The only market indicator that matters in 2016

A December rate hike is pretty much a done deal. The market’s focus has shifted from the timing of the first rate hike to the trajectory of subsequent rate hikes. That’s where the FOMC statement and post meeting press conference will be of utmost importance. A hawkish message would send the USD soaring, which would serve to depress US exporter competitiveness and push equity and commodity prices downwards. On the other hand, a more dovish message would push the USD down, provide a better earnings growth for US companies, lift commodity prices and be equity market friendly.

In many ways, market expectations leading up to the December FOMC meeting is similar to the sentiment backdrop leading to the recent ECB meeting. The market believed that Mario Draghi would implement more QE carpet bombing of the eurozone economy, but instead it came away disappointed as EURUSD soared by over 2% on the day. Marc Chandler highlighted some insightful comments from Yves Mersch of the ECB on how market expectations got wildly overblown. To make a long story short, Mersch indicated that the market misunderstood how a consensus gets formed in the Governing Council. Moreover, the prevailing belief at the ECB was that the current stimulus measures were already effective. Therefore there was no need to take the kind of extraordinary measures expected by the market and it could afford to adopt a wait and see attitude.

All eyes on the Fed

As we approach the key December FOMC meeting, past Fedspeak has indicated that the Yellen Fed is a big believer in the Phillips Curve, which postulates a tradeoff between inflation and unemployment. So with unemployment falling and wage pressures rising, it`s no big surprise that the Fed wants to raise interest rates to dampen inflationary expectations (chart via Jereon Blokland, NAIRU = Non-accelerating inflation rate of unemployment, or the unemployment rate at which inflationary pressures start to set in).

Central bankers know that monetary policy operates with a lag, so that they have to try anticipate future path of inflation. The key question then becomes, how quickly will the Fed raise rates? Janet Yellen and other Fed officials have made it clear that this rate hike cycle will be very different from previous ones as the pace of increases will be much slower and *ahem* data dependent. If the Fed`s message is perceived to be at or below the light blue line, watch for the markets to rally hard.

Watching the USD for direction

The key to the markets isn’t just the trajectory of interest rates, but the effect on the USD. The fate of the USD has broad cross-asset class return implications as currency strength has been a headwind to equities and commodities for most of 2015. A strong USD has held back the earnings of US companies selling into foreign markets. As well, commodity prices are inversely correlated to the USD and a reversal would alleviate much of the angst surrounding the financial stress caused by resource companies in financial distress plaguing the junk bond market.

As we approach the FOMC meeting, market sentiment is heavily skewed to long USD, short commodity and equity positions.

Current market psychology is therefore setting up for an ECB like market reaction to the FOMC announcement. As a reminder, this is what happened to the euro after the ECB meeting:

Right now, the market is laser focused on the divergence in monetary policy. The Fed is tightening while every other major central bank in the world is accommodative. This divergence trade has created expectations that supports USD strength because of expectations of a widening interest rate gap. However, Fundstrat pointed out that a long USD position hasn’t always been a winning trade in the past when the Fed started a tightening cycle with the Fed and ECB diverged in monetary policy. In fact, the USD has weakened three out of five times such conditions have occurred (via Value Walk):

Moreover, Dana Lyons pointed out that the Dollar Index appears technically vulnerable to a bearish reversal:

To put the longer term technical picture into context, the chart below shows the USD Index (top panel, inverted scale) consolidating sideways and possibly starting to reverse itself. The next two panels show the relative performance of energy and materials stocks against their markets (US market in black, European market in green). These sectors also appear to be in various of consolidation and bottoming.

If the Fed’s message is even mildly dovish compared to expectations, the resulting rally will rip the face of many dollar bulls and equity and commodity bears.

Reasons to be bullish

Notwithstanding any consideration of Federal Reserve policy and the effects on exchange rates, there are a number of other reasons to be bullish on stocks. John Butters of Factset reported that forward EPS estimates to be rising (annotations in red and estimates are mine):

Analysis from Ed Yardeni indicates that forward EPS is highly correlated with coincidental economic growth. Therefore the trajectory of forward EPS serves as a confirmation of economic strength or weakness. Peering into the crystal ball, New Deal democrat’s monitor of long leading economic indicators show that there is no sign of a recession 12 months from now:

Among long leading indicators, interest rates for treasuries, corporate bonds, and mortgages all are neutral. Money supply, mortgage applications, and real estate loans are still positive.

