Strong July Gives Way To Volatile August As Trade War Escalates

July was yet another solid month for stocks, as the major market indexes eclipsed and held above psychological barriers, like the S&P 500 at 3,000, and the technical consolidation at these levels continued with hardly any give back at all. But of course, the last day of July brought a hint of volatility to come, and indeed August has followed through on that with a vengeance. As the old adage goes, “Stocks take the stairs up but ride the elevator down,” and we just saw a perfect example of it. The technical conditions were severely overbought, with price stretched way above its 20-day simple moving average, and now suddenly the broad all-cap indexes (S&P 500, Dow, Nasdaq) are challenging support at the 200-day moving average, while the small cap Russell 2000 index has plummeted well below its 200-day and is now testing its May low.

For the past 18 months (essentially starting with the February 2018 correction), investor caution has been driven by escalating trade wars and tariffs, rising global protectionism, a “race to the bottom” in currency wars, and our highly dysfunctional political climate. However, this cautious sentiment has been coupled with an apparent fear of missing out (aka FOMO) on a major market melt-up that together have kept global capital in US stocks but pushed up valuations in low-volatility and defensive market segments to historically high valuations relative to GARP (growth at a reasonable price), value, and cyclical market segments. Until the past few days, rather than selling their stocks, investor have preferred to simply rotate into defensive names when the news was distressing (which has been most of the time) and then going a little more risk-on when the news was more encouraging (which has been less of the time). I share some new insights on this phenomenon in today’s article.

The market’s gains this year have not been based on excesses (aka “irrational exuberance”) but instead stocks have climbed a proverbial Wall of Worry – largely on the backs of defensive sectors and mega-caps and fueled by persistently low interest rates, and mostly through multiple expansion rather than earnings growth. In addition, the recent BAML Global Fund Manager Survey indicated the largest jump in cash balances since the debt ceiling crisis in 2011 and the lowest allocation ratio of equities to bonds since May 2009, which tells me that deployment of this idle cash and some rotation out of bonds could really juice this market. It just needs that elusive catalyst to ignite a resurgence in business capital spending and manufacturing activity, raised guidance, and upward revisions to estimates from the analyst community, leading to a sustained risk-on rotation.

As a reminder, I am always happy to take time for conversations with financial advisors about market conditions, outlook, and Sabrient’s portfolios.

In this periodic update, I provide a detailed market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings look neutral to me (i.e., neither bullish nor defensive), while the sector rotation model retains a bullish posture. Read on…

Market Commentary:

The S&P 500 posted its largest weekly loss of the year last week (down 3%). And with the worsening trade war with China devolving into a fledgling currency war, it should come as little surprise to see that the weakness continued into Monday (down another 3% in one day!), despite an impressively resilient US economy bolstered by strong consumer confidence. Moreover, entering August, trading volumes were at one-year lows in what had been a “low participation” rally, so more volatility was to be expected. The CBOE Volatility Index (VIX) closed Monday at 24.59 (note: it closed last Wednesday at 13.94), which is above the “panic threshold” of 20, and even after Tuesday’s strength, VIX remained slightly above 20.

An increasingly intractable and protracted trade war:

If you think Monday’s selloff was ugly, I hope you didn’t notice the afterhours futures action in which the S&P 500 futures were down another 120 points (!), setting up Tuesday for an even worse day. But instead, futures recovered as China moved to stabilize the yuan, and so Tuesday delivered a nice little bounce (some might say a dreaded “dead cat bounce,” but time will tell). It all demonstrates how awful a major escalation in trade and currency wars – beyond just tariffs – could become. Notably, the recent surge in bitcoin may have foreshadowed the abrupt fall in the yuan and Chinese capital flight.

I observed in my article last month that cyclical sectors were finally showing signs of life this year, and they continued to do so in July, getting a boost from a combination of an imminent Federal Reserve rate cut and a US trade delegation headed to Shanghai to resume talks – the first high-level meetings since mid-May when talks came to a screeching halt and all previous progress was thrown out. But although the Fed came through with a 25-bps rate cut, the trade talks collapsed after a half day, before they barely had a chance to get started. President Trump waited until after the FOMC decision before unleashing angry tweets, which included announcing 10% tariffs on $300 billion in additional China-made imports. These additional tariffs were originally planned for the end of June but were postponed ahead of his meeting with President Xi at the G20 summit – and in fact, Trump had indicated at that time they would be reinstated if he was unhappy with the progress of negotiations.

In response, not surprisingly, China decided it would prefer to save face and step away from further talks, even if it means risking further damage to its economy. But China’s situation is likely much more tenuous than we are led to believe, and its posturing means it must further increase monetary stimulus for a “house of cards” leveraged economy that was already showing cracks (including major bank failures). And although the yuan has been falling against the dollar, which has helped offset the impacts on US tariffs internally, the downside is that a weaker yuan reduces its consumers’ purchasing power, encourages capital outflows into stronger currencies, and raises borrowing costs, which can be disastrous for China’s highly leveraged economy.

Then on Monday, as the yuan came under intense selling pressure, China threw in the towel on supporting the yuan at the politically sensitive (“red line”) level of 7.0, so it closed the day at 7.05 – its weakest since 2008 – which sent stocks globally into a tailspin. Later in the afternoon, the US Treasury Department officially labeled China a “currency manipulator” (the first time since 1994), paving the way for further sanctions. Although China stands accused of “weaponizing” its currency, it was not so much an overt devaluation as it was acquiescing to the global forex market’s pressure on the exchange rate – given escalating tariffs, falling manufacturing and growth slowdown, coupled with its escalating problems with Hong Kong (and don’t forget the Taiwan Issue). Forex experts are now discussing the possibility of the US Treasury tapping into the Exchange Stabilization Fund (ESF) to intervene in any further decline in the yuan.

China may actually welcome such outside intervention. With its slowing economy, rising debt load, weakening currency, lost supply chains, domestic capital outflows, and need to attract global capital, not to mention its difficulty handling the escalating Hong Kong protests and its lack of control of Taiwan, its leaders really need to shore up its currency and resolve the trade war soon. Otherwise, as hedge fund manager and expert speculator Kyle Bass has opined on Twitter, “Mass Exodus of capital out of CNH and HKD. This collapse has just begun.” Separately, Bass has stated, “Tensions between the two countries are broadening out to include economic, military and ideological dimensions…. We see these tensions as structural and long-lasting…. I think it's important to note that this is about intellectual property theft. It's about industrial espionage. It's about resetting our relationship with a China who has been taking advantage of the U.S. for a long time…. We can't get lost in the bigger picture here, and it is the incompatibility of two economies butting heads with one another in their cultural differences….”

A persistent preference for defensives over cyclicals:

Before the market’s recent turn of events, stocks had been buoyed by those powerful market forces FOMO and TINA – i.e., ”fear of missing out” and “there is no alternative.” And right on script, last week brought the Fed’s widely expected 25-bps rate cut and the US trade delegation’s visit to Shanghai. However, although stocks have managed to scale a proverbial wall of worry from all the unsettling macro and political news and unresolved trade wars, it seems clear that investors have not overlooked those issues at all, as the market segments that would normally lead the charge to new highs (e.g., cyclical sectors and small caps) have been lagging. Moreover, through last Friday, nearly 20% of the S&P 500’s stellar YTD performance was attributable to its four largest holdings: Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), and Facebook (FB), so narrow mega-cap Tech leadership has been a key aspect of the market strength, as well.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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