foxex: Support is Broken, Long Live Support!

Focus on the Price

Friday, December 14, 2018

1. Support breaks on disappointing economic news

3. Was healthcare a victim of profit-taking?

Major Moves

There are competing theories today as to what caused the Dow Jones Industrial Average and the S&P 500 to drop -2%. Some analysts are concerned by the drama surrounding President Trump's former legal counsel and associates, while others point to issues in Chinese growth and economic announcements. While speculation about impeachment and cabinet appointments makes for interesting headlines, in my opinion, the market is more likely to respond to policy than rumors—at least when it comes to politics.

What seems most likely to have caused the decline was poor economic data released from China overnight. Industrial production numbers on a year-over-year basis were up 5.4%, which is still positive but less than had been expected. Retail sales growth was up 8.1%, which is also very good, but less than expected.

I think the argument in favor of the news from China being the catalyst for today's selling is strengthened by the fact that risk-off assets—such as the Japanese Yen—started to rally just as those news reports were released last night. However, regardless of the actual cause of the selling, traders were caught in a bull-trap this week and short-term support in the major indexes is broken. Just in time for long-term support to come into play.

S&P 500

Investors have to be very careful about confusing the stock market with the economy on a day like this. Although sellers were in control throughout the day, the underlying economic fundamentals in the US are still strong. For example, contrasting with Chinese retail data, US retail sales on a month over month basis were up more than expected (if you include auto sales) in a release this morning.

The current market environment reminds me of the volatility in 2010-2011 that started with the "Flash Crash" and ended after the "Fiscal Cliff". During the entire period, earnings, jobs, and spending were on the rise while the market failed to make significant gains.

There was significant political uncertainty at the time, as this was the heyday of the 'debt ceiling' fights, but ultimately, valuations caught up with the fundamentals in 2012-2014.

From a technical perspective, the S&P broke short-term support, but that merely places it at the prior lows following the declines in February. A break of $2,640 was disappointing, especially after the bullish divergence earlier this week, but if the major indexes break long-term support at $2,600 a bear market becomes much more likely.

Risk Indicators

Although the failure of bullish momentum this week is disappointing, there still isn't much panic reflected in the traditional risk indicators. The VIX is elevated, but not rising above its highs; high yield bonds didn't break support this week; and government bonds remained stable.

Another risk indicator I think is often overlooked is the movement of safe-haven currencies. For example, the Japanese yen is an important reserve currency and is in demand during periods of market disruptions. During the first quarter market crash, the yen rose nearly 8% against the dollar and nearly 9% against the euro.

The yen is also an attractive source of funding when investors want to borrow cheaply to buy risky assets. For example, if an investor believes they can borrow yen for 2-3% and use those proceeds to buy risky assets like high yield bonds, or stocks the yen falls in value. Therefore, if traders are really worried about the market they buy back their borrowed yen positions and seek a safe-haven that tends to boost its value very quickly. This is a version of the "carry trade."

As you can see in the following chart, the yen has been stable and flat during the current market disruption. Despite a small blip higher today, the yen has been remarkably flat over the last few weeks. The normal correlation would have predicted a much stronger yen. We can interpret this as evidence that although equity prices are falling, traders are just not ready to panic yet, which means this level of long-term support is likely to hold.

Read more:
Forex Trading for Beginners

What Forex Traders Should Know About the Yen
Which Economy is Larger: China or US?

What caused the healthcare selling?

Traders were especially focused on basic materials, technology, and healthcare stocks during today's selling. We can probably blame the China news for the selling in tech and basic materials, but what's the problem with healthcare?

This is where today's volatility may help traders plan for risks in the market over the next few weeks. While it's possible that investors were nervous about healthcare because of political uncertainty and lower ACA healthcare signups, it seems more likely that investors are taking profits off the market leaders.

You may have missed it previously, but healthcare stocks, on average, had regained their prior highs at the end of November. If this pattern holds for other groups, it means we could be in for another round of selling the news when earnings are released next month. The defensive sectors (consumer staples & utilities) have also done well on a relative basis over the last several weeks, but I don't expect profit taking to start pressuring those groups unless interest rates start to spike.

Bottom line: Channel-bound

It probably looks a little like I am moving the goal posts for bears by flagging long-term support in the $2,600 range, but those are the prior major lows which means investors will have a tendency to mentally-anchor to those prices. If we don't see any significant negative news over the weekend, I would be surprised if the major indexes didn't bounce a little higher before traders start stressing about the Fed's announcement on Wednesday. I also maintain that the level of uncertainty is high enough that resistance should be very difficult to break in a single rally, which will keep the current channel intact for now.