foxex: Market Bounces but Tariffs Still a Big Risk

Chart Advisor | Focus on the Price

Tuesday, May 14, 2019

1. When are the effects of tariffs priced in?

2. Risk indicators still below panic-mode

3. Bullish but cautious as more trade details emerge

Major Moves

In my experience working with individual and professional traders over the last two decades, there is always some confusion about when the effect of an external factor (e.g. tariffs) will be felt in the market. It is helpful to think about issues like this as a weighted probability.

For example, economists at Goldman Sachs estimate that the tariffs on another $300 billion of Chinese imports will cost 0.4% of GDP because of increased consumer and production costs. If that is correct, then we can make a rough estimate that it would wipe out earnings growth for the rest of 2019. That isn't the same thing as a recession, but it's certainly not good for stock prices.

Since the trade war isn't new information, we can assume that investors were already including the costs of the tariffs multiplied by the probability that they would become a reality since the trade dispute started.

For the sake of this exercise, let's say an investor expects the tariffs to take 15% off what the S&P 500's value would be without the tariffs. The probability of rising tariffs was relatively high last month even though the market was performing well. If we imagine that the probability of these additional tariffs was 30% in April, then the investor was adjusting that into the price and the S&P 500 was 4.5% (15% x 30%) lower than it would have been without that risk.

For the sake of this example, I used very precise numbers that would be virtually impossible to determine at the time, but the point I am making is important. Even though the market was rising last month, investors were still pricing in a certain percentage of the possible costs of increased tariffs that have stunted returns compared to what they would have been otherwise. Traders do not wait to make all the adjustments to stock prices once a possible risk becomes a reality.

This concept matters because if you assume that the none of the potential costs of the tariffs have been priced into the market yet, it could lead you to assume that prices should be even lower than they are and you may miss opportunities for upside profits. Sometimes traders underprice risks, but that is more rare. It is far more common to oversell the downside which is why investors like Warren Buffet have said "be greedy when others are fearful".

S&P 500

I don't think market volatility has come to an end yet, but, from a technical perspective, I think there is a good possibility that the S&P 500 will treat the 2,800 range as support. This has been an important pivot for over a year and was the neckline for the bullish inverse head and shoulders breakout in March. In my view, this is about as likely a short-term support level as I could expect.

As I mentioned in yesterday's Chart Advisor, support was starting to look a little weak, but was not fully invalidated without another negative close today.

3 Charts That Suggest Now Is the Time to Buy Gold

Cryptocurrencies on the Comeback Trail

Risk Indicators - No Signs of Panic

The selling over the last two weeks has triggered a lot of negative moves in the most important asset classes, however, most risk indicators are still signaling this as a short-term correction rather than something more severe. As I mentioned in last Wednesday's Chart Advisor, the SKEW index is still in its "normal" range, which is good.

The SKEW tracks the premium levels of out of the money put options on the S&P 500 index. These puts are used by large traders to hedge against large drops in the market. If traders are worried about a big move, the price of those options rise which pushes the SKEW higher. If you are unfamiliar with how put options work, imagine that they are like buying an insurance policy on your portfolio. If the risk to your portfolio is high, the insurance will become more expensive.

As you can see in the following chart, the SKEW is still at relatively low levels compared to prior market selloffs. This tells us that demand for put options as a hedge against a large decline is still very low. In my experience, this is what it looks like when investors are preparing to look for dip buying opportunities rather than a selling frenzy.

NVIDIA Stock Breaks Down Despite Bullish Analysts

CyberArk Rally Continues After Strong Q1 Earnings

Bottom Line - Still Bullish But Very Cautious

My tone today has been intentionally bullish, but I am wary of overstating the case. The risk that a tariff war could escalate out of control cannot be priced into the market and remains an unknown. The correction has been well within a normal range compared to prior years I think many of the potential costs of the tariffs are already priced into the market.

However, protectionist intervention in the economy by politicians has a bad track record. I suggest that investors remain bullish but with a focus on risk control until uncertainty recedes and we have more concrete progress on the trade disputes between the US and China.

Trailing-stop/stop-loss combo leads to winning trades

Learn the basics of investing

How can we improve the new Chart Advisor? Tell us at chartadvisor@investopedia.com