**This is an edited version of a weekly update that went to subscribers of Crisis & Opportunity last week. In deference to paying subscribers, the names of the recent stock recommendations have been blacked out.**
Don’t expect the trade war between the US and China to abate anytime soon. The hawks are in charge of US policy, and they appear determined to address the ‘unfair’ trade practices behind the large deficit the US runs with China.
China, despite rhetoric to the contrary, appears equally determined to protect its trade position and will retaliate against any US sanctions.
While it’s not exactly a stalemate, it’s hard to see how negotiations won’t cause some collateral stock market damage…well, they already have to some extent. By late January, stocks had run so hard in the US that just about anything would have brought them down a peg or two.
Which is what the talk of a trade war did. Now, after falling about 10% and with volatility having increased significantly, US stocks are delicately poised. As you’ll see in a minute, you could argue that either a new bear market is about to get underway, or that US stocks are in a consolidation pattern within a broader bull market.
Why is this distinction important?
Because the outcome should determine your investment strategy for the rest of the year.
We’ve already done this to some extent by getting ahead of the curve. In the December issue of Crisis & Opportunity I highlighted the risk of a bear market unfolding in 2018 and didn’t recommend a stock to buy.
In January, we went for gold junior a stock not correlated to the broader market. Our February pick, was conditional on its share price breaking above a certain level, and therefore confirming a new upward trend was in place. While it’s gone close, it hasn’t yet done that, so remains on the watchlist.
And then last month, we went for a consumer finance group trading on just over seven times earnings, a roughly 50% discount to the broader market.
So you can see that we’ve been preparing for life in a bear market for some time. By this I mean giving ourselves every chance of making some money while also recognising the downside risks of a market potentially transitioning from bull to bear.
How is this transition looking now? Let’s assess the S&P 500 first. I show it as a line graph so as to remove the intraday price swings. As you can see, there are two distinct bottoms, both occurring around 2,580 points.
Since the second bottom on 2 April, the S&P 500 has struggled to bounce back.
However, while the index remains above 2,580, then you’d have to say the broader bull market remains intact. But a break below this level and I’d suggest we’re heading into a bear market, a deeper and more prolonged one than ‘the market’ expects right now, if it’s expecting one at all.
The chart is an illustration of changing investor psychology. The final strong rally into January had everyone bullish and the few remaining bears sheepish and out of ideas. The sharp sell-off in February rattled some nerves, but the bullish sentiment remained and another big rally confirmed this view. But it ran out of puff and stocks fell back to their February lows.
This was a blow to confidence. The bulls aren’t so bullish anymore. A break below support will shift sentiment again, and the mood will become much more bearish.
A look at the Dow Jones Industrials index (below) shows that it has already broken below the February low. Perhaps this is a sign of things to come for the S&P 500?
As you can see, the Dow is making lower highs and lower lows, a sign of a downtrend. Unlike the S&P 500, this is a more cut-and-dried case of an index heading into a bear market. Perhaps that has to do with the Dow being full of internationally exposed companies, which are more likely to feel the impact of a trade war with China.
Finally, let’s take a look at the leader of this two year long bull market rally, the NASDAQ. The chart below shows that the rally is still intact. While momentum is definitely slowing, higher highs and higher lows this year suggests the bulls are still in control.
The three most important equity indexes in the US (and therefore, globally) are diverging in their assessment of what’s going on. The NASDAQ remains bullish, the S&P 500 is a coin toss, while the Dow Jones Industrials is turning bearish.
This is telling you there is increasing confusion about the direction of global markets right now, a far cry from January 2018 when just about everyone was bullish.
You only have to look at the VIX Index (below), which is a measure of volatility, to see a visual representation of the confusion. An often classic sign of the end of a bull market is a pick up in volatility, and you’re seeing that now.
What does all this mean?
We could be on the cusp of moving into a bear market. While that doesn’t change anything as far as the Crisis & Opportunity approach goes, you should keep this in mind when thinking about your own portfolio.
In a bear market, it’s much tougher to make money. You have to focus more on value and stock picking, rather than ‘concepts’ (batteries, lithium etc.) and sectors (tech), which tend to run hard in a bull market due to the weight of money chasing the ‘story’.
But you can make money in a bear market. If you were with C&O in 2015, you’ll know that our approach lead to some exceptional gains given the broader market fell heavily. Stock picking is the way to go in a bear market, and if the market does continue to struggle in 2018, I’m confident we’ll continue to find good money-making opportunities.
Editor, Crisis & Opportunity