Brexit and Blacklists Baffle Market Bulls

Major Moves 

The list of Chinese technology companies that are restricted from doing business with U.S. firms may grow by another five firms soon. The new additions to the list are surveillance and security technology companies like Hikvision and Dahua.

Most Western investors are likely unfamiliar with the companies that could be directly restricted, but there are secondary effects that could erase yesterday's reversal in more well-known U.S. technology and semiconductor groups. For example, if more Chinese firms are prevented from buying tech from Intel Corporation (INTC) or Qualcomm Incorporated (QCOM) the sellers are likely to suffer as well.

You can see the effect of the trade war and blacklisting on Micron Technology, Inc. (MU) in the following chart. The stock completed a large "double top" technical pattern by breaking below $36.63 on Friday and has continued its move to the downside. In my experience, using a Fibonacci retracement of a reversal pattern does a good job of identifying a likely initial target, which in this case, is near $31.71 per share.

Trade wars and blacklisting are likely to drag on other firms in the tech sector as well. While not directly affected like the chipmakers, companies like Apple Inc. (AAPL) are at risk of retaliation by the Chinese government. Unfortunately, this week's trade-related troubles will be compounded by further losses in Qualcomm, which lost its case over anti-trust behavior today as well.

While these issues aren't necessarily big enough to cause a major economic disruption in the United States, performance in the tech sector can have a big impact on short-term investor sentiment. Unless tensions can be reduced quickly, these issues are likely to keep the S&P 500 from reaching its prior highs.

S&P 500

Support for the S&P 500 large-cap index and the Russell 2000 small-cap index has continued to hold despite some of the back and forth in the market. Prices are still roughly in the same range as they were at this point last week and haven't shown much additional momentum since the major indexes bounced on May 15 and May 16 last week.

As I discussed earlier this week, I am concerned about the potential for a head and shoulders pattern that could be completed if prices lose further momentum. This could be a trigger for more volatility, but investors should give the market some room to shake out before getting too bearish even if the pattern does complete. Somewhat counter intuitively, bearish head and shoulders patterns don't have a good track record for predicting large downside moves in bull markets.

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Risk Indicators – Brexit

It's been a refreshing change that Brexit hasn't been the headline issue driving market volatility lately. The last time I mentioned the risks of Brexit was in the April 24 issue of the Chart Advisor. However, I need to make some adjustments to my European-U.K. divorce estimates after news that Prime Minster Theresa May is coming back to Parliament with more unpopular proposals.

Hardliners within May's government are worried that she will present Parliament with the opportunity to vote on much softer options for Brexit – including the possibility of a new referendum – the first week of June. Both pro-Brexit and anti-Brexit MPs are unhappy with May, and there are no assurances that any deal she presents will last if she leaves office in June (or earlier).

As a result of that uncertainty, the British pound (GBP) has been losing against the dollar since May 6. The currency is nearly back to its lows from last December. The problem with this trend is that a weaker GBP relative to the dollar makes U.S. exports to the U.K. more expensive and therefore less attractive. Depending on how you run the numbers (there is some dispute about this), the U.K. is one of the few major Western economies with which the U.S. runs a trade surplus.

For some industry groups, this is a bigger issue in the short term. For example, automobiles and electrical power generation equipment are two of the largest categories for import to the U.K. from the U.S. Although performance among some of the automakers has been better recently, stocks like Ford Motor Company (F) could languish at resistance if the pound falls further. Electrical equipment makers like Emerson Electric Co. (EMR) are similarly at risk.

The Brexit situation and Theresa May's future will likely be a moving target for investors on a day-to-day basis through the first week of June. Watching the GBP should give us some insight into the risk of additional market volatility. If the GBP breaks support below $1.26 per pound, a bigger reaction in the stock market is more likely.

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Bottom Line – Risks Are Rising but Not Systemic

The risks from the trade war and Brexit can be unnerving, and I expect they will continue to keep market volatility elevated in the short term. However, despite those risks, the downside potential is likely to be limited in the short term. Further accommodation by the Fed, consumer spending, hiring and revenue growth are still positive enough to justify an optimistic outlook in the short term.

In my view, analyzing the external risks of the U.S./China trade war and Brexit through stocks that have direct exposure to those unknowns is the most useful strategy. Focusing on domestic stocks as a whole isn't as productive because the large-scale effects will be difficult to predict at that level.

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