His conclusion is that the American economy is currently undergoing a soft patch caused by USD strength.

As anticipated due to Thanksgiving Day seasonality, coincident readings improved from absolutely horrible to merely bad. The US economy continues to be buoyed up by housing and cars, with a continued though smaller than anticipated boost in consumer spending. I continue to anticipate further near term weakness in the US economy, although the growing service/consumer sector continues to overbalance the deepening industrial recession brought on most of all by the further strengthening in the US$.

 

A constructive technical picture

Aside from positive macro fundamentals, the technical condition of the stock market is oversold, which is bullish. The top panel of the chart below shows that RSI5 has flashed an oversold reading but exhibits a positive divergence. The second panels shows the SP 500 testing a support zone, as well as support at its lower Bollinger Band (BB), which can limit downside risk. The third panel shows the VIX Index, a sentiment indicator, is now above its upper BB where it has seen reversals in the past. The bottom panel shows that the term structure of the VIX is inverting, which is an indication of high fear levels. These are all signs of an oversold market, with the caveat that oversold market can get more oversold in the short run.

 

The reverse of investor and trader sentiment is the action of “smart investors” like insiders. The latest update from Barron`s show that insiders have been heavily buying stocks, for several weeks which is another bullish sign for equities.

Another bullish tailwind is the positive seasonality typically experienced by the markets. Ryan Detrick pointed that that December positive seasonality tends to manifest itself in the last half of the month and starts on the 15th, which happens to be the start of the two day FOMC meeting.

 

Detrick also pointed out that the market is oversold based on the McClellan Oscillator:

 

Indeed, other breadth metrics from IndexIndicators are flashing oversold signals, such as the % of stocks above a 10 day moving average (dma):

And net 20-day highs-lows:

Next week is option expiry (OpEx) week, which has historically had a bullish bias as traders tend to try to temporarily move stock prices and indices to their advantage for option expiry at the close on Friday. Further, Rob Hanna at Quantifiable Edges showed that not only does the market show a positive bias during December OpEx week, but the positive seasonality extends further into the next three weeks.

 

What about junk bonds, China?

Despite all of these bullish tailwinds, my inner bear is worried. He sputtered, “But what about the carnage in the junk bond market and the risk of a Chinese devaluation sparking a trade war?”

There is no question that the level of anxiety in the US junk bond market has been rising. The Marketwatch story “Why the junk bond selloff is getting very scary” provides a useful summary. In effect, trouble in the US high yield (HY) market has foreshadowed downturns in stock prices.

 

 

There is no question that misbehaving HY bonds is an area of concern. However, much of the trouble in HY is attributable to distress in energy and materials.

 

Should we get a dovish message from the Fed and the USD weakens, it should alleviate most of the stress evident in these sectors. Moreover, I pointed out before (see Profiting from a late cycle market) that such credit market developments are typical of a late cycle market where stresses start to appear. Rising credit spreads have historically been very early warnings of recessions so it is premature to panic. In other words, be concerned, but don`t get bearish too early.

 

 

Another risk to the market was the freak out last week over the prospect of another Chinese devaluation, which has the potential to spark a round of competitive devaluation leading to a trade war.

 

 

As this Bloomberg story indicates, the PBoC adjustment in the RMB is largely a technical move to peg the RMB against a basket of currencies, rather than just the USD, as the Dollar has been so strong.

 

In the meantime, the Bloomberg proxy for Chinese GDP growth ticked up, which also alleviates some of the worries that the Chinese economy is tanking (via Tom Orlik). So relax, the Chinese economy is doing fine and there is no need for them to engage in competitive devaluation.

 

Bottom line: If the USD were to weaken in response to Fed next week, which a big if, many of these bearish concerns plaguing the market would evaporate.

 

Place your bets for the week ahead

Early last week, I had forecasted a sloppy stock market, but to wait to buy until readings got to an oversold extreme (see Waiting for the whites of their (oversold) eyes). As stock prices weakened, my inner trader nibbled away to buy some small cap positions on Wednesday and added to long equity positions on Friday as readings became more oversold. By contrast, my inner investor ignored all these gyrations and remained long equities with a tilt towards commodity sensitive sectors.

Both are betting on a dovish FOMC statement and a reversal of USD strength. If the Fed message were to become hawkish – well, that’s what stop loss orders are for.

Disclosure: Long NUGT, SPXL, TNA