One of the biggest lessons learnt over the past three months is to respect the trend. Whether you believe the economy will go through a V, U, W, L or whatever-shaped recovery, going against the trend supported by enormous spending from central banks led by the Federal Reserve is a losing trade.
However, up trends may not be sustainable for a long time if they are not supported by fundamentals. By fundamentals we mean sustained economic recovery and improved earnings. As of now, many investors believe those earnings next year will return to 2019 levels for the S&P 500. If that’s the case, the steep rebound in equities seen since March 23 is justified and given that interest rates will remain near zero for a prolonged period, the reflation trade may still have a further way to go.
On the economic front, several indicators have bounced sharply since the coronavirus pandemic, that is especially true for leading economic data such as PMIs from across the US, Europe and China. But let us not forget they are picking up from an exceptionally low base and will only become meaningful if sustained.
Over the past 10 trading days the equity market has sold off twice, on June 11 and 24 with the S&P 500 declining 5.9% and 2.6% respectively. Such big moves are clear signs of anxiety. The index is now flirting with the long term 200-day moving average and a break below may be a threatening sign for the bullish trend. Short-term pessimism among investors has risen to unusually high levels according to the latest AAII sentiment survey and that may translate into further profit taking if the index breaks below the 200-day moving average.
These are all warning signs for the 3-month bull market. After a significant run, the question now is if there is still further fuel for the rally or are we on the verge of a reverse in trend? Of course, there are reasons to become cautious. Recent spikes in Covid-19 cases in several US states and across the globe is putting the re-opening of economies into question. Whether we’re seeing a second wave or just a continuation of the first wave, the outbreak may reverse actions taken by governments to re-open their economies, hence curbing hopes of a smooth recovery.
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