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Equity sell-off gathers pace

By David Morrison  |  23/10/2018 14:54

All this year investors have favoured US equities over Asian Pacific and European. But that optimism appears to be fading, at a very rapid rate

In previous posts I’ve contrasted the strength of US stock indices with weakness just about everywhere else. Just last month the US majors all hit fresh record highs. Meanwhile, Germany’s DAX and China’s Shanghai Composite both peaked in January this year and have since fallen around 17% and 27% respectively. There are two questions that most investors in US equities have repeatedly failed to ask until now. Firstly, how can this disconnect continue to exist in our financially-connected world? And secondly, when convergence comes, will it be because US equities decline to meet European and Asian Pacific stocks, or will the latter wake up and jump on the bull rocket?

US resilience

The resilience of the US markets has much to do with the idea of exceptionalism and an in-built optimism which does great credit to US investors. Certainly, those who have bought and held over the past nine years, or who repeatedly ‘buy the dip’ have been amply rewarded. This is despite several wobbles along the way, including the European crisis which focused on Greece primarily, the taper tantrum while Ben Bernanke was Federal Reserve chairman, two sell-offs within six months as China devalued the yuan, the Brexit vote and Trump’s election in 2016 and not forgetting the volatility spike and corresponding stock market slump earlier this year. In every case the major US stock indices rebounded and went on to make fresh record highs.

Fundamental concerns now in focus

There is a wealth of fundamental issues which have the potential to derail the markets. Concerns include, and in no order of significance, US/China trade tariffs, tighter monetary policy from developed world central banks (especially the US Federal Reserve), rising bond yields, dollar strength with the resultant emerging market sell-off, Italy’s budget which just today was rejected by the European Commission and the political, trade and future investment implications following the murder of Jamal Khashoggi, allegedly on the direct orders of Saudi Arabia’s Crown Prince Mohammad bin Salman.

US economy peaking?

Up until recently, most of these issues just bubbled away on the back hob with investors on balance believing in a string of market-positive outcomes. Meanwhile, money continued to pour into US equities on the back of a belief in the strength of the US economy. And why not? After all, second quarter GDP rose 4.2% annualised – its best level in close to four years while unemployment remains at a 17-year low and inflation is hovering around the Fed’s 2% target – depending which measure one uses, of course. Add in solid earnings and the Federal Reserve’s repeated insistence that it is gradually tightening monetary policy as a natural consequence of US economic strength (rather than building up an interest rate buffer so they can make effective cuts when the next recession hits) and it is understandable why investors have remained so bullish on US equities for so long.

Good news priced in

But now the concern is that growth may have peaked, which makes this Friday’s first look at third quarter GDP highly significant. Likewise, the current earnings season is seeing stocks get sold off even when they post better-than-expected results. Now investors are questioning whether corporate profitability can improve from here as so much good news is already priced in. This puts aside the fact that corporations have taken on more debt or used spare cash to engage in stock buybacks and dividend payments rather than invest in new plant and machinery, IT upgrades, staff training and all those other things they would do if they really were looking forward to rosy times ahead. As with Brexit, look at what corporations do, not what they say.

Watch support around 2,700

So, the next question is how US markets are stacking up technically. Concentrating on the S&P 500, the index has fallen for four consecutive weeks now and is on course for a fifth. Bear in mind, the sell-off of over 10% at the beginning of this year was pretty much over in a fortnight. Today we’re on course for the third successive close below the 200-day moving average and the index is probing support around 2,700. If it fails to bounce from here, then investors may begin to panic as it raises the possibility of a retest of the February lows around 2,530. That would wipe out all this year’s gains and more. Investors are right to be nervous – especially in the US where the potential losses are highest.
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