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The Trade War Gets Ugly

Written by Briton Ryle
Posted July 2, 2018 at 3:21PM

I don't know if you've ever had back spasms before. I hope not — they are excruciating. It feels like a charley horse cramp: the muscles begin to tighten and the tightness builds until it literally takes my breath away.

I've been getting regular treatment from a chiropractor over the last week (when I could get out of bed), and I'm finally able to get around. I might actually make it a full day in the office today... 

The Dow Industrials lost less than 400 points last week. Feels a lot worse, doesn't it? That's probably because we had to endure a 450-point reversal from the highs on Wednesday. The Dow has now closed below the 200-day moving average (MA) for six consecutive days.

The 200-day MA is the red line on this chart:

The 200-day moving average is often considered the de facto long-term trendline. You can see how the Dow tracks the 200-day MA on the five-year chart:

Now, this isn't a magical coincidence. An index should track a moving average. After all, a moving average simply tracks the average price over a set time period, in this case 200 days. A 200-day moving average recalibrates every day, adding yesterday and dropping the day 201 days ago.

When this moving average is rising, it shows you that prices have been rising steadily for a good while. We consider that a trend. 

You can see that the Dow made two significant breaks below the 200-day moving average, one in the summer of 2015 and one a few months later. Do you recall what happened back in the second half of 2015 that had investors wondering if the bull market was over?

The Bull Is Dead! Long Live the Bull!

Well, the first was the Brexit vote, when English voters chose to leave the European Union. As the EU is the world's largest economic zone, it's easy to see why the threat of EU disintegration would challenge a bull market. Global growth has not exactly been robust, and it wouldn't take much to push the world into recession. 

The second big threat to the bull market trend came as investors realized Donald Trump might actually become president. His confrontational style coupled with threats to leave NATO, NAFTA, and the WTO were perceived as threats to economic growth. 

Sometimes the market gets a little ahead of itself. Investors often sell first and ask questions later.

When they started asking about Brexit, investors discovered it would take years for England to actually leave the EU and that there might be another vote that would reverse the first decision anyway. So buyers came back and resuscitated the bull market. 

After Trump won, investors figured out that the trade war would have to wait. His first moves would be deregulation and tax cuts. Once again, the bull market hopped off its deathbed, and the charge was on. 

But past is often prelude. And we are back to worrying that a prolonged trade war will end the bull market...

Now, scroll back up to that five-year chart. You can see where the Dow is now: 24,165 when I loaded that chart this morning. The Dow is still above its 52-week lows. 

You can also see where the Dow was the last time it broke back over the 200-day MA: right around 18,000. Or, to put it another way, a lot lower — 25% lower.

I can't tell you the Dow is on its way to a 6,000-point sell-off to 18,000. But I can tell you each of the last two times the Dow broke below the 200-day MA, it was the start of a 10% correction. From current levels, a 10% drop takes the Dow just below 22,000, about where it was this time last year.

It's Getting Serious

A couple weeks ago, I told you these tariffs were now officially a drag on the market. The market has been trending lower ever since.

I can't tell you the Dow is headed to 22,000 over the next couple of weeks. But I can tell you this market is not likely to rally until we see some definitive actions on trade. Definitive POSITIVE actions, that is. 

And frankly, I don't get the sense that anything positive is imminent. War is all about pain — which side can take the pain the longest. We've only just begun to feel the pain...

No company has actually reported a drop in earnings yet. A few have warned. Harley-Davidson, for instance, says tariffs could knock earnings down $100 million next year. That's about 20%. It's significant.

Because right now, earnings are expected to grow for U.S. companies. And really, Harley-Davidson is uniquely exposed to tariff issues. So its forecast of a 20% drop in earnings can't be considered a bellwether for all companies. 

But the thing is, it doesn't need to be, given that investors still have about double-digit earnings growth penciled in for the remainder of the year. Second-quarter earnings expectations, which basically start with JP Morgan on July 13, have been ticking higher recently, as have GDP estimates...

But none of that matters because investors can clearly see that an escalating trade war will mean lower earnings ahead. If we start hearing nervous CEOs on the earnings conference calls that start in a couple weeks, look out below.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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