Rally Fails As Gridlock Weighs On Outlook

Authored by Lance Roberts via RealInvestmentAdvice.com,

Market Rally Fails Key Resistance

Last weekend I discussed the fact we had started using the rally to lift some exposure out of portfolios ahead of the mid-term elections simply as a hedge for the “unknown.”

Well, on Tuesday, the ballots were cast and while the Republicans were able to hold onto the Senate, they lost the House. As I wrote on Tuesday, where the markets are concerned, that may not be a bad thing.

The safest outcome for the markets, and the economy, is what is most likely. The Republicans will likely retain control of Congress but will lose enough seats in the House to make passage of any of the ‘Trump agenda’ unlikely. This will result in Congressional gridlock which will limit any substantive changes over the next couple of years. The markets have historically favored gridlock and would likely be a short-term positive for stocks.”

That was indeed the “sigh of relief” seen by the markets on Wednesday as the bulls created a massive one day advance that pushed the markets above key resistance levels. Unfortunately, it didn’t take long for investors to return their focus back to the things which are going to matter the most – corporate earnings and monetary policy.

As I noted in Thursday’s missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019.

More importantly, beginning in 2019, the quarterly rate of change in earnings will fall back to the expected rate of real economic growth. (Note: these estimates are as of 11/1/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

So, really, despite all of the excitement over the outcome of the mid-terms, it will likely mean little going forward. The bigger issue to focus on will be the ongoing impact of rising interest rates on major drivers of debt-driven consumption such as housing and auto sales. Combine that with a late stage economic cycle colliding with a Central Bank bent on removing accommodation and you have a potentially toxic brew for a much weaker outcome than currently expected.

As my friend and mentor Doug Kass recently noted, the election has only served to “poison” the political pot even further.

“The ugliness of the political scene over the last two years is likely to get more ugly. Though Trump will likely be emboldened – there is now a fundamental difference and divide from the recent past (“checks and balances”). The President no longer has a subservient (Republican) House to deal with anymore – the new (Democratic) House is in marked opposition to his agenda. The President will continue to argue that he is at the epicenter of power – but he no longer is.

 As we move towards 2020, the U.S. political scene is headed for a period of elevated animus (even more than we have seen in the past few months) between the Democratic and Republican parties. Whether it’s the affirmation/restoration of voting rights, gerrymandering, infrastructure, the border wall (and other immigration moves), healthcare, etc. – rhetoric will grow even more heated.

In the lame duck session, there will be plenty of fighting over the border wall and other Trump initiatives – it will get messy.

I suspect little, administratively, will be achieved over the next 12-18 months.”

He is most likely correct. It is likely little will get done as the desire to engage in conflict and positioning between parties will obliterate any chance for potential bipartisan agenda items such as infrastructure spending.

Furthermore, there is more than a significant risk to the financial sector with the Democrats now in control of the house. The financial services committee has the support of Democratic members of both the House and the Senate to launch new regulations aimed at increasing oversight on major banks. Given the amount of leverage currently being used to support the financial markets – this could pose a real threat to both the sector, the economy, and the overall markets.

Note: we sold our financial holdings last week.

With portfolios reduced to 50% equity, we have a bit of breathing room currently to watch for what the market does next. 

Daily View

Despite the decline of the market during October, investors really never showed much in terms of “fear.” Volatility never spiked much above the long-term average of 20, interest rates didn’t decline much, and investor’s quickly got back their bullish attitudes.

However, despite the lack of concern, as noted previously the market has now violated its longer-term bullish trend which is concerning and, as noted last week, downside risk through the end of the year continues to outweigh the potential reward.

It is EXTREMELY important the market rally next week above Wednesday’s highs or we will likely see another decline to potentially test the recent lows.

Action: After reducing exposure in portfolios previously, we will look for opportunities to reduce risk further as needed. Sell weak positions into any market strength on Monday.

Weekly View

The action this past week continues to confirm the change in the backdrop of the markets from bullish to bearish.

The failure of the market to break out of the current trading range this past couple of weeks sets investors up for disappointment. It is critically important the market does not violate the trading range lows on a weekly closing basis. As stated above, the market must rally next week, and close above the current trading range, or things will likely become more difficult. As we saw this past week, there is significant resistance to any potential rally both at the short-term moving average and the running bullish trend line. Therefore, upside remains limited currently.

(Also note that a major difference between the current selloff and that in February is the break of the bullish trend line. This is symptomatic of a market topping process.)

Action: Sell weak positions into any strength on Monday and reduce exposure as needed.

Of much greater concern currently is the breakdown in crude oil prices. There is a very high historical correlation between the direction of oil prices and the economy. (Since just about everything economically is touched by oil in some capacity the relationship makes sense.)  The chart below shows oil versus a composite index of interest rates, GDP, and CPI.

The decline in oil suggests that economic growth over the next couple of months is likely to be substantially weaker than current projections. Weaker economic growth will also show up in further declines in forward operating estimates which are already under pressure. This will continue to erode one of the key underpinnings of the bulls which has been “stocks are cheap based on forward estimates.” 

Lastly, participation in the markets remains extremely weak. This is just another indication of the change in the “tenor” of the market to a more bullish backdrop.

Monthly View

On a monthly basis, the backdrop has also worsened. RSI has dropped into correction territory along with a confirmed monthly sell signal. As I noted back in both December and September, extensions of the market that move 3-standard deviations above the long-term mean are unsustainable.

The chart below is a broad technical look at longer-term indicators. Notice that these indicators have only previously unanimously aligned when the market was reversing its trend. That global alignment is occurring once again.

Action: Reduce risk on rallies, as detailed above, and look to add hedges on any breaks of long-term support

None of this should be misconstrued as an alarm to go “sell everything you own and buy gold” tomorrow. However, there are increasing indications that such could be the case sooner than many expect.