Week Ahead: Risk/Reward Makes Caution Advisable

Taking a look at last week's big picture news, we saw that Donald Trump imposed more tariffs and trading partners, most notably China last week, retaliated. Meanwhile, the S&P 500 finished the week higher than it started, with Apple (AAPL) becoming the first $1 trillion-dollar company along the way. The market continues to climb a wall of worry and as we look forward to the rest of this week, logic suggests that will continue to be the main theme.

I, however, remain cautious.

Trading is essentially about assessing risk versus reward, and on that basis alone, piling into stocks at these levels doesn’t look like a particularly smart thing to do. The channel marked on the below chart for the S&P is upward sloping for sure, but we are close to the top trendline, which is clearly defined enough to make it a major resistance level. Usually those things don’t worry me as I am a firm believer that fundamentals always outweigh technical factors, but this time is a little different.

Right now, there are plenty of bad things to counter the good. The difference is that while the good is the most basic good of all for stocks -- corporate performance -- that is by nature about the past. The bad is all about what might happen in the future and that is, for traders, a question of focus. They are currently choosing to ignore the potential dangers and focus on the history, but that could change any day, and there are a couple of things that could make that happen this week.

The first is where we are in the channel highlighted above. We are close to the top of that pattern, and with the trendline having held three times since its formation, another pullback must be on the cards. That may start because of proximity to a level, but when the focus shifts it will quickly become about fundamental worries.

The first of those is, of course, tariffs. The President remains confident that his aggression is working, and so far, it does seem to have created a willingness to talk among our trading partners. Once again, though, in assessing the possible outcomes here there has to be a risk/reward assessment. The evidence to this point suggests that when talks do begin the most likely outcome is a return to the status quo, so in effect the potential reward is little or nothing.

The risk however, is substantial. The trade issues have frequently been referred to as a poker game, but there is an old saying in poker that bluffing by moving all in works every time ... right up until it doesn’t, and then you go bust.

That is the problem with trade wars in general, and this one in particular. Trump is risking a lot to gain a little, and for anybody with a trading background that goes against the grain. Traders are happy to ignore what is going on for as long as the effects don’t show, as it will probably turn out to be a storm in a teacup. But if the technical picture, or anything else for that matter, causes a drop, awareness of the risks of a trade war could quickly turn a minor consolidation into a big decline.

That initial fall in stocks doesn’t have to come from proximity to the top of a channel, however. There is something else, or rather two things, on theeconomic calendarfor this week that should be watched as they have the potential to start a downturn, PPI on Thursday and CPI on Friday. As much as protectionism constitutes a long-term risk for stocks, there is a more immediate risk should the two price indices show strengthening inflationary pressure.

These could prompt worry that the Fed would become more aggressive about rate hikes and cause traders and investors to hit the sell button.

So, overall, the decision to be cautious this week is one based on the risk/reward ratio. The likelihood is still that stocks finish this week higher than they start it, but not by much. A bad week, though less likely, has the potential to be really bad. Given that, I would rather hold off and see the impact of data later in the week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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