Chart Talk {10.09.18}

So rising interest rates have given the stock market a bit of a rough ride in the past week or so.  Above we've tried to lay out the different reference points we will be watching if this market sell off morphs into something a bit more dramatic.  You can double-click on the chart to make it larger if you want to get a better view of things.  Here are a few thoughts on what we've been seeing.

I discussed months ago in a post called "The Highest Probability Scenario For the Rest of the Year" that I felt there was a very high likelihood that stocks would more or less stall in place.  This is what I said back then:

"Under this scenario we think you could see something like this.  Stocks spend much of the year consolidating their gains from the past two years.  The positives of underlying economic growth we are seeing and gains from the tax cuts runs into the worries of higher stock valuations, higher interest rates and higher inflation.  Also as the year ages we start adding political risk into the equation from the upcoming mid-term congressional elections.  In this scenario, stocks spend a better part of the spring finding a level of equilibrium from which they can again start to advance.  Markets then manage a stair step rally into early summer that potentially takes us back to the old highs set in January.  From there markets proceed to give most or all of that rally back, potentially retesting the spring lows.  Once we get into the fall and once the outcome of the elections are priced into stocks there is a possibility we again attack the old highs from January.  Under this scenario we see stocks showing price appreciation of 7-10% this year.  Now obviously it is unlikely the year will pan out exactly as I've drawn the lines.  They are a hypothetical general illustration.  Still it seems there is a very high probability that a scenario similar to what we've shown above is what we'll have seen once 2018 winds down."   

Now it hasn't panned out exactly like we hypothesized back then.  There was no further downside to the market over the summer and we actually made new highs in the S&P 500 and other major US indices have gone higher as well.  But this rise has been something of a mirage.  Market breadth, that is the number of stocks advancing versus those declining has been retreating most of the summer.  Stock leadership has basically been confined to a small group of well known technology and health care names.  Meanwhile overseas, international markets are struggling to break even for the year.  Many, like emerging markets are down nearly double digits in 2018.  David Rosenberg over on his twitter feed recently noted that 17% of the S&P 500 is down 20% or more from their 52-week highs; fully 43% is down at least 10%.  These are the sort of statistics that have historically been found worrisome.

I have always thought that the period prior to the mid-term elections would bring about some market uncertainty.  The market's expectations as discussed last week is for the Democrats to take back control of the House.  I've thought all along that while this is likely, it may not be as dramatic as the press has hoped.  Markets, however, do not like uncertainty and there is now a higher probability for this to weigh on markets until the results are in.

Now as to those interest rates, I think what's been bothering the markets is not so much the advance but how rapidly rates have risen this fall.  Stocks are going to need to find some area of equilibrium where they can come to grips with not only where interest rates are now but where they might be a year from now.  Currently, the market's expectation is for at least three interest rate increases by the Federal Reserve next year.  Taking that data into account you can see how longer term rates could rise to around 4% next year, something we also discussed last week.  4% money is serious competition for equities.

Before you read more into this article than is intended, let me say this.  I think there is a strong possibility that major market stock indices will advance 7-10% by the end of the year on a total return basis.  Assuming we don't have something unexpected show up I think the economy is strong enough to weather higher rates and once we get beyond this period of cyclical weakness stocks could take us up a leg higher as the animal spirits get back into the game for the traditional end of the year push.  I've thought most of the summer that there was the possibility for a period of market weakness and now maybe it's here.  Stocks don't always go higher and sometimes you can get a correction by time as much as price.

Not so sure yet what to make of 2019 but that's a topic for another time.

Chart is from Tradingview.com although the annotations are mine.

Long ETFs related to the S&P 500 in client and personal accounts.