Major Test for US Equity Markets Approaching

The bounce that began a couple of weeks ago continued last week, but this time the S&P500 rose only 0.9% so the rate of increase has slowed down considerably. Volume was modest, which also suggests that the driver behind the recent bounce is based more on short covering than on new money rushing back into stocks. And volatility continued to edge back down, as would be expected whenever market prices move upward.

On the economic front, last week’s results were notably weak. In fact, they were so weak (again) that many market analysts are pointing them to argue that the Fed will have to hold off on hiking interest rates, and therefore this by itself becomes a reason to stay invested in stocks. In other words, bad economic news may be turning into good news for risk markets. And specifically, last week, retail sales excluding the volatile auto sector cam in abysmally bad, well below expectations. Producer prices, excluding volatile food and energy, also plunged…..implying that a deflationary upstream situation is taking hold, and also implying weakness upstream in US production pipelines. The Empire State manufacturing survey fell much more than consensus estimates suggested it would. The Philly Fed business outlook also plunged. Job openings, as reported by the JOLTS survey, collapsed. Only consumer sentiment and initial jobless claims beat expectations.

In terms of technical analysis, a major test—one that’s been mentioned here for the last several weeks—is fast approaching.  Now that the S&P500 has been bouncing for a few weeks, and now that the closing prices have recaptured the 50 day moving average, the next major test is the 200 day moving average.  It’s a big test because for the last three years, traders have very successfully used pull-backs down to the 200 day moving average to put on new long positions. But this strategy finally failed in August, just a couple of months ago. So everyone who bought at the 200 day moving average in August has been underwater on those positions for about two months. And decades of investor behavior history suggests that whenever prices rise enough (and this applies to professional investors as much as it does for retail, mom-and-pop investors) to eliminate the losses, or break-even, that investors tend to get out of those positions because they’re happy that they’ve erased their recent paper losses. But as all these relieved break-even investors “get out” of the market together, their selling puts a lot of downward pressure on prices….near the 200 day moving average.

So if prices can not only reach the 200 day, but more importantly, overcome the huge resistance that will almost certainly hit them at this average, then they will have overcome a major hurdle, a hurdle that needs to be go away before prices can continue to move even higher. Of course, history also suggests that this resistance often holds. In other words, so many investors get out together, pushing prices downward again, that big selling returns.

We should which direction the US equity markets will take over the next week or two.

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