When to be fearful and when to be greedy.
This was a sentiment driven week. Not because it contained Valentine's Day but because markets moved on expectation rather than what is actually happening. The overriding factor was that traders continued to look for positive signs from the ongoing US-China trade talks. The March 2nd deadline is perhaps traders’ Valentine’s Day. It is certainly a red-letter day. Many believe the outcome of the talks will make or break the market’s love affair with stocks and the Dollar. But this ignores what is really driving this market: a gap between expectation and reality that is likely to grow through 2019 and then narrow sharply.
US indices shrugged of the worst US retail sales miss since 2009 after Fed’s Kaplan blamed what may now be a one-off 2019 US Government Shutdown. A sentiment driven S&P closed exactly at our 2777 objective and 2019 highs after digesting reports Warren Buffett had liquidated some AAPL shares and bought JPM in the last quarter of 2018.
The unstable but significant rotation out of tech stocks (NDX) into financials (DJIA) promises more sentiment driven fireworks this week after President’s Day. However, a more fundamentally oriented USDJPY stayed depressed due to lower US yields that continue to lag Euro Bund yield by over a week. The German DAX barely noticed that Germany avoided a technical recession by the narrowest of margins as it closed the week strong, or that the Bund is very close to a sharp reversal with repercussions for the Euro. Indeed the Euro recovered from ECB’s Coeure comments that the eurozone’s recent economic slowdown was more pronounced than expected and that they were considering cheaper (TLTRO) loans to banks to help achieve their inflation target.
But it gave us a chance to buy after exactly hitting our 1.1235 EURUSD target. Prophetically the day before, Sterling spiked perversely lower after strong UK retail sales and then recovered encouragingly for our near term long. A depressed but stable AUDUSD may present us with a similar opportunity this week as the RBA publishes dovish minutes due to a weakening outlook for the Asia/Pacific region, a region that will remain affected more than others by commodity prices. Both Gold and Oil closed the week strong as crude remains in the early stages of a recovery currently buoyed by the expectation of output cuts rather than the reality.
So what is going on. When the data is saying one thing, why are markets doing the opposite? Why do indices continue to recover when the underlying fundamentals appear to be doing the opposite.. deteriorating. The answer is sentiment.
In our 2019 Sentiment Outlook for both Indices and Individual Stocks (published this week) we presented a wide range of useful sentiment indicators and stated
Markets move on sentiment, primarily about what the price will do. But that price sentiment is conditioned also by the expectation of the underlying fundamentals and that, in turn, is also obviously influenced but what the fundamentals are actually or appear to be doing.
The (10 versus 2 year) yield spread is widely seen as an indicator of a recession or recovery within a year. Essentially it is the bond market view of the economy – the difference between what generally savvier bond traders think the Fed is doing with rates (2 year) and the likely impact on inflation (10 year). It has been in a downtrend since 2014 leading many prematurely to project a recession. Although it is at its lowest since the 2008 recession it is only when it slips to zero (expected in the first half of 2019) that it actually indicates a recession is coming. Not exactly easy to trade. A market can move a lot in 12 months. Interestingly the price action of SPX and our USD forecast is very similar to the last time it dipped below zero at the end of 2005.
Finding the right fundamental sentiment indicator is important. One that is both accurate and correlates closely to price but also leads turns. The Michigan Consumer Sentiment Survey is one of the best.
SPX – Michigan Consumer Sentiment
In sustainable trends, both price and fundamentals move together particularly in the middle (Wave 3) of a trend where sentiment about both will also increase. However, a trend cannot be sustained in the longer term (such as the start of 2018 for stocks and the Dollar) if price and fundamentals diverge, requiring an adjustment at some point in either price and/or the fundamentals. It took EURUSD 140 days after its interest rate differential topped in 2017 to turn lower throughout 2018.
The impact of Protectionism on the economy and stock market prices was only really felt in December, eight months after they were announced. Sentiment about the Dollar and the economy appear now to be diverging.
DXY – Michigan Consumer Sentiment
How long and how far a market can move before it finds a dynamic equilibrium (where price meets the fundamental) is a function of both previous and current price sentiment as well as fundamental expectations. Where a trend has been long established such as the economically driven stock bull markets since 2009, it takes longer for the market to realise the fundamentals have turned. It takes traders longer to adjust accordingly because they need more evidence in a prolonged economic recover to believe a deterioration isn’t a ‘glitch’ as Kaplan put it this week. They have also got used to ignoring seemingly wrong (but possibly delayed) indicators that may project a downturn when the price continues to go higher.
That is very much the situation now as the market has become increasingly bullish for Stocks (and the Dollar).
But that doesn’t mean stocks at least will not continue higher at least later for much of 2019 for two reasons.
The first is that inflationary growth may stop deteriorating. We have highlighted in both Index 2019 and Stocks 2019 why Earnings are so important to the current upswing to determine whether the sentiment gap between price and fundamentals is growing. This will be the crucial difference between only a retest or new highs for US indices. The recent drop in Michigan Consumer Sentiment and Retail Sales could be glitches even though we think not.
The second is just because the market is bullish doesn’t mean they are long enough and are not willing to buy more on dips.
One of the reasons why US indices haven’t yet retraced significantly is that people waiting for the dip are now chasing it. Whether it will sustain the rally will depend also on new entrants. We have talked a lot about capacity and how new highs would attract new entrants in the market. Volumes (particularly retail) will be an increasingly important sentiment indicator later n the year particularly in individual stocks if corporate buybacks kick in.
One of the reasons why the Dollar doesn’t seem able to sustain rallies is not just because the market has been bullish but also that it actually remains overly invested in it as evidenced by leveraged funds.
Forex - Commitment of Traders
That was very much the story of 2018 and likely to be more so in the coming weeks and months.
Here’s to making the very best.
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