As we head into 2016, we’re gearing up for an exciting year. At this point, nobody knows whether it’s going to be a bullish year or a bearish year, but we’re counting on it being an exciting one either way.
We may not know which direction the market is going to go, but we do know that traders on Wall Street are going to be watching a few key indicators as they look for clues.
While this is not a comprehensive list, here are a few things we think everyone should be watching:
- China
- The strong U.S. dollar (USD)
- Share buybacks
- NYSE margin debt
- The Japanese yen (JPY) carry trade
Let’s start with China.
China
China kicked 2016 off with a bearish bang. Bearish sentiment accelerated after the Caixin Manufacturing PMI (Purchasing Managers’ Index) came in at 48.2, below expectations of 48.9, which were already low. This weak economic indicator couldn’t have come at a worse time.
On July 8, when the Chinese stock market was in freefall (see the red box on the Market Vectors China A-Share Fund (PEK) chart in Fig. 1), the China Securities Regulatory Commission announced that executives, directors, and anyone holding more than 5% of a company’s stock would be forbidden from selling their shares for six months.
Fig. 1 — Weekly Chart of Market Vectors China A-Share Fund (PEK)
This means that all major shareholders have had to sit on their hands and watch while the Chinese economy has continued to slow down and the Chinese stock market has continued to lose value.
Fast-forward six months, and it appears that many traders want to get a jump on the selling before major shareholders are able to start selling their shares. This sent negative concerns cascading around the global financial world.
The Chinese government is trying desperately to stem the bearish tide and reinvigorate the Chinese economy. One of the ways it is doing this is by devaluing the Chinese yuan (CNY). As you can see in the Chinese yuan/U.S. dollar chart in Fig. 2, the government has been ratcheting the CNY lower compared to the U.S. dollar (USD) in an attempt to stimulate exports.
Fig. 2 — Daily Chart of Yuan/U.S. Dollar Exchange Rate
As we head into 2016, it’s important to keep an eye on the Chinese economy. If it can rebound, it is likely to have a bullish impact on the global economy, which would go a long way toward lifting spirits on Wall Street. If it can’t rebound, it will be a bearish drag on the U.S. stock market.
The Strong U.S. Dollar
The USD has been getting stronger, not only against the CNY, but also against the euro (EUR).
The PowerShares DB U.S. Dollar Index (UUP) chart in Fig. 3 shows that the USD is resuming its uptrend.
Fig. 3 — Daily PowerShares DB U.S. Dollar Index (UUP)
The strong USD has had a negative impact on U.S. exports for the past few quarters. It has also had a negative impact on the foreign-generated revenues of large multi-national companies headquartered in the United States.
With the USD continuing to rise, U.S. exporters and multinational corporations are likely going to continue to feel the pinch.
Share Buybacks
Share buybacks have been a huge contributor to the success the stock market has seen during the past few years. During an era in which top-line revenue hasn’t been growing as quickly as it did following previous recessions, share buybacks have gone a long way toward boosting bottom-line earnings.
Buybacks have also changed the supply-and-demand equation in the market. For every share a company buys, there is one fewer share available for traders to purchase. This decrease in the supply of available stocks has helped push share prices higher.
As you can see in Fig. 4, share buybacks have been increasing since the end of the recession in 2009.
Fig. 4 — S&P 500 Buybacks
Unfortunately, it appears that the pace of buybacks has plateaued and could start to decline now that the Federal Open Market Committee has embarked on its rate-hiking program.
If companies start to scale back their repurchase programs, it will be a bearish drag on the market.
NYSE Margin Debt
While share buybacks have gone a long way toward reducing supply in the stock market, buying stocks on margin has gone a long way toward increasing demand.
When you buy a stock on margin, you borrow half of the money for the purchase and put up the other half on your own. This gives you a 2:1 leverage ratio. In other words, you can buy twice as many stocks as you otherwise would be able to. This increased demand pushes the price of stocks higher.
You can monitor the amount of borrowing that is going on in the market by tracking NYSE Margin Debt levels. As you can see in the NYSE Margin Debt chart in Fig. 5, margin debt levels started dropping last summer, which was a negative sign for the market.
Fig. 5 — NYSE Margin Debt
However, since reaching a low in September, margin debt levels have started to rebound. This is a good sign.
If margin debt levels can remain high, it should have a positive impact on the market. But, if margin debt levels start to decline again, watch for stock prices to drop.
NOTE: Margin debt numbers for December will be reported at the end of January.
The Japanese Yen (JPY) Carry Trade
Just as traders can increase their buying power by borrowing money on margin, they can also increase their buying power by engaging in carry trades.
A carry trade involves selling one currency short and then using the proceeds from that short sale to invest in assets that are denominated in a stronger currency. For example, for the past several years, traders have been selling the Japanese yen (JPY) short and using the proceeds to invest in USD-denominated assets such as stocks.
This trade works well so long as the short currency continues to weaken compared to the strong currency. If the short currency starts to strengthen, it can force traders to unwind their positions.
To unwind a carry trade, the trader has to sell the assets she purchased in order to raise enough capital to cover the short position taken on by the weak currency. In our example, that would mean the trader would have to sell her U.S. stocks to raise enough capital to cover her short JPY position.
As you can see in the weekly chart of the JPY/USD exchange rate in Fig. 6, the value of the JPY is starting to rebound after a long downtrend.
Fig. 6 — Weekly Chart of Japanese Yen/U.S. Dollar Exchange Rate
If the inverted “head-and-shoulders” pattern that is taking shape ends up playing out, sending the value of the JPY higher, watch for traders to start liquidating some of their U.S. stock holdings, which would apply more bearish pressure to the market.
As we gear up for the start of earnings season next week, the geopolitical and economic news continues to unsettle the markets. However, the market has not given up, yet.
We anticipate more bearishness ahead, but we are going to approach with caution.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.
