. Unlike the initial response of the 2014 decline in Oil (which ultimately led to a stagnate US market) a decline in 2018 would not occur with a Fed Funds rate below 10 basis points. If an Oil bear market were to begin in the next 6-12 months, equities may reflect similar price movement to that of June '00 - March ‘03. Only this time we will not have Quantitative Easing in our toolbox to stimulate growth. Below are the Light Crude Oil Futures and S&P 500 Monthly charts.
A horizontal trend line will prove to be resistance for Crude Oil, that coupled with the double top formation we saw on the weekly chart, it would be safe to remain neutral on Oil in the short term.
A large 30+% decline in Oil would be very difficult under current global commodity conditions. (i.e. current inventory levels, trade agreements etc.) But that does not mean conditions are unchangeable.
The Russell 3000 index is a great gauge of the US market. The index tracks the performance of the 3,000 largest US traded stocks which represent roughly 98% of all US incorporated equity securities. I said previously how US stocks in recent weeks are re-adjusting their price movements to that of Global equities. The below chart is the MSCI World Index Fund compared to the Russell 3000 index (daily chart).
Notice during February’s sell off, % return for both indices were relatively equal. At the height of the Russell’s return YTD (9/20/18) we saw just under 9% while at that same time the MSCI World Index saw a 4.5% return. Many traders picked up on this divergence and understood it could not sustain the separation forever.
The below chart are both weekly candle stick displays - of the Russell 3000 index and the % of stocks within the Russell 3000 that are currently trading above their 50 day moving average.
When roughly 25% + (above green line) of the Russell 3000 is trading above the 50 day moving average consistently, we see a continuous bullish uptrend in the index. We saw it from 2012 - 2014 (briefly selling off in October of 2014) and again 2016 to the beginning of 2018. This may seem simplistic, but the key here is consistency. It only took 10 months of inconsistency for the S&P 500 to shed -50% in 2008.
This past week was the first notable week of earnings season - this brings with it more volatility and more long-term investors checking their portfolios, deciding whether or not to hold or sell. I believe until we see clear sector rotation and establishment of trends in value stocks like McDonalds, Coca-Cola, Wal-mart, Auto-zone, Twitter etc. it is safe to play the market defensively.
And remember, a stock does not have to be paying a dividend for it to be considered a part of the value family!