Trade War: Escalation Phase

The dramatic turn in the trade negotiations that has taken place since the stock market closed on Friday, May 3 is captured in the segment below from The Wall Street Journal:

“The U.S. and Chinese governments both sent signals ahead of their trade talks in Washington last week that a pact was so near they would discuss the logistics of a signing ceremony. In a matter of days, the dynamic shifted so markedly that the Chinese deliberated whether to even show up after President Trump ordered a last-minute increase in tariffs on Chinese imports because the U.S. viewed China as reneging on previous commitments.”

The markets are adjusting to the shift from a cooperative phase in the trade war to an escalation phase. The drop in the U.S. stock market futures on the morning of May 13 after China announced another set of tariffs on U.S. goods sends a clear message the financial markets are concerned about the economic damage that could come from an ongoing and combative trade war. The million-dollar question is how long will the current escalation phase last? Markets will have higher odds of stabilizing if the U.S. and China can show some signs of possibly making their way back to the negotiation table.

BIGGER PICTURE

There has been a slight shift in the data associated with the market’s long-term trend, but nothing earth-shattering at this point. Today’s relatively small adjustment to our asset mix got us back in line with the data and respects the uncertainty related to the duration of the current decline.

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The market’s waning momentum in recent weeks told us to be open to a normal 4-10% pullback in the S&P 500. As of Monday’s close, the S&P 500 has experienced a drawdown of 4.55% based on closing prices and 5.17% using the recent intraday high and intraday low.

FIRST 90% DOWN DAY

Monday brought the first day in 2019 that featured extremely lopsided volume figures. Over 90% of NYSE volume was associated with declining issues.

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We know a 5% correction falls into the normal and to be expected category. How concerning is a 90% down day? As shown in the table below from Pension Partners, forward returns and percent positive figures for the S&P 500 are slightly better following a 90% down day relative to an average day.

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The chart below provides a good visual proxy for the, thus far, relatively small shift in the data related to the market’s longer-term trend. The S&P 500 closed below the 50-day and below the gap. Price still remains above a still upward-sloping 200-day.

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The VIX was a mixed bag during Monday’s session. It printed a daily closing high above last week’s high, but the intraday spike was lower than last week’s spike. Since closing prices tend to be more relevant, it is probably fair to say the VIX closed Monday in “still concerned” mode.

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As noted in this video clip, even under a favorable longer-term outcome scenario, the market may continue to be volatile over the next 90 days. It is possible we will sit tight for the remainder of the week; it is possible the data will call for additional incremental steps to reduce exposure to risk assets. We will continue to take it day by day with an open mind about all outcomes.

This post is written for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.

Long-Term vs. Intermediate-Term

SUNDAY TWEETS

A little after noon Eastern time on Sunday, President Trump shifted the odds related to this week’s scheduled trade talks between the United States and China.

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LONGER-TERM OUTLOOK REMAINS FAVORABLE

Given the look of the chart below during Monday’s session, it is fair to say the market’s longer-term trend remains favorable, something that is reflected in our current mix of stocks, bonds, and cash.

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SHORT-TERM EVIDENCE OF WANING MOMENTUM

The market has moved a long way since making a V-bottom late in 2018 and is starting to show some signs of slowing momentum on shorter-term timeframes.

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Under our approach, the million dollar question is:

Are we allocated properly based on the evidence in hand?

After making one minor chess move to lock in some gains in SCHB during Monday’s session, the answer is yes. Our exposure to cash and bonds takes into account the increasing odds of a 4%-10% pullback. Our exposure to stocks takes into account the term “odds” in the previous sentence and reflects the still favorable long-term outlook.

It is possible the waning momentum above will be followed by a pullback. It is also possible the market is simply pausing to digest the previous gains before pushing higher. In any event, the market’s intermediate-term risk-reward profile is not as favorable as it was a few weeks ago.

FIRST SET OF GUIDEPOSTS

Given present day facts, we will most likely be able to sit tight should the market decide to revisit the gap and or 50-day moving average shown in the chart below. Hypothetically, a move back toward the gap could represent an opportunity to redeploy some of our cash. As always, we will see how things unfold on the data front over the coming days and weeks. We are simply outlining one of many possible outcomes. As long as the USA/China trade meetings remain on the docket, it is easier to sit tight and respect the still-favorable long-term outlook. A cancellation of the trade talks could bring stronger selling pressure and lead to a decline of greater duration and magnitude.

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SCHB has been lagging SCHX in recent months, which made it easier to lock down some of the gains in SCHB. Our last buy in SCHB came back on 2/22/2019.

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On a positive note, the S&P 500 is still making a series of higher highs and higher lows. Protecting gains while trying to stay with the existing trend is a balancing act based on hard data and probabilities.

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If selling conviction picks up later this week, another area of possible support lies between 2722 and 2815. A drop back to 2722 would represent a 7.5% correction from the recent closing peak of 2945. As we all know, a 7.5% pullback falls into the “normal and to be expected from time to time” category.

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CONFIDENCE vs. CONCERN

The most relevant question is not “what was your last trade, a buy or a sell?”, but rather “how are we currently allocated between stocks, bonds, and cash?”. It may be helpful for clients to review their household allocations in these terms, which reflects all the data we have in hand (model/trends/bird strike):

% Allocation to Stocks = % Confident

% Allocation to Cash + % Allocation to Bonds = % Concerned

Given what we know today, it is prudent to be confident, but some concern is also warranted in the short-to-intermediate term. If the facts evolve in a manner that justifies some additional adjustments in the coming days/weeks, we will not hesitate to act.

WEEKLY VIDEO

This week’s video covers four long-term “be open to better than expected outcomes” setups in the financial markets.

This post is written for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.