foxex: Trade Hopes Lead to a Bounce

Focus on the Price

Wednesday, December 12, 2018

1. Trade hopes trigger bullish S&P 500 signal

3. Brexit & No confidence vote

Major Moves

President Trump said he would consider intervening with the US Justice Department's efforts to extradite Meng Wanzhou, the CFO of Huawei, who just made $7.5 million in bail in Canada. The goal of such an action would be to help facilitate a trade deal between the US and China.

The magic words for the markets these days are "Trade deal."

The bulls roared out of the gate Wednesday morning on renewed hopes for any kind of improvement in the trade outlook. The Nasdaq rocketed up over 2% at one point, and the large cap indexes trailed just behind. The rally faded late in the session, which may have been caused by worries around the pending no-confidence vote for British Prime Minister, Theresa May (spoiler alert: she survived the vote.)

The only major category to lag behind the rally were the big dividend-payers who are less attractive when stocks and interest rates are rising. Those groups include utilities, REITs, and consumer defensive, which was highlighted in yesterday's issue. Most of the non-fundamental risk indicators have been sedate lately, so buying off support isn't a big surprise–even if it might still be temporary.

S&P 500

As I've noted before, the large-cap indexes are at support so a rally back to the top of the channel isn't unexpected from a technical perspective. But there is another interesting sign of emerging momentum for bulls. The S&P 500 completed a "bullish divergence" with the stochastics indicator today.

Originally created by Dr. George Lane in the 1950's the stochastics oscillator measures buying and selling momentum by analyzing the relationship with the close price and the daily high and low. If the oscillator forms higher lows (with at least one of those lows below 20%) while the price of the index forms lower lows, the indicator signals emerging strength.

As you can see in the following chart, the S&P 500's lows formed on November 23rd and December 10th were sequentially lower while the corresponding lows on the stochastics oscillator were rising. This combination of lows is a bullish divergence which has a good track-record during bull markets. While it may not feel like a bull-market right now, it certainly hasn't turned into a bear market yet, so the technical trigger is valid in my opinion.

In my experience, short-term price targets based on a bullish divergence should be split into two levels. The first is the high price between the two lows, which is the top of the current channel. I use a fibonacci retracement to place the second price target 61.8% above the prior high. Both of those targets are outlined in the chart. For reference, I also annotated an example of a mirror image of this signal, a "bearish divergence," that appeared just before the big decline in October.

Read more:
Three strongest stocks in S&P 500

Do tech stocks still have additional downside?

What is a bull trap?

Risk Indicators

High yield bonds continued their rally today as well. The bullish signal discussed in yesterday's issue turned out to be prescient. I believe high yield bond traders often lead stocks because their focus is on the underlying risks in the market rather than the more uncertain potential for unlimited upside.

However, the selling in small-caps Friday through Tuesday has kept the Russell 2000 below support. Traders should care about the relative performance of small-caps to large-caps because underperformance tends to lead big drops and bull-traps. A little mixed behavior for a few days isn't something to be concerned about, but if this persists traders should be wary of resistance.

For example, on the following chart you can see the iShares Russell 2000 small-cap ETF (IWM) with a relative strength indicator applied below the price. The indicator is based on the daily performance of IWM divided by the S&P 500, which will rise when small-caps are outperforming and fall when small-caps are underperforming the large-cap index.

Because small-cap stocks tend to rise and fall faster than large-caps the relative strength indicator will usually shadow the price of the Russell 2000. However, when stocks are rising with large-caps in the lead, it usually indicates a weak trend and the indicator will be falling. The lead-up to both corrections in February and October this year were preceded by this kind of divergence.

Its too early to assume the rally won't continue, but–if this underperformance continues–resistance on the S&P 500 is much more likely to hold. Interestingly, in modern financial theory, Eugene Fama and Kenneth French have a model (not surprisingly called the "Fama French" model) that attributes most excess returns in a portfolio to its exposure to small-cap stocks.

Brexit and Confidence

Traders in the foreign exchange (Forex) bid the British pound (GBP) higher against the dollar today on expectations that Prime Minister, Theresa May, would survive her party's no-confidence vote today--which she did. Driven by distress over the Brexit deal May is pushing, the vote could have put an early end date on her administration.

Dissatisfaction with the Brexit terms negotiated by May led to a cancelled vote on the matter in Parliament on Monday. While Brexit is seen by the market as "bad news" a vote of no-confidence would have been even worse. If today's momentum is enough to carry the pound/dollar back up through resistance at $1.2700 it could also help boost the prospects for stock returns as well.

Bottom line: Outlook is starting to improve

Bullish momentum across most asset classes today was encouraging. However, investors are worried about a repeat of the fakeout on December 3rd, created by misplaced optimism that President Trump would be able to find a solution to the trade tensions between the US and China after the G-20 meetings. The willingness to buy stocks up off support indicates that the floor under the major indexes is solid, however, it's too early to count on resistance being broken before the end of the year.