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Prepare for a return to volatility; top fundamental theme and event; US earnings - DailyFX Key Themes

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JohnDFX

Amid Extreme (Low) Volatility, Determine Your Approach and the Eventual Change 

Volatility continues to sink into extreme levels of doldrums – and this is a theme that all traders should take time to appreciate at regular intervals. Low volatility is a defining feature of a financial landscape. Whether fundamentals catalyze a cascade of value repricing or a technical cue is capable of triggering an avalanche of entry/stop orders is predicated on the conditions first laid out by the depth and activity level of the speculative medium. First and foremost, the type of markets we are dealing with should determine the trading approach we take. If we were to expect a high probability of key breakouts or simply expect such explosive moves to be relatively frequent in the broader market, we would expect volatility to be high and liquidity low – the thinner market depth helps amplify the ‘run’ from sudden jolts of activity. For trending markets, low volatility is a prevailing theme; but liquidity or market breadth are usually generous as participation in the move remains strong. In markets were both volume and volatility are low, observance of ranges (or imperfect congestion patterns) is more common. Recognizing the state of our markets alone is of incredible value for all traders. If my specialty is momentum trading in trends, I would want to remain sidelined when range trading prevailed or endeavor to create a robust range strategy and a barometer to tell me when we are transitioning to different speculative states. Yet, just as the phases of matter (solid, liquid, gas) are all related, so too are the phases of a speculative market. Range can transition to breakout with the application of volatility which then transforms into trend when liquidity follows the spurt of activity as the uncertainty in the volatility itself settles. 

In the conversion of these different forms, it often proves difficult to determine what kind of market we are dealing with – not even the market is certain – and thereby what type of trading approach we should take. Arguably one of the least forgiving transitions occurs from the quiet and steady ranges into the more explosive breakouts. The shallow liquidity can precipitate enormous moves beyond just the first bloom of volatility. This is often the ignition to sudden speculative collapse as with February 2018 or the eruption of a full-blown financial crisis as with the Dot-com bust. We are once again facing this particular fluid state. Some are comfortable in the range that they are seeing from the likes of the EURUSD which has carved out one of its longest, controlled ranges (as a percentage of spot) since the Euro began trading. Or even more dangerous, there is a default assumption of trend like that from the S&P 500 or Dow which are in the midst of recovering from the last explosion and are not yet returned to the decade-long bull trend so many have profited from through a passive strategy approach. From the trend assumption, there is an assumption of slow capital gains and modest dividend income against a backdrop of risk that is unrealistically low. So, how do investors/traders approach such an ambiguous situation? Use the strategy most common with range trading. Shorter term trades, more reasonable targets, awareness of important levels and more engaged observation of market conditions will make for active trading but also faster reaction time should conditions truly start to change. 

Trade Wars and US GDP: Top Theme and Top Event 

As we move into a new trading week with the recognition that market conditions are extremely restrained, it is natural to assume continuation of the same. Yet, as we discussed above, that is an assumption that leverages far greater risk than potential. When we consider the exact conditions for transition, there are various circumstances that can bring about a transition of indecision to trend or low volatility to explosive. That said, the evolution of quiet to volatile is very rarely based in sheer technical originations. It is possible that the rank and file grow so complacent and liquidity so shallow that an unexpected technical development triggers an outsize market drop that then cascades into wholesale deleveraging as everyone returns from the sidelines with a single motivation: to exit quickly. Far more common in the annals of transitional market history is a fundamental spark that draws mass participation and trading intent all at once. And, for those already familiar with the inverse correlation between the S&P 500 and VIX, the more capable driver is the one that is bearish and/or stokes fear. With that flight path established, we should take into account what the most promising/threatening theme and event risk are through the period ahead. 

On the theme side (meaning a general fundamental influence that is steadily a concern with flare ups around scheduled or impromptu developments), trade wars are presently the most ominous  circumstance. It is true that we have a key growth-based risk (US GDP) and dependency on depleted monetary policy has leveraged an impossible future, but recognition of global recession or a hopeless backstop aren’t inevitable do to their existence alone. In some contrast, trade wars are starting to draw greater and greater scrutiny as burden to the global economy and circulation of capital around the world. What’s more, there are a number of threats being juggled presently and any one could drop. The US just recently threatened to apply $11 billion in tariffs against the EU in retaliation for subsidies the latter has given to plane manufacturer Airbus – and of course, the EU has said it is ready to retaliate as soon as the threat is acted upon. With the United States’ direct neighbors, there are hurdles being erected to the USMCA negotiated as a revamp of the previous NAFTA; but the real risk resides with the President’s threat to shut the Mexico border and/or apply tariffs to imports of Mexican auto parts if the country doesn’t do more to stem the flow of illegal immigrants into the United States. Then there is the universal risk of President Trump weighing a universal import tax on all autos and auto parts, a measure that will predicate a global trade war (or at least US versus the Rest of World) that assures a stalled economy. If we are looking for a capable threat with a clear date and time, the US 1Q GDP release will act as top event risk. The world’s largest economy is a bellwether for the globe with so many troubling figures coming cross the wires these past months and open risks like the monetary policy losing its ability to stabilize and the impact of trade wars leeching through. Market it on your calendar. 

US Earnings Will Have More to Say Than Just the State of US Corporate Profitability 

For systemic themes, the most frequent three in the rotation these past months has been: monetary policy; concern of economic recession and trade wars. However, these are not the only complicated matters that can spur fear (or greed in positive turn). One typically-seasonal consideration that will return to the forefront in the week/s ahead is US corporate earnings. We have actually had updates from a few major corporations over the past two weeks, with a greater concentration on the top banks. Thus far, we are left with an impression that registers as continuation of the questionable enthusiasm the markets has sustained for quarter after quarter stretching out through some years. If we are to maintain that questionably content view of profitability and growth through the weeks and months ahead, this week’s run will play a particularly important part in setting the course.  At the top of the list, we have the likes of: Amazon; Microsoft; Anthem; Caterpillar; Exxon Mobil and Procter & Gamble among many others. These are some of the largest companies in a variety of different industries and they will naturally account for a strong overview of the entire systems health. 

However, there is another aspect to this bout of earnings season that we should consider: the thematic influences that will be touched upon in the underlying economy and financial system. If you were looking at the ‘bleeding edge’ of speculative appetite, there is good evidence to suggest that the tech sector continues to hold the torch that investors in most other areas of the economy and markets continue to follow. If you want to look at a quantifiable measure of this preference, consider the general performance of the tech-heavy Nasdaq Composite to the blue-chip Dow – or even the ratio of the two. A leader can be a boon or a burden though depending on the direction it takes. If tech were to pitch lower into a speculative dive, it would likely undermine confidence across the system. With that in mind, consider the largest players in Amazon and Microsoft or a more forward guidance-leveraged FANG member like Facebook as greater risk than reward. Another theme that we will touch upon is general economic growth. The largest companies in the indices or a look into the core of economic activity through the likes of Procter & Gamble, Anthem or Exxon will give some direct lead in to the GDP figures due. Then there are trade wars. We have seen these concerns flag as the threats are days or weeks old – and in the case of the US-China, negotiations are progressing – but the financial impact cannot be overlooked. The likes of Caterpillar who has registered negative impact in the past, Boeing who is at the center of the EU threats via Airbus and even Harley Davidson who was a target for President Trump last year can tell us the state of play.

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