Equities: More Downside To Come?
Submitted by Nic Lenoir
We started the year saying that without a catalyst equities would trade between 1014 and 1236 for the S&P future, knowing that we think there are a number of risks that could lead to much more aggressive downside scenarios. Our outlook has not changed. And we still feel that China is one of those catalysts that could create serious problems in the market.
While the recent sell-off and risk aversion has been triggered by Obama's remarks on banking regulation, we think in the end whatever proposal he may come up with will be watered down to nothing. Every government over the past 30 years has been populist, especially in response to adverse equity market price action, so we think in the end politicians will scare themselves into doing nothing. Maybe this is the first time this principle will not be respected in 30 years, but we don't think so. Then there was obviously Paul Volcker standing in the background. He is the worst nightmare of all those who have been riding the whole of liquidity provided by governments around the world. However, as much animosity there might be between Congress and the Fed as they fight to decide who gets the stick to police around, it will be a hard task to debunk Mr. Bernanke out of his role as chairman. And no congressman really wishes he had not done what he did as in the end they have the most to lose if the established order was to be destroyed. If anything there is a greater chance Mr. Geithner's head rolls I would argue.
Meanwhile far away from this domestic political drama, China is taking steps to take liquidity. That is a development that could have far greater consequences. Indeed China's CPI is more sensitive to commodity prices as the US's (especially since we have been convinced to forget about food and gasoline) and 2009's rally in commodities means inflation numbers in China are likely to come in strong. The PBoC has no political capital when it comes to letting CPI getting far out of its target band. Congratulations to those who had called for early tightening in H1 2010. The fact is that China may start exporting its inflation through currency appreciation or yuan based inflation, and will hike rates as Chinese real estate is in the very late stage of a massive bubble. Surely that can't be good. If Asia and China is the motor of the rebound, then surely asset prices can't welcome a hiking cycle on the back of a real estate bubble and an unprecedented lending spree. How much is China willing to commit sepuku is anyone's guess but consequences could seriously threaten our fragile economic equilibrium.
Looking at price action, the Shanghai composite index has closed below the highs of September which invalidates a bullish impulse scenario. The 200 dma provides temporary support but we think further downside is likely.
We contended at the start of the year that no matter what happened medium-term US equities had to correct before anything else could happen even in a bullish scenario. The 1075/1065 support zone for the S&P future is not so far away. What will necessarily capture the eyes of the bears is that on a log scale we failed on the 61.8% retracement line at the highs (see weekly chart), so a very bearish argument can be made that we are entering the next huge sell-off from a technical standpoint. This is all the more interesting that the Dax shows the same feature in terms of retracement, and we also have a perfect a-b-c structure since the lows of March 2009 with c = a, so market symmetry definitely reinforces the bearish case. Note also on the daily chart for the Dax that the medium term supporting 100-dma has been violated on this last sell-off. On the hourly we feel that the S&P future may have completed a wave 3 of lower order, but bullish divergence is relatively mild, and so the rebound could well top around 1,105/1,108 before another drop to 1,065 to complete this initial sequence.
We will further update as the short-term price action develop but technically we have some strong arguments for a bearish case of greater order building up.
Good luck trading,