As expected, we have seen a decent bounce from the report two weeks ago but no key levels have been broken here.
The bounce has been swift but narrow with a new higher high in very few sectors though inc US finance, ( US Oil & Gas is very close) and in Europe only travel and leisure has broken out with finance lagging badly. US housing related stocks have barely bounce at all from their deep sell off and neither have the prior defensive leaders like health care, food and beverage and retail related stocks. (All the sectors inc utilities and telecos that generally have a negative correlation to rising interest rates note!)
Summary, the technical damage done in the June sell off sustains with nothing signalling a change of stance re the ongoing distribution and correction calls. On this basis we have bounced back into sell zones for US indexes.
“Our early October target for the SP500 is at 1450 and a break of this level would call for 1380/1350 as a worst case scenario”.
But the issue, as always, is short what? Its been a theme in the forum pages of what the best hedging vehicles will be for this coming index weakness. Whether to use the technical weakness in the – beta European indexes and or the Emerging market indexes as the basis for short positions or conversely whether the + alpha ie the US indexes as a short target. Probability wise, the + alpha indexes are not usually the indexes to attack though the Swiss team argue here that given the US dollar strength issues and extreme AAII investor positive sentiment toward the US (and negative sentiment on the Ems and Euro area) the alpha should on this occasion be the target.
A key plank of the Swiss team’s report again seems to be rates and currency. Rates have risen considerably in recent weeks across the yield curve and across all credit based instruments from corporate to junk to mortgage rate to treasuries. What’s worse rates have sustained even as equity indexes have bounced. Higher interest rates normally squeezes domestic demand (especially in high debt ratio environments) at a time when world demand is already weak and greatly driven by consumer demand. A stronger US$ is also usually a drain on world liquidity as the dollar is internationally a funding currency. The combination of higher rates and stronger dollar basket is key bearish signal though not a timing signal in itself, of course.
For my own comment here, in terms of targets. I’d say the team will be correct that the US indexes are the correct target if this coming weakness is purely a correction rather than a market crash. As we saw in the 2009 crash liquidity becomes a key driver in a crash driven event. The US markets always normally sustain liquidity as their capital markets are so deep and their central bank always ensures liquidity. In a panic environment, for purely liquidity reasons, the US indexes should sustain their relative positive out performance. We cannot determine here how much strength this technical weakness will gain to the downside as she reveals herself. This we will have to play according to what technically occurs as the move gathers momentum.
Inter market wise
“financials are a key driver of the current bounce are getting increasingly overbought and they are forming a big non confirmation on the indicator side, which means the rally in financials will be increasingly limited and this also means that the SPX will sooner or later lose its biggest asset versus the world. If we do not see a rotation back into defensives/value it will be difficult for the SPX top to hold the current high price levels”.
Issues such as these in the US are earnings impairing for Financial services, if they pass into law.
So the logic runs that technically finance has been leading this charge and unless the old leaders ie the defensives rejoin the attack then the indexes will at the least see a distribution and most likely a correction.
If we put this report together with the recent MS report detailing the sector action correlated to higher rates we start to see the wood for the trees here. Defensives do badly in rising interest rate environments. They often have large balance sheets with large long term funding needs and operate in highly regulated environments where they cannot easily and quickly pass on a steeping yield curve.
It therefore follows that the defensives are unlikely to join, unless rates fall considerably again. And this is not what the market is reading into the FED’s tapering comments at present as can be seen in credit market prices.
In this high ratio debt environment credit market rates are all important in determining asset markets direction.
If this rally is to continue, as rates rise, it would need the positively correlated sectors to higher rates to start to significantly out perform. These include construction, autos, chemicals, resources etc. Opposite to what we would expect to see at the start of a rate rising environment (which usually signifies the economy is starting to over heat) these sectors are already struggling which is generally not a good starting point for a sustainable rally.
US sector targets for the Swiss team remain the HGX and the Dow Transports.
Timing wise near term the 10 yr treasury remains a key indictor. The higher the rate the more pressure on equities given the structural weakness above re cylicals vs defensives. The second key indicator is the US$. The $ is at key levels vs several pairs inc the euro. The euro today fell again to 1.277 which is key area. A fall through the historic support, rise in the us$ in tandem with the t-bond 10yr rising to the resistance at 2.8% or so would badly squeeze equities and likely trigger another correction wave as the over bought financials fade and the defensives struggle due to the higher rates. Trading wise monitoring these correlations and inverse correlations on one screen is not a bad strategy at this point in the market over the next few days and weeks, in my view.
Without delay here the report:
And I also highlight this useful GS report which nicely reminds us of the coming week’s important tech charts. A very useful doc to reference which ill aim to publish every Friday alongside the WF macro reports.
As a general comment we have seen asset markets rise considerably across the world since the 2008 boom and subsequent bust in 2009, inc the implosion in the financial system and credit market collapse. The rally has been driven greatly by the hunt for yield thus far in this negative interest rate environment. In the last few months credit conditions have started to tighten once again and this has lead to the defensive high yield equities to sell off in a dramatic fashion. The cyclical stocks continue to be weak as world pmis and consumer demand struggles. Structurally this makes for an interesting H2 here with weakening equity market internals, tightening credit conditions and strengthening US$ which further tightens credit conditions. The May highs were confirmed in several key sectors in the US, if less so in Europe and not at all in Asia and EM markets. As we have said before there remains some technical strength in key sectors but its weakening here. Credit rates and US$ are key to keeping this cyclical asset market bull alive. Any significant divergence between rates the US$ and equity markets are an opportunity on both sides of the market here. Without either much more liquidity and or significant market turbulence gold remains likely to be unloved though a near term bounce is to be expected given the sell off she has seen in recent months.
All the best
Rich
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