foxex: Crack! S&P 500 Breaks to New Lows

Focus on the Price

Monday, December 17, 2018

1. Support breaks on government spending and healthcare woes

3. Probability for a rate hike is falling fast!

Major Moves

After an initial recovery early in the session, the major stock indexes formed an intra-day double-top and dropped to a new short-term low. The proximate cause was likely a sell-off in healthcare stocks and reports that President Trump isn't likely to support a stop-gap spending bill to avoid a government shut down this week.

Historically, government shutdowns (like 2018, 2013, 1996, and 1995) are rare, short-lived and didn't impact the market much if at all. Although history is an unreliable guide in the market, it's still not safe to assume that a shutdown would automatically mean a major decline.

In my opinion, the most pressing issues are selling in the healthcare sector as the Affordable Care Act is back in jeopardy, and a potential surprise from the Fed on Wednesday. The sharply negative reaction in market risk indicators to today's selling has a different tone than the declines last week.

S&P 500

The S&P 500 is now clearly below support at $2,600. This essentially completes a long-term, and somewhat lopsided, double top pattern formed through most of 2018. The S&P 500 has now joined the Russell 2000's small-cap stock index which was already trading below its lows from the first quarter.

What seems to be happening is that equity prices in the US are catching up to those internationally. For example, stock prices in Germany and the US are usually positively correlated, but the S&P 500 diverged from that relationship with the last rally through the third quarter. You can see in the following chart, the normal relationship between the iShares MSCI Germany ETF (EWG) and US stocks had diverged but are now heading the same direction.

Does the end of the S&P 500's divergence with European stocks (also small-caps, emerging markets, and commodity prices) help investors?

The S&P 500 has had a lagging relationship with most other 'risky' assets this year. A virtually identical setup preceded the declines in late 2015 as well. Unfortunately, international indexes don't tend to give advance notice for S&P 500 advances like they do for declines. Index relationships like this are good for planning risk-control but aren't as useful for timing new entries.

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Risk Indicators

Healthcare stocks were hit hard with two rounds of bad news. On Friday, a federal judge in Texas struck down the Affordable Care Act pending appeals. And traders continued to sell Johnson and Johnson (JNJ) after asbestos was found in its baby powder products.

On the ACA front: nothing changes for consumers or Medicare recipients yet, but it throws a lot of uncertainty at that part of the market. Health insurers were hit right away with companies like Molina Healthcare (MOH) down nearly 10% because of specific exposure to Medicare and Medicaid plans. On average, the healthcare sector in the US was down 2.5% today.

Besides the obvious safety concerns, the reason Johnson and Johnson (JNJ) is such a problem for the group is that they represent a very large percentage of ETF and other fund holdings with exposure to the healthcare sector. For example, JNJ is roughly 10.5% of the holdings of the SPDR Health Care Select Sector SPDR Fund (XLV), which has a net asset value of $19.6 billion.

As JNJ falls in value, related stocks are sold due to rebalancing and concerns that the product issues may be a more general issue. As you can see in the following chart, today's negative movement completed a double-top in XLV. This is particularly disappointing for bulls because healthcare stocks were one of the only groups to regain all their October losses when the market rallied at the end of November.

Read more:
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What about the Fed?

According to the CME Group's FedWatch tool (pictured below), the futures market is pricing in a probability of 72.3% for a rate hike on Wednesday, which is a big change since Friday when the probability was almost 76%. It has been years since the futures market was this uncertain about whether the Fed would raise the target rate this close to the actual announcement.

This increases the possibility that the Fed will surprise investors. If the target rate is left flat, will investors approve because it keeps the cost of capital low, or will that be seen as a lack of confidence in the market? This is starting to feel a lot more like 2013 when traders panicked after the Fed Chair, Ben Bernanke, hinted that they would begin tapering quantitative easing.

In my opinion, I think the Fed will raise the target rate to 2.25-2.5% to reaffirm their independence and make sure investors can have confidence in prior guidance. However, I also expect that the economic statements and press conference will have a very dovish tone (fewer rate hikes in 2019) that will boost the market.

Bottom line: Support is a hard argument to make now

From a technical perspective, the major large-cap and small-cap indexes are below support. The distance off the highs don't qualify as a bear market yet, but its more than halfway there. Statistically, double-tops (S&P 500, XLV, etc.) have a poor track record of hitting their price targets while earnings growth rates are still positive, which is currently the case. Rather than searching for big bearish plays, I believe investors should use the decline to identify stocks with relative strength that may rise earliest if investors like what the Fed has to say on Wednesday.

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