By Brian Dolan, Head Market Strategist Major markets appear to have finally turned an important corner. I say ‘finally’ because I had suggested over the past several weeks that markets had reached extreme levels and that Fed Chair Yellen’s comments last week could spark a more sustained rebound in risk assets. In their infinite wisdom, however, markets had one final spasm of pessimism, testing prior lows and even exceeding them in some cases.
But just as the decline from the start of the year was especially abrupt, so, too, has been the initial phase of the rebound. Just since the lows last week, the S&P 500 has bounced about 6%. And while the run down was at times inexplicable, and reeked of panic, the foundation for a rebound is more comprehensible and sustainable.
How Did We Get Here?
A combination of highly correlated factors precipitated the recent declines. As I have argued in the past, most were overblown to begin with and many are now being addressed by official responses. The key is that official actions provide a basis for stabilization, which should see market fears dissipate. In order of importance, I would focus on the following factors:
- China slowdown: fears of a more abrupt Chinese slowdown were exaggerated from the beginning in my view, but now we have movement from the government on relaxing banking regulations to free-up lending as well as renewed infrastructure investments. The rapid depreciation of the Yuan has also been officially addressed. Take China off the list of economic concerns.
- Fed rate hike expectations: the divergence of US interest rates from the rest of the world has now been reversed. While not explicitly taking further rate hikes off the table, Fed officials have made it very clear they are now on perma-hold, which today’s FOMC minutes reinforced. It would take a marked improvement in the global outlook or US performance, both of which would be risk positive in their own right, to justify additional Fed tightening. Scratch Fed rate hike fears from the list of risk negatives
- US Dollar Strength: the US dollar strengthened on expected US interest rate hikes/cuts by others. That has now been reversed and the US dollar index is now trading at the average level of 2015 (See chart below). While still elevated compared to 2014, fears of a strengthening dollar should also fade. US dollar strength? No problemo.
- Oil price declines: Oil price declines were the result of many of the factors listed above: China weaker-bad for oil; US rates higher-US dollar higher-bad for oil. Now that those factors have largely abated, oil prices should stop falling. However, the fundamental supply/demand imbalance is likely to persist for the next six months, at least, meaning there is little upside for oil in the near future. (I can’t rule out some supply-side shocks boosting prices down the road, but I would tend to think they’d be short-lived.)
Source: Bloomberg; DriveWealth
We also have the Bank of Japan (BOJ) going negative on interest rates, as well as trying to talk down the JPY (supportive of Japanese stocks). The ECB is next up on March 10 and is expected to cut rates further into negative territory and increase the amount of asset purchases. Markets have already priced in such a move, and the risk with the ECB is that they underwhelm again by delivering enough to meet expectations but not alter the investment climate substantially.
In my view, most of the fundamental pieces have fallen into place to stem the rout in risk assets and lay the foundation for a sustained recovery. Market sentiment, however, remains extremely fragile and subject to further short-term spasms based on incoming news and events. At the same time I would expect such setbacks to become increasingly shallow.
A Picture is worth a Thousand Words
If you want to look past the fundamentals, what can the charts tell us? The picture is quite bullish and similar across asset classes and individual markets, e.g. potential double bottoms in S&P500, MSCI World Index and crude oil (WTI), suggesting a significant low has been seen for risk assets. Equally encouraging is that the current rally in those markets is now testing above the Kijun line (yellow), a major source of resistance in the current downtrend.
Source: Bloomberg; DriveWealth
A few key price points to keep in mind (I’m focusing on the S&P500 for brevity): 1870/1880 Tenkan line (purple)/Kijun line is now important support; a bullish crossover of the two also appears imminent. A break of the neckline/50% retracement at 1945/50 would confirm the double bottom formation and target a return to the 2080 area. The 61.8% retracement and the base of the cloud converge at the 1975/1980 area and could offer initial resistance.
Note, however, that the cloud is falling rapidly and is extremely thin, meaning it’s only minor resistance for the next two weeks. A daily close above would further suggest that the trend has shifted higher. This will need to happen soon. If we enter March and are still below the cloud, markets could languish at recent low levels for several more months as the cloud becomes denser and more formidable resistance.
Both from a fundamental and technical perspective, a bottom looks to have been seen. Investors should monitor the key price levels highlighted above to track the progress of the rebound and potentially pursue buy-the-dip strategies. As resistance levels are overcome, confidence can build that the worst is behind us.