Short sellers, Be Prepared for a Countertrend

May 30, 2019

The S&P appears to be tracking our Q2 analysis with short-term trading indicators increasingly oversold for risk assets testing first key support levels. A 1-2 week trading bounce seems likely into early June given the S&P 500 is testing a 2775-2800 support band. China’s Shanghai Composite has shown early evidence of stabilization the past week at 2800-2900 while the Chinese Yuan (USDCNH) is pausing under 6.95 resistance. WTI Oil, despite last week’s decline below $60, is attempting to rebound from support at its 100-day moving average near $58.

05-30-2019 SPY

The S&P 500 and S&P 500 SPDR (SPY) are at interesting junctures because both are oversold and both are at their 200-day simple moving averages (SMAs).  In addition, we are at the turn of the month, which covers the last four days of this month and the first four days of June. Over the last twenty years during this eight day stretch at the turn of the month, the S&P 500 has closed higher 65% of the time. The combination of oversold conditions, support and the turn-of-the-month could produce an oversold bounce.

Of the 479 companies that have reported so far (96% of the S&P 500), 73% are beating earnings estimates by a median of 7%. 56% are beating earnings by an average of 3%. Along with the market trying to get a handle on the turmoil with China and tariffs, the latest concern is the re-inversion of the 10Y-3M curve. Looking at the 7 precedent 10Y-3M inversions (since 1966), 6 of 7 were the result of the 3M rising above the 10Y.  Those were recession signals. The sole exception out of the 7 was September 11, 1998 during the Russian debt/Long-Term Capital crisis which triggered massive risk aversion.  Although, it was also a major buying opportunity.

The key point to understand is if the inversion is due to 10Y falling, this is considered global risky asset "risk off" trade—not a business cycle turn. We think investors are "overreacting" to this inversion.  In 1998, it was a huge tactical buy signal, as it marked "peak risk off". That inversion was seen 1.5% before equity markets bottomed and then embarked on a 48% rise over the next 10 months. 

Bottom line: Short sellers should be prepared for a countertrend rebound in the next couple of weeks, while investors should remain patient until weekly/tactical indicators show evidence of bottoming, accompanied by a trend shift in bond yields and industrial commodities. 

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