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Are US equities running out of steam?

Posted on: 04 March 2019 , by: Darren Sinden , category: Market Review

Contrarian: there are reasons to think that the US 30 index could be ready to sell off from here.

US equity indices enjoyed a fantastic start to 2019. They’re showing gains of +11% or more this year to date. Several, including the US 2000 index, have done even better.

What's more, volatility has fallen sharply with the VIX index, the measure of fear and greed among investors in US equities, declining by -42% over the same period. This indicates that markets were in a risk-on mood during the first two months of the year. However, I do wonder if we’ve seen the best of the US stock market for now and whether we might be due for a pullback following such a great run? 

There are several reasons to think this could be the case, one of which was highlighted in a recent Credit Suisse strategy note. In this note, the bank found that US equity markets rally between +11% and +12% following sharp downward movements, much like the one seen in Q4 2018, of circa -14%. That suggests that the recovery may have run its course and you can see the sell-off in late 2018 and the subsequent bounce in the chart of the US 30 below.

Highly-correlated charts

I also note that the charts of US stock indices look very similar at the moment. That’s not so surprising when we consider that the correlations between them are very high. According to data from the Pepperstone Smart Trader Tool’s Correlation Matrix (one of our suite of Smart Trader Tools), US indices share positive correlations in the high 90s, meaning that they’re very likely to move in the same direction at the same time.

In recent days we have seen the appearance of ‘high wave candles’ in the daily charts of US equity benchmarks. These candles tell us that the indices are rejecting moves to higher levels. I’ve highlighted an example of this in the chart of the US 30 index below. Here we can see a shooting star (the red candle in the middle of the highlight) a classic example of a high wave candle pattern.

DJIA daily chart

Such patterns require confirmation, and as of the time of writing, we’ve not yet had one. However, what we have seen are two spinning tops, the red and green crosses in the highlight above. This signals indecision from traders, implying they’re unsure about what the next move will be, and showing that neither buyers or sellers are in control of the market.

What’s needed is a catalyst to help them make up their mind and as we’ll see, there are several candidates on the horizon.

Negative newsflow and key data

Recent data and newsflow have been on the negative side - the summit between the US and North Korea ended without a deal or joint statement being signed. At the same time, the USA’s chief trade negotiator, Robert Lighthizer, cast doubt on the likelihood of a positive outcome to US-China trade talks as China was reluctant to agree to US enforcement and monitoring of any deal.

There are plenty of key US data points due for release this week, any of which could be the turning point for US equities. The ISM manufacturing PMI on Tuesday and February’s Nonfarm payrolls on Friday are top of the list. Disappointments in this type of data could quickly change the mood. 

So what should traders look out for?

I’ve drawn an uptrend line in the chart above. The US 30 is currently below it but needs to stay there and ideally move below recent highs, such as 25883 from the 15th of Feb and the 21st of Feb low at 25762. However, the move to the downside in US equities, if and when it comes, will be about a change in sentiment rather than specific technical levels. 

We should certainly be able to recognise it when we see it. We’ll be looking for risk-off behaviour, bonds and safe-haven currencies, such as the Japanese yen and Swiss franc, should rally. We should also see volatility pick up at the same time as risk asset - equities and emerging market currencies - head lower.    

This is a case of being aware of the possibility and prepared for the eventuality. Looking at the downside, we can think about a pullback in the US 30 index to 25,000, which has round number value and the 200-day EMA line at 24852, with the 23rd of November low at 24268 a deeper level below that.

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