S&P 500 analysis: US stocks drop after Fitch downgrade

The biggest catalyst behind the stock market sell-off today is that unexpected announcement from Fitch downgrading US credit rating. Overnight saw US index futures and global equity markets drop, before futures bounced back a tad. However, the selling then resumed again shortly after the cash markets opened.

In case you missed it, Fitch downgraded the US from AAA to AA+, with a stable outlook. The ratings agency cited the fiscal deterioration over “the next three” years and high levels of government debt as the main reasons for the downgrade.

What happened the last time US credit rating was downgraded?

The last time that the US credit rating was downgraded was about 12 years ago at the hand of the S&P ratings agency, who reduced the US to AA+ from triple A, on August 5, 2011. That cut had happened late in the afternoon on a Friday, so when the markets opened the next Monday, the reaction was a swift one – the S&P 500 index fell about 80 points or 6 and a half percent:

Will history repeat itself?

The sell-off in response to the 2011 ratings downgrade had come on the back of an already-weak market, with the index being in a downtrend.

This time, the market is in a clear uptrend, which partly explains why we haven’t had a major sell-off yet. But this means that there’s the potential for a sharper sell-off as investors digest the news with the cash markets having just opened.

It is not all about the debt downgrade

Apart from the Fitch ratings downgrade, the focus will remain on the jobs market this week. The release of the ADP private payrolls report earlier didn’t lift the mood much, even if the data came in much better than expected at 324K vs. 191K eyed.

Jobless claims and the employment component of the ISM services PMI will be released on Thursday, and then – the big one – the official nonfarm payrolls report on Friday. In terms of company earnings, results from tech giants Apple and Amazon will be the big ones to watch on Thursday, which could move the S&P 500 sharply. 

The Fed has made it quite clear that US monetary policy is now restrict enough and that the next policy decision in September would be entirely data dependent. Until then, we will have two more inflation and a couple of jobs reports to consider. While the focus is clearly on inflation as employment is still very strong, any potential weakness in jobs data could cement expectations of a policy hold. But another surprisingly strong employment report on Friday would keep the threat of further Fed hikes alive. This may explain why stocks have fallen today despite the strong ADP report.

S&P 500 analysis: Bullish exhaustion ahead of big events

The S&P 500 reached a 16-month high last week, before losing some momentum on Thursday. And while the bulls quickly bought that dip, Thursday’s high has not been broken, which is giving the bears a clear invalidation level to work with.

Therefore, watch last week’s low at 4527 (i.e., Thursday’s bearish engulfing candle low) closely as a decisive move below it could trigger some follow-up technical selling. But if we see a quick break and a bounce back inside last week’s range, then that would be a potentially bullish signal.  

All told, the risks are skewed to the downside in the short-term outlook. With some investors likely to sit on their hands ahead of Friday’s US employment data and earnings from giants Apple and Amazon on Thursday, we may see the correction get a bit larger in light of the Fitch downgrade.

Meanwhile, the Relative Strength Index (RSI) has been diverging with price action at ‘overbought’ levels, pointing to possible bullish exhaustion.

-- Written by Fawad Razaqzada, Market Analyst

Follow Fawad on Twitter @Trader_F_R

Source for charts used in this article: TradingView.com

How to trade with City Index

You can trade with City Index by following these four easy steps:

1. Open an account, or log in if you’re already a customer 
   
   • Open an account in the UK
   • Open an account in Australia
   • Open an account in Singapore
   
   
2. Search for the company you want to trade in our award-winning platform 
3. Choose your position and size, and your stop and limit levels 
4. Place the trade