U.S. Equities Not Out of The Woods Yet (2.0)

Last week’s note, sent to subscribers on Monday morning, was apparently quite aptly titled: US Equities Are Not Out of The Woods Yet. After posting a robust rally of 399 Dow points on Monday of last week, the terrain shifted quickly on those that had been hoping to put the February correction in the rearview mirror. It was a brutally relentless pounding for those long the market. The move lower was fueled in large part by continued concern over inflation, the impact of that inflation on interest rates and monetary policy, Fed Chairman’ Powell’s testimony before both Congress and the Senate and finally, President’s Trump’s offhanded announcement that it is his intention to address imposing tariffs on imported steel and aluminum. Given the compromised state of investor psychology and the technical susceptibility of US equity markets heading into last week, markets were in no position to follow through on Monday’s head fake much less muster even a hint of stability– though markets did manage a mixed close on Friday.

When it rains, it pours they say. Last week was an example of that. The rotating themes of concern outlined above provided no shelter for investors as US equity markets posted their worst weekly performance since February’s long-awaited pullback to technical support. In the case of the S&P 500, that support was found at its 200 DMA.

As is evidenced by the Dow Industrials chart below, during February’s selloff, the Dow 30 faired modestly better than the S&P 500 in that the 200 DMA remained well below the pivot point for the reversal that ensued. However, the Relative Strength line of the Dow Industrials chart took a significant dip last week relative to the S&P 500. That relative underperformance is a direct result of its “Industrial” makeup and the perceived exposure of those Dow 30 component companies to international trade. Investors feel that in a landscape of rising interest rates and potentially rising trade tariffs, the Dow will underperform the S&P 500. As is evidenced by both charts, the daily volume on the trade lower, Tuesday through Thursday, far exceeded the volume posted on Friday’s mixed performance. That is an indication that the bias remains lower for prices. Additionally, given the technical weakness framed by these charts, the Dow may, in fact, have more room to run on the downside. Interestingly, on Friday the S&P 500 managed a positive close (+0.51%) while the Dow industrials lost 0.29%.

The themes that triggered the re-engagement for the move lower in equity markets last week all remain central to investor behavior this week. Inflation metrics in the February employment report, due at this week’s end, will likely be primary to not only the directional trade for equities in the near term but will also inform the directional trade in yields. February’s Employment Report is critical as we are still at an inflection point of sorts. Bloomberg consensus is calling for a gain of 205k jobs and an unemployment rate of 4%. But what matters nearly as much in this landscape is the degree to which inflation is manifest in the wage data components of the report.

Bloomberg consensus is calling for average hourly earnings to tick lower to 0.2% from January’s 0.3%. Average hourly earnings on a Y/Y basis are expected to remain at 2.9%, matching January’s results.

Market outlook remains cautious

Federal Reserve Chairman Jerome Powell does not mince his words. In his testimony on the Hill last week he made it clear that he intends to follow the flight path for policy laid out by his predecessor, Janet Yellen. That translates into a transparent and data-driven approach to policy with a firm bias towards tightening. This week’s economic calendar will provide much in the way of data from which to glean the likelihood for further tightening and its timeline.

An indication of investor concern and skittishness can be found in the monthly chart for the CBOE Volatility Index. The VIX closed out last week at 19.59. Though well below the highs established in the first half of February, it does reflect investor caution. That bias to hedge lower equity prices with volatility exposure remains the trade this week.

The question in the minds of many is whether the S&P 500 will retest its 200 DMA, and if it does, will that very critical level hold? We may not know the answer until Friday. In the meantime there are plenty of variables that I expect will drive volatility and misdirection. At the top of that list is the tariff narrative. The threat of imposing tariffs that President Trump inserted into the national and global economic dialogue will remain topical for quite some time. It will be up to investors to price in the winners versus losers. It would appear that companies with less exposure to the tariff narrative and companies that stand to gain from rising interest rates stand to outperform the broader market. I would argue a primary beneficiary of this landscape is financials.

I find it interesting that the interest rate on the widely watched 10-yr. slipped last week despite all the talk of rising rates, not to mention sliding equity prices. Since the February 21 closing yield of 2.94% the 10-yr has pulled back to close at 2.86 on Friday after trading to intraday low of 2.80%. As I have written about in previous posts, the sharp run-up in yields that defined February’s trade was an overreaction to the wage data in January’s employment report. Yes, rates have remained relatively elevated, and there is little chance there will be a meaningful move lower from here, but they have remained range bound over the past two weeks.

Despite all the themes that are driving fear, equity price compression and yields higher, I remain constructive on equities. I do expect heightened volatility and consider a retest of the 200 DMA for the S&P 500 likely in coming sessions. A successful retest of that critical technical level should provide for a resumption of gains for equities over the next several months though the sledding will likely be a bit tougher.

Flickr photo: Thomas Hawk

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