The Return of Tariff Man

The trade truce was too good to be true. That all changed last Friday when President Trump upended the trade truce in response to heightened Chinese control on exports with rare earth elements. Trump threatened higher tariffs on China in a Truth Social post. He added, “I was to meet President Xi in two weeks, at APEC, in South Korea, but now there seems to be no reason to do so.” Later in the day, he announced an additional 100% tariff on Chinese exports on top of the current 30% duty and added export controls on critical software.

Even though my trade war factor had been signaling rising anxiety since early August as U.S. companies with domestic revenues were leading the equal-weighted S&P 500, implied stock and bond volatility (bottom panel) had been tame for months. To be sure, tariffs were starting to bite, but most trade partners declined to retaliate. Implied volatility readings were in the “Assertive Trump” zone. It was only a matter of time before Trump spent some of the built up political capital to assertive his authority.

Stock prices were rattled by the news. I had been warning for weeks that the market is extended and could pull back at any time. Is this the bearish trigger?

As investors approach Q3 earnings season, S&P 500 forward 12-month EPS estimates were rising, in spite of the risks of forced margin compression as tariffs took effect. The S&P 500 responded by slowly grinding upward to make new all-time highs.
 

 

On the other hand, goods demand is fading after a summer surge, which was likely attributable to tariff front running. The risk is investors will be disappointed in H2 as sales and possibly operating margins become squeezed from tariff effects.
 

 

The continued slow grind up in the S&P 500 has also been accompanied by a headwind of weakening banking system liquidity.
 

 

 

A Welcome Pause

I regard the market weakness as a welcome pause that refreshes. I see no signs of a major market top and my base case calls for a 5-10% peak-to-trough pullback. We’ve seen this movie before. The trade war is effectively over, and China won (see The Trade War is Dead, Long Live the Trade War!). Trade tensions will eventually fade, when implied volatility indicators spike into the TACO (Trump Always Chickens Out) zone.

In the meantime, corrective action is just starting. Friday’s market action saw trend breaks in the S&P 500, equal-weighted S&P 500, and the Russell 2000 – all except the NASDAQ Composite. This is the kind of widespread technical damage that can’t be ignored.
 

 

I highlighted last week the technical breakdown of the NYSE McClellan Summation Index (NYSI) last week, and the breakdown continues. Past episodes have signaled pullbacks of differing magnitudes.
 

 

The latest estimates of retail investor participation shows that retail demand is at record levels. Retail investors are all-in, and possibly in leveraged positions, which is likely to exacerbate downside risk should the market panic.
 

 

Bullish psychology is showing signs of coming off the boil. The 10 dma of the equity put/call ratio reached a crowded long level and it’s beginning to turn up. Similar episodes have also been signals of market pullbacks in the past.
 

 

I am also monitoring the relative performance of the defensively oriented consumer staples sector. Even as its relative performance deteriorates, relative breadth indicators (bottom two panels) are bottoming and starting to turn up. Better relative performance by consumer staples would be a signal that the bears are seizing control of the tape.
 

 

Small-cap stocks as especially vulnerable to downside risk. The Russell 2000 ETF (IWM) staged an upside breakout from an inverse head and shoulders pattern in June, with a measured objective of about 248, which was recently achieved. The advance was accompanied by a severe negative divergence in the small-cap Advance-Decline Line. The breach of the dotted rising trend line can be regarded as a risk-off signal.
 

 

However, two components of my Bottom Spotting Model flashed buy signals Friday. The VIX Index spiked above its upper Bollinger Band, and the NYSE McClellan Oscillator (NYMO) has become oversold. While the 5-day RSI is not one of the five components of the model, it is also oversold.
 

Historically, two or more simultaneous buy signals from my suite of five models have been tactical buy signals, but I am skeptical that one day’s price action after a steady advance is enough for a tradable bottom.

My inner trader is confused. He is inclined to interpret these conditions as signs that the market will stage a short-term bounce early in the week, but sufficient technical damage has been inflicted that an immediate V-shaped bottom is unlikely.
 

 

In conclusion, I’ve warned in the past weeks that the U.S. equity market advance was extended and it could pull back at any time. President Trump’s threat to impose high tariffs on China seems to be the bearish trigger. My base case calls for a 5-10% pullback, and I regard any correction as a welcome pause and opportunity to add to equity positions at lower prices.