December 11, 2018
J.P. Morgan’s top quantitative analyst, Marko Kolanovic, on Friday blamed the financial media for the stock market’s recent volatility by saying that there is a yawning chasm between the real U.S. economy and how the markets are behaving. In his 2019 Outlook, Kolanovic wrote that strong corporate profit growth and consumer spending signal that the economic expansion isn’t about to end, in contrast to future P/E estimates and institutional equity holding levels near five-year lows. Kolanovic added that “Positive GDP and earnings are the ‘reality,’ which is currently starkly disconnected from equity sentiment, valuation, and positioning.” Kolanovic added, “To some extent, we trace the disconnect between negative sentiment and macroeconomic reality to the reinforcing feedback loop of real and fake negative news.”
Kolanovic cited a combination of domestic political groups, analysts and foreign actors who are amplifying negative headlines to sow discord and erode faith in financial markets. He said there are “specialized websites” that present a blend of real and fake news and distorted write-ups of financial research. Kolanovic concluded by saying, “If we add to this an increased number of algorithms that trade based on posts and headlines, the impact on price action and investor psychology can be significant.”
Yikes! I am glad that Kolanovic said it, because I could not have said it better. The truth of the matter is that trading algorithms are jerking the stock market around almost daily, as well as increasing the volatility of crude oil and natural gas prices, which are all too often based on planted fake news stories. In fact, I would also add that when the financial media locks in on topics, such the China trade spat or Fed interest rate hikes, they beat every fear factor to death and refuse to adjust their tune to the proven facts.
My favorite economist, Ed Yardeni, wisely pointed out last week how computer-driven algorithmic trading continues to trigger dramatic one-day selloffs by dumping ETFs in essentially a “sell everything” trade. Investor bargain hunting after these big machine-driven selloffs has been tepid, since investor confidence has been undermined by not only the algorithmic trading, but also the fact that many popular ETFs continue to trade at discounts to their Intraday Intrinsic Value (essentially their net asset value).
Stocks initially surged last week on the G20 news that President Trump and China President Xi agreed to a 90-day trade truce, which effectively postponed the new 25% tariffs (which are currently 10%) on $200 billion worth of Chinese imports. The official statement said, “Both parties agree that they will endeavor to have this transaction completed within the next 90 days. If at the end of this period of time, the parties are unable to reach an agreement, the 10% tariffs will be raised to 25%.” Furthermore, the White House said, “China will agree to purchase a not yet agreed upon, but very substantial, amount of agricultural, energy, industrial, and other products from the United States to reduce the trade imbalance between our two countries. China has agreed to start purchasing agricultural product from our farmers immediately.”
Clearly, there is a lot of work to be done to resolve the current trade spat with China, but a good outline is currently in place, so Treasury Secretary Steven Mnuchin and his trade negotiators now have a lot of work to do with their Chinese counterparts. Although the U.S. has the greater leverage with China, the Chinese trade negotiators are smart and think differently than their Western counterparts. Specifically, the Chinese are always looking to continue their trade dominance in selected markets. Furthermore, the fact that GM is not closing their plants in China but are closing multiple plants in Canada and the U.S., is a sign that big multinational companies continue to work with China vs. boosting North American trade.
Both President Trump and Chinese President Xi are going to want to say that their respective countries have “won” when any trade resolution is announced in the upcoming months, so it appears to me that the U.S. will most likely win on farm exports while China will likely win on its manufactured goods.
All Eyes Are Now on the Fed
Too many in the financial media are talking about how “falling interest rates and a flattening yield curve are ominous signs of a potential recession.” All this proves that the U.S. remains the global oasis! First, so as long as long-term rates are falling, that is a good sign, regardless of the “tilt” of the yield curve.
Here is a sample of how fast and far the Treasury yields have declined in the first week of December.
Second, now that interest rates have fallen in a flight to quality, dividend growth stocks are expected to lead the overall stock market, since the S&P 500 now yields almost 2% and is largely tax-advantaged (i.e., taxed at a maximum Federal rate of 23.8%), so yield-hungry investors and dividend growth stocks are expected to initially lead the stock market recovery. Overall, the financial media continues to fail to see the forest for the trees by refusing to point out how the S&P 500 continues to boost its underlying dividends and corporate stock buyback activity. We may see $1 trillion in stock buybacks during 2018.
All eyes are now on the Fed and their upcoming Federal Open Market Committee (FOMC) meeting next week. I am now expecting a dovish FOMC statement due largely to falling Treasury yields and hope that the FOMC statement will essentially act as a “launching pad” for the stock market to stage a powerful year-end rally. Investors hate uncertainty, so if the Fed can remove interest rate uncertainty and signal that the FOMC is unlikely to raise key interest rates further due to slowing economic growth (e.g., autos, housing and global factors), moderating inflation (due to lower crude oil prices) and lower market rates (falling Treasury yields), I expect an “explosive” reaction and a “melt up” in the stock market.
On Wednesday, the Fed released its Beige Book survey in preparation for its upcoming FOMC meeting. Most of the Fed’s 12 districts reported “modest” or “moderate” growth. The Dallas and Philadelphia Fed districts noted “slower growth.” Unlike previous Beige Book surveys, this one acknowledged weakness in existing and new home sale, which means the upcoming FOMC statement will most likely be dovish.
The Labor Department on Thursday reported that productivity rose to 2.3% in the third quarter, up from 2.2% previously estimated. Normally, stronger productivity helps to boost wages, but between higher productivity and lower labor costs, inflationary pressures are clearly moderating.
Finally, the Labor Department on Friday announced that only 155,000 payroll jobs were created in November, substantially below economists’ expectations of 198,000. The October payroll report was also revised down to 237,000, from 250,000 previously estimated. The unemployment rate remains at 3.7%, a 49-year low. Average hourly earnings rose 0.2% (6 cents) to $27.35 per hour, up 3.1% in the past 12 months. The average workweek dipped by 0.1 to 34.4 hours, which may signal a hiring slowdown.
Overall, the stock market will be taking its cue from next week’s FOMC statement. Due to falling Treasury yields from international capital flight, plus moderating inflation fears, the Fed can pause raising rates in 2019. The Fed never fights market rates and I expect the upcoming FOMC statement will ignite a strong year-end rally. Hopefully this momentum from a more dovish Fed will continue in January when another round of strong quarterly earnings announcements should propel stocks substantially higher.