foxex: Will Washington's budget fight kill support?

Focus on the Price

Tuesday, December 11, 2018

1. Budget fights in Washington disrupt the intra-day rally

2. Russell 2000 small-caps retest resistance

3. Early signs of life emerging in junk bonds and defensive stocks

Major Moves

An initially positive open lost steam through the stock-trading session. An acrimonious meeting between President Trump and Senate and House Democratic leadership about border wall funding and a potential government shutdown certainly helped take the wind out of the market as prices fell.

Does a government "shutdown" affect the market in any predictable way?

This is a difficult question to answer because there aren't many historical examples. Unfortunately, the government shutdowns of the past were followed by inconsistent market behavior. Forecasts get even more complicated by the different circumstances surrounding each prior congressional deadlock.

For example, the shutdown in January 2018 was immediately followed by the "volatility collapse" of the first quarter, but the shut down in October 2013 was a mere blip on the chart with no significant losses. Before 2013, the last actual government shutdowns were in 1995 and 1996: they barely registered.

Threats to close the government (or portions of it) over a budget fight are more common than actual shutdowns but they are also difficult to compare. While there have been some outlier disruptions–like the debt ceiling fight of 2011–the market has mostly shrugged off events like this easily. If this round of political fights follows the historical pattern, stocks could wind up oversold if the initial reaction to the news is negative.

Russell 2000

The S&P 500 has remained at support since we updated the technical view in yesterday's issue. However, there was some interesting intra-day price action on the Russell 2000 small-cap index. Unlike the Dow Jones Industrial Average (DJIA) and the S&P 500, small-caps broke short-term support last Friday and the index was rejected at that support level on an intra-day basis today.

Intra-day evidence that former support has turned into resistance is only preliminary confirmation, but it gives traders some additional insight into the risk appetite of investors. If intra-day resistance holds on the small-cap indexes, the major market benchmarks like the DJIA could be at greater risk this week.

Risk Indicators

Most markets were fairly flat today, although there was surprising relative strength in the high-yield bond market. This is good because most of the indexes that track this asset class are at a potential short-term support level. As you can see in the following chart, the iShares High Yield bond ETF (HYG) bounced off the same low established in mid-November.

Most investors are familiar with the positive correlation between high yield bonds and stocks. The relationship is imperfect, which is why high yield bonds often lead breakouts in stocks. However, the correlation between the two asset classes is not the only reason high yield bonds provide insight into the stock market's future direction.

High yield bonds are less influenced by the day-to-day fluctuations in the interest rate environment. Instead, because high yield bonds are at a higher risk of default than "investment grade" corporate or government debt, the price will shift based on long-term expectations for solvency.

High yield bond traders are laser-focused on the expected ability for bond issuers to make future coupon payments and principle repayment. Small changes in the anticipated default risk makes big changes in the average value of the high-yield debt market. This should help explain why a decline in the high-yield category often precedes a big drop in the market. Lower highs in junk bond funds and indexes warned of the big correction in the first quarter 2018 several weeks in advance.

One day's bounce doesn't make a trend, but in my opinion it shows that investors who are focused on risk (versus growth) were willing to add risk on an otherwise uncertain day. Admittedly, it's kind of a stretch to find any positives today, but I think this is a signal worth watching. If high-yield bonds continue to rally, it would be a very positive sign for small-cap and large-cap stock indexes.

Bottom line: Not worried about D.C.

Investors would have been justified to expect a bigger move in the market considering the budget fight in Washington. However, historically speaking, traders tend to take this kind of thing in stride so we probably won't see much of an affect on stocks in the short-term. In the meantime, support is still holding without any deterioration in the broader risk indicators. Consumer defensive and high-yield bonds are worth watching for an early sign of improving momentum.