Surely Not Straight Up Again?

Equity markets, having reached short term oversold levels that even we identified last week, have rallied very smartly in the last week or so. This rally is very similar to other V-shaped rallies we have seen in recent years, and seems to be the hallmark of the buy the dip crowd. Are equity markets really just about to go vertical again, or is the topping process that we have outlined more likely? We are sticking to our topping process, and will look around some other markets where extremely large positions may be about to get unwound, likely leading to some large price swings.

Let’s start with the US Dollar, which we believe is having an important effect on markets at the moment. In chart 1, we can see that the main trend has been down for most of the last year or so. The Dollar tried to rally last Autumn, but bearish forces soon reasserted themselves by year’s end and the decline in early 2018 has been quite brutal. Yet this week, the Dollar had every chance to break below a small shelf of support, which it did on an intra-day basis, but not on a closing basis.

In fact, the daily price action on Friday has the look of a failed break below support. We are going out on a bit of a limb here, but we think the Dollar, having been hated in recent weeks, is putting in a bottom of some sorts, and may well mount a decent rally in the next few weeks. A break below Friday’s low of 88.25 would negate this view, but the reward versus risk of being long the Dollar here looks quite attractive to us on a trading basis.

Chart 1 – US Dollar Index (Daily) with 50 Day Moving Average (in purple)

If we are right that the Dollar can rally for a bit here, this is likely to be a drag on most commodity prices. In particular, we think that oil prices could be vulnerable in the weeks ahead. With the oil price well above breakeven production costs now, more drilling activity is taking place and US production is already at a record high. With price bouncing back towards resistance (see chart 2), we think that speculators, who are holding record long positions, will be tempted to take profits after a very strong rally in recent months. We think the rally of the last week or so will fail below $63.

Chart 2 – Oil Price Daily Chart with resistance (in red)

We have made quite a fuss in recent weeks that bond yields would move higher. Everyone is focused on the 3% level for the 10 year US Treasury, inflation is ticking higher, the Fed seem committed to their programme of normalisation and the federal budget deficit is set to increase markedly. When everyone expects something to happen in markets, it rarely happens. As such, we are beginning to wonder whether yields may be close to a high of some sorts (low in price).

It may seem a little counter intuitive to be looking for Dollar to strengthen and bond yields to decline, but inter-market correlations have broken down badly in recent months, and so we look to the individual charts for trading guidance over and above historic correlations. That said, it does make sense to us that if Oil trades lower, that will help yields lower as well. Or in other words, it is the breakdown in correlation between the Dollar and other assets in recent months that may correct in the next short period of time.

Lastly, on the equity markets. For a number of quarters now, equity markets in the US in particular have marched relentlessly higher irrespective of the performance in other assets. Perhaps equity prices will simply move straight higher after the recent wobble. However, we continue to look at the last week or so of bounce as a correction within a topping process.

European markets have struggled relative to the US in recent months, and the rally of the last week or so has been more modest too. Of course, this could well be related to the weak US Dollar, which is why a Dollar rally may be important for equity markets too.

A combination of Dollar strength and positions liquidation in commodity and FX markets in the next few weeks will surely cap the current bounce in equity markets. The S&P 500 traded up into resistance at the end of last week, and showed a loss of momentum on Friday. We think that this is the initial sign that equity markets will not go straight back up again like they have done after previous short-lived corrections.

Chart 3 – S&P 500 Daily Chart

To conclude this week, with emotions still running quite high, and volatility still somewhat elevated, we are concentrating on price action to try and guide us in the weeks ahead. Towards the end of last week, there were tentative signs that the Dollar may stage a rally of some sorts, and that bond yields, selected commodities and equity markets may be vulnerable to some weakness. The correlations may not make 100% sense here, but they haven’t for some time.

In the big picture, we still think that equity markets are egregiously expensive and vulnerable to significant weakness and we continue to look to sell into strength here. If equity weakness is seen alongside rising yields, then investors will have to think long and hard about how they build diversified portfolios. We will surely discuss this subject further in the next few months, but in the short term, we think that we may seem some market reversals including equity and commodity weakness and Dollar and bond strength.

Stewart Richardson
RMG Wealth Management

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