Breadth, Profitability, China, and Greece All Add Up

The S&P 500 has lost critical technical support at the 200-day moving average and the 2,000 level — putting its post-2011 uptrend in jeopardy. Many observers pooh-poohed the importance of the technical “death cross” last week. Turns out to have been meaningful indeed, as it was a milepost by which to observe the stark loss of market momentum.

Globally, the Shanghai Composite lost its 200-day moving average — a critical measure of the long-term trend — after authorities had vigorously defended the line in the sand since early July. Bourses from Japan to Germany are all wilting. Treasury bonds and precious metals have been on the rise as investors seek safe havens. And currencies of emerging market countries from Vietnam to Kazakhstan are under pressure.

The PowerShares U.S. Dollar Bullish Fund (UUP) lost its 200-day average for the first time since last summer. The yen and the euro are rising, despite aggressive stimulus efforts by the Bank of Japan and the European Central Bank, as popular currency “carry trades” are slammed.

There may be no single driver for the decline, but a number of factors have combined in the context of what had been quiet calm in the U.S. stock market:

— There’s been a multi-month decline in market breadth, as fewer and fewer U.S. stocks participated to the upside. We have chronicled this.

— Corporate profitability has been pressured by slowdowns overseas, the stronger dollar, a tightening job market, and lower energy prices. We’ve also noted this.

— China has seen a marked slowdown in its economic data, has suffered a 32% stock market decline, and conducted a surprise devaluation of its currency last week.

— Greece is back in the news as Prime Minister Alexis Tsipras has stepped down ahead of snap elections.

— Tensions are rising on the Korean peninsula after North and South Korea exchanged artillery fire.

Besides China, the acceleration of last week’s decline seems to have been driven by concerns surrounding the approach of a potential Federal Reserve interest rate hike on Sept. 17.

We’re in the midst of “hike havoc” — not unlike the “taper tantrum” of early 2013 as former Fed Chairman Ben Bernanke considered the beginning of the end of the QE3 bond purchase stimulus program.

Will the Fed ignore building financial market turmoil or be pressured into waiting?

The Fed seems to be tilting toward an earlier rate liftoff with a pause afterwards (the “one and done” scenario for 2015). Yellen has tried, unsuccessfully, to play down the importance of liftoff timing and has said that wage growth and inflation aren’t a precondition for the initial rate hike.

St. Louis Fed President James Bullard, who famously saved the market back in October during the Ebola-driven selloff by reassuring investors that the Fed could unleash more stimulus if needed, also raised expectations of a September hike Friday when he said the Fed doesn’t react directly to equity markets and that he’s more optimistic about the global economic outlook than the market is.

For investors who have grown complacent in the belief the Fed will always support markets, this was like an ice pick through the heart on an already scary day.

The last time the Fed faced a cliffhanger decision, it blinked. Bernanke delivered a surprise “no taper” decision at the September 2013 policy meeting; postponing the taper until December, just three months before current Fed Chairman Janet Yellen began her term.

Will Yellen fold, too? The drop in the dollar suggests currency traders believe she will.

Yet the selloff in pretty much everything else suggests a nagging fear the world’s most important central banker is about to turn hawkish, focusing on steady job gains and stable GDP growth while ignoring the market rout. According to Oxford Economics, the U.S. economy is growing at a 3% annual rate, which is not too shabby.

Capital Economics believes the Fed has set a “pretty low bar for a rate hike” and with GDP growth likely to be higher than the Fed’s June projection they not only “think that the Fed will raise rates in September, but there would appear to be a good chance of a second hike in December as well.”

Analysts at Nomura think differently, and see the odds of two rate hikes this year at only 8% and put the odds of a September hike at only 20%. Their most likely outcome is the first hike coming in December (with 44% odds) followed by no hike at all in 2015 (at 36% odds).

Much depends on the strength of the August jobs report on Sept. 4 — the last before Yellen & Co.’s fateful decision. Stay tuned.

Best wishes,

Jon Markman