Did the market grow too pessimistic?… looking at the S&P’s support and resistance lines … how the strong U.S. dollar might actually help your portfolio … Europe is bleeding investment capital
Investors remain on edge after the Fed-triggered selloff on Aug. 26.
The issues are the same as they have been all summer. If the Federal Reserve continues to raise interest rates and inflation stays high, then corporate profits will fall and eventually, the economy will slow.
That comes from our technical experts, John Jagerson and Wade Hansen of Strategic Trader.
Of course, as John and Wade quickly point out, knowing what’s behind the selloff is the easy part. The far greater challenge is determining how much risk and fallout from higher rates is already priced into today’s market.
As we look ahead to the Fed’s September meeting, traders are putting the odds of a 75 basis-point hike at 86% as I write on Friday. We can see this courtesy of the CME Group’s FedWatch Tool.
Source: CME Group
If we look all the way out to March of next year, traders are putting 50.4% odds on the fed funds target rate being 3.75% – 4.00%. Just one month ago, these same traders only put 33.2% odds on that level.
This elevated expectation makes sense when you factor in the hawkish chatter from various Federal Reserve presidents.
For example, here’s Federal Reserve Chairman Jerome Powell from yesterday:
History cautions strongly against prematurely loosening policy. I can assure you that my colleagues and I are strongly committed to this project and we will keep at it until the job is done.
And here’s Federal Reserve Bank of Cleveland President Loretta Mester from Wednesday:
Given current rates of inflation, I believe that the Fed has more work to do in order to get inflation under control.
This will entail further rate increases to tighten financial conditions, resulting in an economic transition to below-trend growth in nominal output, slower employment growth, and a higher unemployment rate.
Not exactly dovish.
But in recent weeks, did the market grow too pessimistic?
Back to John and Wade:
In our experience, when the market is near its recent lows, it is far more likely that investors are overpricing the negatives.
Stocks tend to be easily oversold in conditions like this, which makes a bounce more likely in the short term as estimates revert to the long-term average.
If a bounce is likely in the short term, we would expect it while the S&P 500 is near support in the 3,900 range.
Based on the market-action since Wednesday, it appears we’re getting that bounce – and for good reason…
In the chart below, note how the general 3,900 level has served as support and resistance numerous times since the spring.
To give you a sense of how high this latest rally might run (if it has legs) before it hits serious resistance, note the trend line below.
I’ve connected the S&P’s peaks here in 2022, then extrapolated.
You’ll see this extrapolation eventually intersects with the S&P’s 4,150/4,175 range, which is where we’ve seen resistance before, and likely will again.
Meanwhile, how are John and Wade factoring the strength of the U.S. dollar into their S&P forecasts?
In the Digest this week, we noted the negative impact that a strong dollar has on the earnings of many U.S companies due to currency headwinds.
But it’s not all bad news.
From John and Wade:
A rising dollar is a problem for exporters, but it’s a boon for importers and attracts foreign investors.
This is good for service businesses and retailers because it takes fewer stronger dollars to buy imported goods. Because of the mostly consumption-based U.S. economy, cheaper imports should help lower inflation levels and increase spending.
For example, consider a product that a retailer imported from Germany six months ago that cost 100 euros. At the time, it cost $111 to buy 100 euros to pay for the product. Today, it costs just $100 to buy 100 euros.
That means the effective price of that German product has fallen by 9%.
To get a sense for this dollar strength, let’s look at the U.S. Dollar Index. This is a measure of the value of the U.S. dollar relative to the value of a basket of six major global currencies – the Euro, Swiss Franc, Japanese Yen, Canadian dollar, British pound, and Swedish Krona.
Here’s its performance over the past 12 months:
John and Wade point out that the dollar hasn’t been this highly valued against the euro since the dot-com boom of the early 2000s.
And it’s not just the euro – the dollar is gaining against just about every major currency, including the Japanese yen, British pound, Canadian dollar, and Swiss franc.
“Money flows to wherever it’s treated the best”
There’s one final reason why the strong dollar could be a boon for U.S. stocks, and it boils down to a simple question…
Where else are global investors going to go?
Here’s John and Wade to put it more eloquently:
Because the dollar is gaining, it makes U.S. investments more attractive to foreign investors as well.
If they buy U.S. stocks, the rising value of the dollar compounds their profits (assuming stocks rise as well).
When compared to alternative investments, a rising dollar makes U.S. assets look much more attractive.
The data support the idea that money is exiting Europe.
According to BlackRock, investors are pulling money out of European equity ETFs at the fastest pace since the 2016 Brexit referendum.
In August, $7.7 billion were withdrawn in the sixth straight month of net outflows. This was the heaviest net selling with the exception of the $8.9 billion in July 2016.
The spiraling energy situation, rampant inflation, and now, the European Central Bank ECB) getting hawkish with its rate-hike policy, which is likely to end in a recession, are all fueling this pullout.
On that note, just yesterday, the ECB raised rates 75 basis-points.
The European Central Bank announced the largest interest rate hike in the central bank’s 24-year history on Thursday as the eurozone battles record inflation stoked by an energy crisis.
The ECB said it would hike rates by three-quarters of a percentage point, following a smaller — though still historically large — half-point increase in July.
Back to capital outflows, Kenneth Lamont, senior fund analyst for passive strategies at Morningstar puts the widespread money-exodus this way:
The yield curve shows [the market] is expecting a recession.
Clearly, there is risk being taken off the table. The market is positioning itself for the storms ahead.
Now, you can make the argument that the U.S. is facing its own recession and storm, but as it appears now, the clouds are far more ominous over Europe.
Putting everything together, what are John and Wade doing right now?
Back to their update:
The underlying economic fundamentals (especially labor) are strong enough to prevent a major selloff, so we expect support at the current level to hold.
However, we recommend waiting for the next bounce to take hold before adding a lot of risk to the portfolio.
John and Wade wrote this on Wednesday. Since then, the S&P has pushed 2% higher as I write. It appears we could be seeing the beginning of that “next bounce” right now.
We’ll keep you updated.
Have a good evening,