Downgrade of the USA by Fitch: An analysis of the stock markets

Dear Readers,

Fitch, the American rating agency, is tearing apart the markets! But why exactly is this happening, and how does it affect your investments? We must take these questions seriously, especially after the recent downgrade of US creditworthiness.

The Risks in the Stock Markets

We find ourselves in a phase where the market is dancing on thin ice. After a long rally phase that understandably brought optimism to investors, there are now clear signs that the risks for investments have increased. How did we get into this situation?

World Index - currency neutral: Right at all-time high. Will the breakout come?

Downgrade of the USA

In a historic move, Fitch has lowered its rating of US creditworthiness. Donald Trump's attempt to overturn the 2020 election and the growing political polarization in the USA have, according to Richard Francis of Fitch, led to an "erosion of governance."

The decision to downgrade occurred for the second time in history, with the first time being in 2011. The violent attack on the US Capitol on January 6, 2021 reflected the deterioration of US governance and contributed to the downgrade.

The S&P 500 fell by as much as 18% during the three weeks around the 2011 downgrade - a clear sign that the market reacts sensitively to these changes.

Market movements are complex. They are characterized by emotions, expectations, will, and capabilities of investors. The momentum was already exhausted, the remaining potential was low, and then came the news from Fitch.

The major drivers of the rally, such as semiconductor stocks, had reached lofty heights. The path forward was fraught with resistance. Nevertheless, the market had apparently overcome the resistance - until the downgrade came.

Analogy to the Market: Emotions and Human Behavior

Stock markets are not static, rational constructs. They follow deeply human patterns of behavior, and that makes them seemingly unpredictable. However, when viewed emotionally and from the perspective of crowd behavior, they suddenly become very logical and transparent.

Compare the rally of recent months to a marathon. The last few weeks were the most difficult section, full of uncertainties and steep climbs. Just as the end was in sight, the news from Fitch came and struck like a bomb.

Outlook: Caution is Advised

With the downgrade by Fitch, markets like the DAX are in danger. The Nasdaq is very overextended, and the potential fall is correspondingly deep. There are massive divergences in momentum indicators that point to a downward tendency.

S&P 500 currency neutral: Trend intact, but massive divergence in RSI!

If this trend breaks, then a downward trend should first establish itself, giving this market room to breathe and leading 10% lower into the 4000 region in the S&P. Such a 10% correction occurs statistically twice a year, so it would be a completely normal movement and the opportunity is favorable. As so often, in such situations my gaze wanders to the volatility index VIX, which indicates the expected volatility in the markets.

In spring, I correctly predicted the breakout of American markets based on the VIX, because it established itself below the zone of 19 to 20 points. A sign of calm in the markets. Meanwhile, it has also broken out of its long-term upward trend, also a sign of calm here. But will this calm hold?

It still is the case, currently the VIX is testing exactly the old upward trend at about 17 points. So far everything is still in the green zone, but the break can happen very quickly here, because the markets are excessively relaxed.

The Leeway Fear Indicator is almost as relaxed again as in December 2020. At that time, the markets were already at all-time highs. Other indicators also point to overheating. The market is dangerously blind to downside risks, as the price of put options shows. They are as cheap as ever, meaning the downside risk is assessed as extremely low.

The Cheapest Hedge You Have Ever Seen

“US stock bulls have grown so confident in the market that the cost of buying protection against a 5% dip in the next YEAR has fallen to what BofA strategist Ben Bowler is calling the ‘cheapest you likely have ever seen.’” pic.twitter.com/NZvUvKEuzQ

— Macro Charts (@MacroCharts) July 28, 2023

Many professional investors had to or must desperately buy because they missed the rally and are now under pressure to catch up. The sentiment among fund managers is very good, as our market analysis this week in the weekly briefing has shown. In principle, this is positive for the market and would normally end in a strong year-end rally.

Only the year-end is still far away and one should ask whether the buyers haven't leaned a bit too far out the window in an attempt to be the first to jump on the moving train. I tend to think that we have a weak August and September ahead of us in the short term, which will cause maximum pain among all those who were just forced into the market by missed gains.

How important the point is at which we find ourselves should be made very clear by the following chart, which shows the S&P 500 when you factor out the change in the money supply of US dollars in circulation:

At this point, the index has already failed twice, in 2020 before Corona and in 2021 before the Russian invasion. Will it fail a third time? On the other hand, if it breaks through here, it triggers a beautiful double bottom formation that can catapult the markets to undreamed-of heights. In short, in the rather unlikely event that the market doesn't fall here, this is a sign of extreme strength and to be rated very positively in the long term.