The US equity market has had a massive linear recovery in the first few months of 2019. The sell-off that occurred in the fourth quarter of 2018 was driven by concerns over higher US interest rates and a slimming down of the Federal Reserve balance sheet.
The stock market reaction was a 20% pullback from the September high to the December low. That reaction was sufficiently shocking to cause the Fed to make a U-turn on its policy of "rates moving higher on autopilot".
Fed chair Jerome Powell announced that interest rates would likely remain flat for most of 2019 and that the slimming down of the Fed balance sheet would be put on hold.
Equity markets cheered those comments and responded with a massive V-shaped recovery rally in the first few months of 2019. The S&P 500 has gained 600 points, or 25% off the 2,350 lows of December 24 2018 to the recent peak at 2,950. Interestingly, the recent high at 2,950 was at about the same level as the peak that was printed in September.
The rally of the past few months has seen the weekly stochastic oscillator move into overbought territory. But all of that bullishness has run into a wall in the form of Donald Trump and his tweets. Traders now have to keep Trump’s Twitter feed open at all times to keep up with the US president’s unpredictable behaviour.
A sharp sell-off in the market from early May has been caused by an escalation in the trade war between the US and China. On Twitter, Trump accused the Chinese of "breaking the deal", referring to ongoing negotiations between the world’s two largest economic superpowers. In early May, Trump announced that additional tariffs of up to 25% would be slapped on a further $250bn worth of Chinese imports into the US.
One wonders whether Trump knows that it is Americans who pay those tariffs and not the Chinese. When elephants fight, the grass suffers.
Indeed, in this case the grass that suffers has been the US equity market, with a knock-on effect to other equity markets around the world. Technically the S&P 500 has broken down below the lower end of a large rising wedge pattern that has been forming since the start of the year. How much further any weakness goes remains to be seen.
Trump and Chinese President Xi Jinping are due to meet at the next G20 summit, in Japan in June. Until then the market may continue to trade nervously, awaiting the outcome of that meeting.
The VIX index may provide some clues as to when this sell-off reaches a climactic end. The VIX index is often referred to as Wall Street’s "fear gauge". A high level of volatility is associated with a market in a heightened state of fear or panic. Fear usually peaks during sharp pullbacks. The two dramatic sell-offs in 2018 were accompanied by the VIX index spiking above 30. Once it reached above 30 it was an indication that the level of panic in the market was at an extreme and the market bottomed.
At the time of writing the VIX is still some way off the 30 level, but if it does move above 30 in coming weeks, that may be an indication of a climactic bottom on the S&P 500.
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