This Week's Message: Our Trade-Risk Rotation Theory

Clearly, recent technical trends favor the economically defensive sectors over the cyclical. We should view this as a legitimate red flag that the bull market may be moving into its later stages; as traders rotate (their buying) away from economically sensitive stocks to those that tend to fare better when expansions begin to peter out.

The problem, however, with the late-stage theory is the fact that, on balance, the macro data continues to signal notably low recession risk. For example, our financial stress indicators continue to read substantially positive (low stress in the system), which is the opposite of what generally occurs as the economy begins to crack under the weight of expansionary excesses; bear markets typically need recessions...

So, if general conditions don't favor a rotation to defensive sectors, what then is going on?

While I am indeed taking seriously the latest signals within the sectors, I suspect that it may simply be traders hedging against the risk of a protracted trade war; a scenario that I believe would indeed lead ultimately to a serious global recession. 

Last Thursday and Friday (strong equity market rally) saw action that supports the trade-risk rotation theory (see next paragraph). While staples nonetheless led the pack to end the week (on Wal-Mart's huge earnings beat), industrials, financials and materials all handily out-performed the S&P 500. Tech, however, under-performed markedly, but that's consistent with our view that tech is overdue for some under-performance relative to our other top sector weightings.

Thursday's catalyst for a nearly 400-point gain in the Dow appeared to be a Wednesday night announcement that a delegation from China was heading to the U.S. in late August to work on resolving the rapidly deteriorating trade relationship between the two countries. Friday's trading started off relatively weak until the announcement that those talks are meant to pave the way for a Xi/Trump summit in November; upon which the Dow quickly rallied triple digits, while the S&P 500 and the Nasdaq Composite both went from negative to notably positive on the day. 

As for non-US equities, clearly, the threat of trade war, along with a stronger dollar, has taken its toll. Thus, last Thursday and Friday's action there also supports the trade-war fear thesis, as the developed and emerging markets indexes, as well as the Eurozone itself, all outperformed the S&P 500 handily.

Of course, in closing, we must acknowledge that two days' action does not remotely a trend make. But two days (among multiple others throughout the year) of aggressive buying of trade-sensitive sectors on potentially trade-friendly news is indeed worth noting, and respecting, while general conditions remain positive. Otherwise, under bearish macro conditions, we'd chalk up such a rally simply to market noise and something to sell into...