While it's difficult to say for sure, the market's near-positive performance today seems to mirror the optimism about a trade deal between the U.S. and China dominating the financial headlines. The top negotiator for the Chinese, Liu He, will be in Washington on Thursday, which could result in some further positive rumors/news on Friday.
The concerns about the U.S.-China trade relationship encompass more than just the damage higher tariffs might do to U.S. retailers, consumer spending or agricultural exports from domestic producers. Tariffs designed to cause economic damage in China are likely to spread to other emerging markets like India and South America. As you can see in the following chart, despite today's recovery in U.S. equities, Indian stocks were down another 1.6%.
There is a strong relationship between emerging markets and commodity prices, which is a real weak spot for the United States' two largest export partners: Canada and Mexico. In other words, if China's economy contracts, commodity prices will fall. That hurts Canada and Mexico (commodity export dependent economies), which in turn will reduce demand for U.S. goods and services in those markets.
Although the major U.S. indexes did less-bad today, I am still concerned that volatility expectations remain high. I would put very favorable odds on a short-term bounce, but the CBOE Volatility Index (VIX), or market fear index, is clearly reflecting a "wait and see" attitude from investors. Now that first quarter earnings are mostly behind us, I think investors will potentially over-focus on trade issues, which will likely keep the average trading range fairly wide in the short term.
However, as I have said a few times over the past two weeks, a short-term consolidation in the S&P 500 as the index hits its prior highs is not unusual nor alarming. In my view, the fact that small-cap indexes like the Russell 2000 have remained above their recent breakout points is an extremely encouraging sign that risk takers are still looking for good opportunities.
I will be looking for things over the next two weeks that would confirm a recovery like better performance in the high-yield bond market and transportation stocks. Both of these key categories have been too weak for my comfort, and a return to prior highs (or a breakout) would increase my confidence that the major stock indexes are due for another run higher.
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Risk Indicators – No Signs of Full Panic
As I have previously written, the VIX has been flashing some important short-term warning signals, but I think there is good evidence that investors still aren't worried about a full market panic.
One of the key market indicators I rely on is the SKEW index. Like the VIX, the SKEW is published by the CBOE exchange and is a measure of investor behavior through the options market. Specifically, the SKEW looks at what is happening to put options on the S&P 500 that are used by professionals to hedge against downside risk.
If investors expect a large decline in the market, the SKEW will spike higher because those put options are in demand. The SKEW will decline when investors are more confident and not as worried about a big move to the downside.
In the following chart, you can see how the SKEW was signaling market panic with spikes starting last August as the S&P 500 was topping out just before the big declines in the fourth quarter. Compare the current move in the SKEW to prior periods of confidence like late December and January. Even as the market was selling off on Tuesday, the SKEW was falling and pricing in a low probability for a big decline.
This index isn't 100% predictive, but in my experience, when the SKEW is declining with the market, it is a reliable signal that the downturn is likely to be limited in size and duration. Basically, it indicates that, although traders are stressed, the market's dips will turn into buying opportunities.
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Bottom Line - Watch Inflation Data
As I mentioned in Monday's Chart Advisor issue, the biggest economic news due this week is the Producer Price Index (PPI) tomorrow morning and the Consumer Price Index (CPI) on Friday. The PPI will be particularly interesting because investors may be able to detect damage from the tariffs in the data. I am not expecting a big surprise, but unlike ordinary PPI releases, this one has the potential to move the market if the data is particularly poor.
Specifically, what investors will be looking for is whether producer (manufacturing) prices are rising because of the tariffs. That kind of inflation will put the squeeze on Washington and may help to motivate a short-term resolution to the current trade disputes.
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