Fear and Fundamentals

The stock market and the economy are not the same thing. Sure, there are connections and feed-back mechanisms between them, but they do not track each other consistently. That is why classic fundamental analysis is only partially useful in understanding the market. Fundamental analysis can tell you what the market should be doing based on economic indicators, such as GDP growth, inflation, earnings, etc., and, sometimes, the market does in deed match fundamental expectations. The problem is that too often they seem to be completely unaware of each other; for most of the last ten years, fundamental analysis has been saying that the market should not be as high as it is because of the high PE and slow GDP growth, yet the market refused to listen. If you only looked at fundamental analysis, you would have missed the entire bull market up to this point.

This disconnect between fundamentals and the market, arises from the fact that the market reflects investor expectations (sentiment), which makes it an expression of the participants’ emotions, not their logic. The market is an emergent phenomenon; it forms out of the feelings of its participants, not out of the earnings, or GDP numbers. Feelings are not necessarily logical, therefore neither is the market. There is one dominant emotion — fear — which is unsurprising since Homo sapiens, as well as being hunters, have always been prey. Fear, it can be argued, is the only emotion driving the market. The old market adage is that “fear and greed” rule the market, but we maintain that these are two expressions of the same emotion; greed being simply the fear of missing out. The result is that the market, historically, over-shoots in both directions.

Technical analysis does not try to explain why the market is behaving the way it is. Instead, it simply looks for historically repetitive patterns that might give some clue as to where the market is most likely to head. Technical analysis attempts to quantify human emotion.

Some phenomena, affect both economic fundamentals and investor emotions (fear). A perfect recent example is Thursday’s proclamation by the “very stable genius” president of the United States, that he will impose tariffs on all steel and aluminum imports. Anyone who has read any economic history (which the Donald has not), knows that tariffs lead to retaliatory measures which end up hurting everyone, especially the first mover. This predictable negative economic impact, raises the level of fear in the investing public (at least for now) and ends up reflected in the price of the market. There is a fair chance, however, that more informed minds will prevail, and the tariffs will be limited to steel and aluminum from countries that are doing the dumping, not the US’s important trading partners. One can only hope, because we do not have to look back very far in history to find an example of the negative effects of tariffs on steel. In 2002, G.W. Bush imposed tariffs on steel that had a net-negative effect (read the report in full). The highlights:

• 200,000 Americans lost their jobs to higher steel prices during 2002. These lost jobs represent approximately $4 billion in lost wages from February to November 2002.
• More American workers lost their jobs in 2002 to higher steel prices than the total number employed by the U.S. steel industry itself (187,500 Americans were employed by U.S. steel producers in December 2002).
• One out of four (50,000) of these job losses occurred in the metal manufacturing, machinery and equipment and transportation equipment and parts sectors.
• Every U.S. state experienced employment losses from higher steel costs.
• The analysis shows that American steel consumers have borne heavy costs from higher steel prices caused by shortages, tariffs and trade remedy duties, among other factors.

And with regard to the dollar, the chart below shows how it (and the S&P 500) behaved during the 2002 tariff imposition.

And here is how the S&P 500 and GLD traded around the tariff news this week:

This time around, should this insanity proceed, the world will not wait a year-and-a-half before taking retaliatory action. This is an example where fundamental economic changes play emotional havoc with the market. If this actually is allowed to go through, we could be put on a short-cut to recession and the next bear market.

We continue to maintain the view that the fundamentals (trade war notwithstanding) continue to be solid, and that after rallying for more than a year without a correction, the market is in the middle of an emotional (fear) response, not at the start of a bear market. Having said that, however, if the Donald insists on starting a trade war with the rest of the planet, then a recession could appear much sooner than we currently expect.


Equities

Sentiment
The trading in the S&P 500 continues to replicate the pattern of the correction of 2000. This week bullish sentiment, according to the AAII independent investor survey, decreased -7.4% to 37.3%, and bearish sentiment increased slightly +0.6% to 23.4%. Most of the drop in bullishness moved over to the neutral camp which stands at 39.3%. That is similar to what happened in 2000 (two charts below).

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Long-term, the topping pattern continues to play out as in the past (chart below).

The 8-week moving average (MA(8)) of the put-to-call option ratio has turned around and made a new high. This invalidates the potential up-spike that seemed to be forming last week and reaffirms the continuation of the correction, albeit, in a volatile manner (chart below).

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Technical

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On the daily chart, the MACD has made a bearish cross-over, the stochastic is dropping from over-bought levels, and the ADX shows increasing bearish momentum. All of this, implies further downside-volatility in the near-term (chart below).

Fundamental
The 10-y minus 2-y differential was slightly lower again this past week, going from 0.63 to 0.61, and continues to maintain an overall slope that would see an inversion in the second half of 2018. Which would imply a recession could start sometime in 2019 (chart below).

Earnings continue to be strong, and the consumer sentiment is still elevated. As we stated n the introduction, the only immediate fundamental danger is implementation of tariffs by the Donald himself.

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Gold

Gold normally trades in correlation with the four big markets: the dollar, the USD/JPY FOREX pair, interest rates, and TIPS (inflation expectations). Since the start of the year, however, gold has disconnected from its usual correlation with interest rates and with inflation expectations. Effectively, gold has become a currency trade by continuing to strongly correlate with the dollar and the USD/JPY pair, while the dollar has disconnected from its usual correlation to interest rates; interest rates are rising, but the dollar has been dropping. The dollar still appears to be bouncing off a double bottom even though the threat of tariffs knocked it back later in the week, causing gold to recover after reaching down into $1310-$1300 resistance (chart below).

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Technically, gold bounced off support at $1310 — $1300 as the stochastic reached into over-sold territory, the MACD has started to flatten, and the RSI reaches up to meet the down-sloping trendline. Gold will meet resistance at $1330 and again at $1335 which could pressure gold back down once again (chart below).

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