We recently wrote an article for City Index titled “The bond bell rings” which outlined our thoughts for an impending correction in the U.S. equity market and specifically in the S&P500. Less than 48 hours after the article was published, the S&P500 experienced an eye opening 6% two-day fall, its sharpest decline since early February, which dragged global equity markets lower with it.
The view for an equity market correction was based on two main reasons. The first being that the month of October has frequently been associated with increased equity market volatility. Not lost on us was the timing of a Bloomberg article released in early October, reporting that China had hacked 30 U.S. companies, an escalation in the U.S. – China trade dispute and the possible next steps down the alarming pathway to a U.S. - China Cold War.
The second factor was the relationship between interest rates and stocks. Specifically, while the direction of interest rates is important to stock markets so too is the speed of the move. As highlighted in the article, the rally in U.S. 10-year Treasury yields during the first week of October occurred very quickly, accelerating after breaking the May 3.13% high. The S&P500 could no longer ignore higher yields and after falling through key support at 2865, the S&P 500 quickly traded to the 200-day moving average at 2765.
Overnight, U.S. equity markets have rebounded significantly. A special mention to Netflix which is trading about 13% higher in the aftermarket after reporting adding 6.96 million subscriber’s vs analysts’ expectations of 5.09 million. After such a rally, it is tempting to think that the October volatility episode has gone as quickly as it arrived, following a similar template to that seen in February.
While I acknowledge this is a possibility, particularly given the rally commenced from near a strong layer of support that included the uptrend from the November 16 low and the 200-day moving average mentioned above, I feel another leg lower is likely for the following reasons.
From a technical perspective, the lows from the October sell off are lacking the type of loss of momentum/reversal candles often seen at the lows before a sustainable bounce occurs. The exact type of candles highlighted on the chart below that preceded the bounce from the February lows. Additionally, from an Elliott Wave perspective, the preferred wave count suggests that the S&P500 completed a medium-term top at the September 2947 high and that the recent decline is just the first leg of a three wave decline that should result in the S&P500 revisiting the February lows, 2550 area.
Technical analysis aside for the moment, employment data released in the U.K. and the U.S. overnight has further reinforced the need for higher interest rates. In the U.K., employment data showed weekly pay ex-bonus, rose to 3.1% year on year, the fastest rate since late 2008. In the U.S., JOLTS employment data showed that U.S. job openings rose to just above 7.1 million relative to 6.2 million unemployed. Put simply there are almost 900,000 more job openings than there are unemployed persons looking for jobs, a sure sign of a very tight labour market.
In summary, because the selloff in October lacks the required signs of seller exhaustion and because interest rates need to continue moving higher, I view the overnight bounce in stocks with some caution. Providing the S&P 500 remains below the 2880/2900 resistance zone my expectation is for renewed weakness before the customary end of year rally begins.
Source Tradingview. The figures stated are as of the 17th of October 2018. Past performance is not a reliable indicator of future performance. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation
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