Lousy investor sentiment is natural, but probably overdone

The markets got off to another rocky start Friday after President Trump tweeted that the U.S. will impose a 5% tariff on Mexican imports.

This tariff would start June 10, increase 5% a month, top out at 25% on Oct. 1, and/or end when “illegal migrants coming through Mexico, and into our country, stop.”

The Dow opened down 300 points, punctuating two weeks of stocks rumbling lower over fears about trade tensions between the U.S. and China crimping growth around the world.

U.S.-China relations grow colder
as trade-war rhetoric heats up

Animosity between Washington and Beijing have escalated sharply after the Trump administration accused China of having “reneged” on its previous promises to make structural changes to its economic practices. Washington later slapped additional tariffs of up to 25% on $200 billion of Chinese goods, prompting Beijing to retaliate.

As trade talks stalled, both sides have appeared to be digging in.

China has denied it had walked back on its promises; it reiterated that it will not make concessions to “matters of principles” to defend its core interests, such as state-owned enterprises.

SOEs in China enjoy not only explicit subsidies, but also hidden benefits such as implicit government guarantees for debts and lower interest for bank loans.


“Obviously, this is beyond the scope of trade negotiations and touches on China’s fundamental economic system,” the state news agency Xinhua said. It added: “This shows that behind the United States’ trade war against China, it is trying to invade China’s economic sovereignty and force China to damage its core interests.”

The rhetoric is heating up — not cooling off. Don’t expect a trade deal this summer. Mr. Market will not be pleased, and cyclical companies’ shares will likely pay a steep price.

***

Stocks’ slide in recent weeks has been sharp enough to scare individual investors — pushing the AAII Bull Ratio below 40%. Fewer than 25% of investors are calling themselves bullish and more than 40% of them bearish.

This is one of the lowest Bull Ratios in the past five years, reports analyst Jason Goepfert.


It’s especially low considering how little stocks have pulled back, he observes. By Thursday’s close, the S&P 500 was still within 5% of its 52-week high. Looking at every week’s Bull Ratio when the S&P 500 was within 5% of a 52-week high, this week’s reading is one of the most extreme.

Goepfert rifled through his database to look at every week when the S&P 500 was this close to a peak, and investors were as or more negative as they were this week.

They were prescient in 2015, he says, pulling in their horns just as stocks were embarking on a rough patch. But that was about their only success.

That was the only time the S&P 500 lost more than 5.2% at its worst point within the next six months. But there were 17 times when the S&P gained more than that amount at its best point in the next six months.

It looks like a case of “irrational pessimism” that has rarely paid off, he concludes. The average gain in the next three months was 3.8%, with 90% positive, and the gain over the next year was 10.9%, with 95% positive.

***

After starting with a 0.25% gain on Wednesday, the S&P 500 closed down hard at a two-month low. A big, fat, ugly reversal — the equivalent of the market gods slamming the ball in your face. The benchmark index was then resting on the 2,800 level that provided support in early May and late March. About 25 points lower is the 200-day average, which is starting to slope down.

You can ascribe a lot of yucky patterns to this type of price action, but you would probably be wrong.

‘Sell in May’: Stocks slid for the past four weeks, making May the first negative month of 2019. All the major averages are now trading below their 200-day moving averages.

Historical data does not support the notion that a set-up like this is headed straight for a crash. Goepfert argues that the pattern has led to mostly higher returns, with relatively low risk compared to the reward.

He adds, quite accurately, that “most technical chart patterns end up with returns that don’t support the way they look.” In short, conventional wisdom is often wrong.

The setup: When the S&P 500 falls 0.25% and closes at a two-month low while it trades above its 200-day average.

There have been 23 instances since 1985. Average change next week is +1.4%, next two months is +2.9% and next year is +9.9%. And that data includes 1987, which featured a 23% decline in the next month.

Final thought: There is no denying that the price action is weak, Goepfert argues. It’s just that when it’s been this weak before, it didn’t consistently lead to meaningful follow-on losses.

***

Still, the main lesson for investors from last week was not trade. It was reports showing that economic data is softening dramatically, putting the White House in a weaker place in trade talks.

The strength of the U.S. economy in the first quarter was one of the factors that goaded President Trump to take a tougher line with China in the trade dispute.

But analysts at Capital Economics argue that the incoming data points to a sharp slowdown, which would leave Trump in a more vulnerable position at next month’s G20 leaders’ meeting.

Many of the data releases this week actually had “the unmistakable whiff of a recession,” according to the analysts.


Earlier in the week, we learned that the Chicago Fed’s national activity index, a weighted average of 85 key monthly indicators, declined by 0.45 in April. This indicator has a tight relationship with GDP growth.

The near-0.5 decline last month is consistent with a contracting economy.

If it was just the Chicago Fed index pointing to such a dramatic slowdown, the analysts would give the economy the benefit of the doubt. But then May’s Markit activity indices were released on Thursday, and they were equally soft.

The decline in the manufacturing index to a decade low was bad enough. But worse was the slump in the services index to a three-year low, leaving it barely above the 50 mark.

As a result, the Markit composite PMI fell to a level normally consistent with stagnation in GDP, the analysts observe.

Finally, this week ended with news of more weakness in capital goods orders and shipments in March and April, which augurs negatively for second-quarter equipment investment.

Employment has held up relatively well. But manufacturing output, retail sales and motor vehicle sales have all come in surprisingly soft.

Recession is not the base case, but CapEcon sees second-quarter GDP growth clocking in at 1.5%. Meanwhile, the Atlanta Fed GDPNow tracker now forecasts 1.3% — both well below the 4% the White House has promised.


While the trade dispute has been seen as the culprit for recent weakness in the equity markets, it’s more likely that the villain in this dour saga is the economy. At this stage, it is getting hard to see how further escalations in the trade war can be avoided, with a 25% tariff on all imports from China — and another 25% on Mexican imports — a real possibility.

The Fed could lend a hand by cutting interest rates by 50 to 75 basis points over the next year. But cheaper money is not a panacea; it’s more of a symptom than a cure. Beware.

Best,
Jon D. Markman

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