Market Analysis

Market in Transition

Can markets extend and sustain new gains without a new free money carrot coming their way?

Since the financial crisis bad news hasn’t mattered as markets always had the next free money carrot to look forward to courtesy central bank induced low rates and QE.

2017 was the icing on the cake marked by record global central bank intervention and a large US tax cut resulting in record low volatility and steady market ascension. A market nirvana if you will.

The resulting euphoria that extended into early 2018 produced historic overbought readings which triggered a short term technical correction in February and since then we’ve seen markets engaged in a multi month price chop with heightened volatility making this a great trader’s market for active and flexible investors as technicals are working a charm.

Now markets are in transition as no new free money carrot is dangling in front of them and, for the first time in many years, bad news may actually matter. Indeed what we are witnessing is a market negotiating the benefits of record earnings with increasing headwinds such as trade tariffs, earnings growth considerations into 2019/2020, rising yields, etc.

To be sure there is still artificial intervention by central banks (but less so) and a lot of the tax cut money is making its way into corporate buybacks and these are keeping an artificial bid under the market to the tune of over $850B in buyback announcements so far in 2018.

Key considerations:

Despite record earnings so far in 2018 we have to recognize that 70% of earnings growth this year is driven by tax cuts. That artificial growth benefit will lesson in impact in 2019 an 2020. Where is extended growth to come from in these years to make up the slack? In this context the concern is that we are seeing peak earnings growth in 2018 and any headwinds that suggest margin compression may cause major problems. Think tariffs, rising yields, price inflation, debt levels etc.

Most indices are either down or flat on the year so far. The narrow leadership of 2017 has become even thinner. Case in point: Even previous $FANG leaders such as $FB and $GOOGL have struggled to make gains, yet $AAPL and $AMZN are standing tall at record highs while 60% of the $NDX components remain below their 50 day moving average:

One may argue that the larger market is entirely dependent on just a handful of stocks not correcting. That’s very thin ice and an issue I had an opportunity to discuss with Brian Sullivan on CNBC earlier today:

In this context to note: $NDX is up for 10 years in a row and current up 6 quarters in a row:

In short, there is precious little evidence of a correction even having taken place.

Looking at $SPX we can observe a very distinct pattern of lower highs and higher lows in 2018:

Key observations:

Firstly, note the pattern of lower highs and higher lows is coming to a decision point, likely in May or June at the latest.

Second, note the lower supporting trend line connecting the US election lows and the February lows. This trend line has been key support in 2018 including last week again. This is critical support full stop and my view is this trend line is key to watch in 2018.

As long as it holds markets can bounce from here and try to overcome some of the open price gaps above, namely 2705, 2750 and 2850 and even new highs beyond that (see also 2018 Market Outlook for potential upside technical targets), but note each gap will be technical resistance. Mission critical: Markets need to start making higher highs and move above the upper descending trend line.

If they don’t, the lower trend line may be broken and that opens up a much larger technical risk zone into February lows and possibly into last summer’s lows:

On this weekly chart note $SPX is engaged in a series of bearish patterns currently showing a potential bear flag. I say potential because it hasn’t confirmed yet. If this bear flag triggers along with a break of the trend line I mentioned before see risk into 2400-2470 on $SPX.

But fear not, this risk zone, if it triggers, may then set up as a tradable buy.

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