EUR 220.60 For Business Accounts Only

Vermilion Macro Vision: U.S. Equity Strategy

The question in our minds is whether the market has indeed bottomed or whether we will experience a bear market rally followed by a retest. Let's consider some technical facts. We often see a retest following a bounce off the lows, which often undercuts that previous low for a day or two. A case in point is the emerging market bear rout of late 2015-early 2016, where the low was made on 01/20/2016 and a subsequent low, or re-test occurred on 02/11/16. It took 16 days for the re-test, however not all markets have re-tests of their lows. We believe the U.S. markets currently are hanging in wait of incremental information on; trade negotiations, the government shutdown and, the willingness of the Fed to stay on the sidelines for future rate hikes.

The U.S. dollar also plays a critical role in the markets behavior and we believe a gradual weakening of the U.S. dollar is likely based on our technical indicators. We believe a weakening U.S. dollar would aid emerging markets and would provide a catalyst for global expansion once again. It would also do plenty to facilitate the return to a risk-on environment in the face of dramatic corrections in emerging markets prior the U.S. markets cascading to current levels. Harkening back to the events leading to the U.S. market lows of 2016, the U.S. dollar was unable to break out of a consolidation, but emerging markets currencies climbed from their abyss and resulted in a global expansion that ultimately led U.S. markets higher.

Corrections and lows have always been established by capitulations and we believe the December, 2018 low will be no different. During early 2016, we undercut the lows of 2015 by almost 12.5% in the Russell 2000, while our December 2018 low was just slightly above a 12.5% correction. In addition, we believe the near-term low was truly a healthy low as the percentage of stocks above their 200-day moving average reached a low of 8.38% on the Russell 2000 and surpassed the lows of 2016 (11.52%). There were only two lows that surpassed these levels during the past 10 years; the low of 2011 (6.91%) and the lows of 2009 (4.60%). Based on this data, one might be lead to believe we have established “the low”. However, the markets have reached levels in which there is formidable resistance and without closure on a trade deal with China, or resolution on government funding, we feel the markets might not be able to surmount the present wall of worry.

Another area that reflects extremes are spreads on high yield corporate bonds which, despite a fed tightening and subsequent Treasury rally, high yield bonds sank under enormous pressure with spreads widening dramatically. We have used the HYG and JNK as barometers in which to view capitulations and the overall risk appetites. Investors have recently come to the rescue of the corporate bonds as spreads have narrowed somewhat, indicating a possible budding penchant for increased risk.

Ultimately we believe the market's attempt to establish a bottom is a process that takes time and often requires an increased number of data points from which to base an informed decision. Below is our synopsis our current observations on various aspects of the market, and provides a checklist in order to make a better decision on the health of the market and where to find leadership.

• U.S. dollar: The U.S. dollar is succumbing to weakness and in many cases is showing signs of rolling over. The recent breakout of the Chinese Yuan to 5-month highs is likely a signal that a trade deal is likely and/or a risk-on environment is likely.

• Defensive areas of the market are showing early signs of weakening: The Utilities and Staples Sectors are rolling over and are incrementally indicating that the market is stabilizing. Economically sensitive areas are showing strong bounces from extreme oversold levels.

• Percentage of stocks above their respective 50-day and 200-day: Breadth is expanding and pullbacks are thus far holding the expanding breadth in check. Markets have not yet taken out their “wall” of resistance, but the evidence thus far favors buying the pullbacks. Even areas that have lagged since early 2018 are showing signs of stabilizing such as Semis, Semi-suppliers and home builders, with the latter rallying back up to its 200-day moving average. We have been bearish on these areas since early 2018 but we are warming up given evidence suggesting the Fed may be moving to more of a neutral stance.

• Large vs Small-Caps: Small caps have led off the lows which is a welcome sight as small caps typically indicate a risk-on environment and usually have lower correlation to trade issues overseas.

• Interest rates: Despite the Fed tightening, 10-year rates declined as investor's fears of a potential recession increased. The inverted yield curve between 2s and 7s is a signal that any further tightening may exacerbate the inversion and investor's fears, but we are optimistic, based on recent Fed speak, that the curve will resolve itself over time. On the other hand, investors should be mindful that any further inversion of the yield curve could have a negative impact on the equity markets.

• Commodities: We do not recall many periods during which commodities climbed and emerging markets didn't also rally. It has been quite unusual over the last year to see oil climb and emerging markets trending lower. We believe these two got out of whack, and it was a welcome sight for oil to decline which, in our opinion, will aid emerging markets to form bottoms.

• Emerging Markets and European Markets remain under pressure: However, emerging markets are and have been outperforming our markets since mid-August. Despite negative economic news coming from a majority of the countries that derive the EEM ETF, RS on the EEM is bullish vs the S&P 500.

The jury is still out if the markets lows will hold as the major indices have rallied to overhead resistance. The data does suggest that investors are moving incrementally towards a risk-on environment, but deep downtrends remain intact and, as such, should cause for caution. We are concerned that even if the bond market moves to a normal, positively-sloped yield curve, we still could tip into recession barring a Fed intervention.

In the remainder of our January strategy we highlight current opportunities within the following Sectors:

• Health Care: Overweight. Health Care continues to have a number of bright spots. Biotech is near RS highs. Large-Cap Pharma remain an area of strength and is typically indicative of safety and offensive positioning during uncertainty. Cardiovascular products is at historical RS highs and contains many significant bases and bullish uptrends.

• Utilities: Overweight (On review for a downgrade to Market Weight). This Sector is losing momentum at a level in which the market is finding considerable resistance. The bankruptcy filing of PG&E is of concern as investors flee this leadership Sector.

• Consumer Staples: Overweight (On review for a downgrade to Market Weight). This Sector is losing relative strength as investors moved to a risk-on stance from the December lows. Without a formidable catalyst for the markets to take out resistance at these levels, we would remain overweight. Again, there is evidence that the Consumer Cyclical Sector is showing signs of a bottom and we will weigh the evidence accordingly before moving to a Market Weight.