Tax plan rumors sank the market on Thursday and the cloud is still here.
For months analysts have been talking about the impact of tax reform on the market. Cutting the corporate tax rate to 20% and allowing repatriation of $2 trillion in cash from overseas would add about $15 in earnings to the S&P and add 270 points to the S&P index. Optimistic expectations rarely work out as expected.
Investors slowly bought the hype and the major indexes continued to hit new highs. Last Thursday those expectations were hit with a dose of potential reality and the markets imploded intraday with the Dow falling -253 points at the low. The leaks of portions of the Senate proposal included more tax brackets, corporate rates unchanged until 2019 and a 12-14% tax on repatriated funds. While compared to the current tax rate/structure this would be an improvement, it was far from what investors were expecting.
The market decline and then the spin doctors went to work. "It is not that bad and still an improvement." The house and senate bills will be merged in the conference committee and President Trump will not accept the 2019 date. The rumor mill was active and headlines were flowing. The market rebounded on Thursday and then went dormant on Friday while they waited for further information.
The news that Alabama senate candidate Roy Moore may have actively sought to date underage women more than 40 years ago, could have a very negative impact on the senate. If Moore loses his election in December, the GOP margin in the senate will drop to only 1 vote. If any two republicans fail to vote for tax reform, it would go down in flames like the Obamacare repeal. That would have far-reaching effects for the 2018 elections and would be very bearish for the market.
In theory, the market prices in all potential events before they happen. The gains over the last several months on expected tax reform gains are a prime example.
Here is where it gets rocky. Just as we priced in gains in anticipation of reform, the market will immediately subtract those expectations if it appears reform is not going to occur. Now that tax reform is front and center in the house and senate that means over the coming weeks every headline is going to cause a market ripple either positive or negative depending on the headline. The closer we get to an actual vote on a conference bill, the more erratic the market may become.
Fortunately, it will take weeks for these events to take place. The house and senate will each have to pass their versions and then the conference committee will take a couple weeks to hammer out their differences. The combined house and senate will be in session for only 14 days over the rest of 2017. They have a week off for Thanksgiving and two weeks for Christmas. With only 14 days of available activity, that suggests the actual vote on the conference bill will not be until January.
This will reduce the number of hard headlines the market has to digest through the end of December. That does not mean there will not be any volatility.
The 2nd/3rd week of November is normally when post earnings depression causes some market weakness. That is not big declines but just weakness as investors exit some positions and look for positions to capitalize on Q4 earnings in January.
November 1st also starts the six best months of the year, in normal years. This means the average investor probably believes it is time to buy stocks.
The S&P has not seen a 5% decline in 495 days and the average is twice a year. We are due for a decline or some sort. Personally, I am expecting it in January. We will be in a new tax year, good or bad, and there are a lot of gains that will be captured from the 2017 rally. The Dow is up 18% in 2017, Nasda1 25%, S&P-500 15%, semiconductors 44%, biotechs 33% and homebuilders 35%. Those numbers alone should make you fearful of a decent decline in the coming months. Markets never go up in a straight line. There are always pauses.
I have been using the A/D line on the S&P as our canary in the coal mine. That means when this canary rolls over and dies, the market is likely to die with it. The A/D line has flattened over the last three weeks even though the S&P closed at a new high on Wednesday. That means market breadth is shrinking. Fewer stocks are leading the charge higher.
The S&P Bullish Percent Index is also weakening. This is the percentage of S&P stocks with a buy signal on a Point & Figure chart. At 71.4% it is close to a six-week low.
The percentage of S&P stocks above their 50-day short-term average has fallen to 63% and that is a two-month low. Market breadth is weakening.
The percentage of stocks over their 200-day long term average strengthened somewhat as the big caps stocks rallied on earnings but post earnings depression could also push the percentage to a two-month low.
The chart of the S&P is still bullish. However, the MACD has been negative for several weeks. The CCI is starting to decline but is still in bullish territory. On the surface the S&P chart is still positive and we should not worry until the index declines below 2,565. Secondary support at 2,545 would be the line in the sand where a breakdown should send everyone rushing to the sidelines. The dip buyers should be active until a dip below that level and then all hands would abandon ship.
I am not anticipating this unless there is some very bad news about the tax reform, Moore's election or more charges in the Russian collusion investigation and then it depends on who is charged.
This is still a bullish chart as long as support is respected.
The Dow chart has the potential to turn bearish very quickly. If support breaks at 23,300 there is a very large air pocket down to 22,275. That would be a monster drop and the index is very unsupported.
However, the index has only closed lower for two days and it is far too early to be running for the exits. We have seen the dip buyers appear on every dip for months and so far there has not even been a dip. Short-term support is holding. Under 23,300 and the outlook will change dramatically.
The A/D line on the Dow mimics the A/D on the S&P. Even on the narrow 30 stock index, the internals are weakening.
The Nasdaq Composite is still bullish as well. The index is only one decent gain below its recent high and above support at 6,675. The Nasdaq has been declining about every four weeks so it is not as overextended as the Dow. The late October dip took some of the pressure off and allowed the recent rally. The 6,550 level is critical support. That would be a 200 point drop from Friday's close and we have seen that type of drop several times in 2017 with no ill effects.
I don't think I have to interpret the A/D chart on the Nasdaq. This is pretty clear that while the Nasdaq has been making new highs the number of stocks participating has declined significantly. When you compare the A/D chart to the chart of the index, it would appear there is more market weakness ahead.
The most bearish index is the S&P 600 Small Cap Index. The consolidation pattern has failed and support has broken. There is a large air pocket between Friday's close at 893 and support at 820. The A/D line is at a 6-week low and the MACD and CCI are both confirming the decline. Without an immediate rebound, the small caps could drag the entire market lower.
The McClellan Oscillator for the NYSE has turned negative at -39 and approaching a three-month low. The oscillator reached -82 in August and -88 in March. Both represented buying opportunities but the indexes were much farther below their prior highs. We are not even close to relative decline levels so the NYMO would have to reach those lows before we could be talking about a market bottom. In reality, the big cap market has not even dipped yet. The NYMO is simply showing us that market breadth is shrinking and that will eventually lead to a market decline if the decline persists.
We rarely ever see a sudden breakdown in all the indexes/indicators at the same time. Normally there is a weakening around the edges with the small caps and the momentum indicators turning down before the big caps stumble. This is the troops deserting the generals and without the troops it is hard for the generals to win the war.
Despite the negativity in the small caps and oscillators, the market has not yet broken stride. With the 3rd week of November normally weak, I would look to buy a dip around expiration Friday unless the longer term trend has changed. Earnings and economics are still strong and the biggest roadblock to a continued rally will be the political headlines.
Enter passively and exit aggressively!
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