After stalling the prior week, the S&P500 dropped about 0.6% last week. Volume was light—in part because there was very little conviction behind the selling and in part because the slower summer trading season has kicked in. While volatility did jump one day during the week, it was promptly sold off and finished not much higher than it began….still near 2017 lows. One of the most profitable trades for all of 2017 and much of last year is to sell volatility short. The only problem with this trade is that by selling downside protection insurance, traders are assuming just that—the risk that US stock prices do take a tumble and if so, then this “profitable” trading theme will be destroyed in an instant. Until this happens though, its becoming a crowded trade and ironically helps push up US equity index prices by making the price of volatility fall artificially lower than it would be were it not for the crowding that’s going on in the short vol trade.
In terms of technical analysis, the S&P500 has now formed a bearish pattern on the daily charts. Last week’s pullback in prices cemented this signal. Of course, this doesn’t mean that further price drops are imminent or 100% likely to happen, but it does mean that the risk of further drops, in the near future, has gone up….and that investors should be more cautious. On the other hand, the pattern on the longer-term weekly charts is still strongly bullish. Last week’s pullback on the S&P is barely noticeable on the weekly charts, which are showing that the upward momentum is still in effect.
Last week’s US economic reports were mixed to weak. Durable goods orders, both headline and ex-transportation, came in well below expectations. The Chicago Fed national activity index was a disaster. The Dallas Fed manufacturing survey disappointed. The Case Shiller 20 city home price index year on year) missed. The Richmond Fed manufacturing survey also missed. Pending home sales disappointed. Initial jobless claims were weaker than predicted. And Core PCE, one of the Fed’s favorite measures of inflation, came in lower than expected. On the positive side, consumer confidence beat expectations. First quarter GDP came in a bit better than predicted (still super low, but not as bad as originally feared). Personal income beat expectations, and so did Chicago PMI.
Finally, the Fed’s rate hiking cycle is beginning to make a notable impact on the short end of the US Treasury curve. While the longer end (eg. the 10 year) is yielding less today than it did on January 1st of this year, the 2 year Treasury is yielding far more. At 1.4%, it’s 20 basis points above the 1.2% it yield at the beginning of the year. And more importantly, it’s yielding almost 2.5 times more than it did only a year ago.
The implications are important, because while loans such as mortgages are priced off the longer-term instruments such as the US 10 year, many other forms of consumer and corporate debt are priced off shorter term reference points. So as the US 2 year yield continues to climb, and climb substantially, this will negatively impact US corporate profits and US consumer disposable incomes (ie. their ability to spend will go down and this will also reduce corporate profits).
The bottom line is that the old saying of “Don’t fight the Fed” works both ways: when the Fed eases, it pays to be long risk assets, but when the Fed tightens, it makes sense to be cautious about being long risk assets. And today, the Fed is in a full-bore tightening mode, so adopting a more cautious investment outlook seems to make a lot of sense.