America Revoke $112 Billion In Chinese Tariffs?

Flat Market, But Still Overbought

The stock market was mostly flat on Tuesday, but stocks are still overbought. It’s common knowledge that earnings season, which is mostly over, was pretty good, that the trade deal is inching closer to completion, and that the Fed is supportive of markets. That’s why the base case scenario being priced in is no recession anytime soon. 

When everything seems great and markets are euphoric, it could be time for a correction. Specifically, on Tuesday S&P 500 fell 12 basis points, Nasdaq was up 2 basis points, and Russell was up 14 basis points. VIX was up again as it increased 27 basis points to 13.1 which is still very low.

There are some indicators giving off a warning sign of a potential correction. Even though the S&P 500 fell, the CNN fear and greed index rose 3 points to 89 which is deep into extreme greed territory. It’s getting very close to the peaks in the fall of 2017 and late 2016. 

Put to call ratio, stock versus bond returns, stock breadth, and the S&P 500 versus its 125 moving average are all at extreme greed. Stocks need to fall, to bring this indicator back to neutral. Often times you see stocks swing from expressing optimism to pessimism which would mean a bigger correction is coming. 

It’s common for almost no one to see a correction coming and then for people to explain how it was obvious after it happened. One way to predict corrections is to look at sentiment indicators like this.

Also, as you can see from the chart below, options traders on the ISE exchange bought 238 calls for every 100 puts. That’s the most euphoria expressed since December 2005. As the chart shows, the last time there were 2 or more calls bought for every 1 put was in September.  Sometimes this indicator is meaningless, but it did flag the volatility in Q4 2018.

Details Of Tuesday’s Action In Markets

Best sectors on Tuesday were energy and the financials which rose 0.45% and 0.42%. Once again, the biggest losers were the utilities and real estate which fell 1.03% and 1.76%. That’s because of the rise in treasury yields. Since October 24th, the utilities sector is down 3.39%. There was a big 8 basis point increase in the 10 year yield as it rose to 1.86%. Its latest yield is 1.84% as it fell slightly on Tuesday night. 

Closing high on Tuesday was the highest yield since September 13th. Investors see the 10 year yield getting up to 2% on hopes the economy is making a cyclical turnaround. If that occurs, it will match the bullishness expressed in the stock market. A big reason for the rise in the 10 year yield is the rise in inflation expectations; increased inflation estimates are in line with a cyclical upturn. Theme here is expected improvement in nominal GDP growth in 2020.

The yield curve continued to steepen which is bullish in my opinion. As you can see from the chart below, the difference between the 10 year yield and the 3 month yield is 31 basis points. That’s a big difference from when it was about -50 basis points in September. 

2 year yield is currently 1.61%. Fed has kept short term yields from increasing by claiming inflation would need to spike for it to raise rates again. Market participants took that as the Fed guiding for no hikes in 2020. I think it’s possible the next decision could be a hike. But that won’t occur until after the economy recovers and generates inflation. That won’t happen in the next few months. Currently, there is a 6.6% chance of a rate cut in December and only a 63.7% chance of a cut in all of next year. I think those odds will continue to fall.

America Could Drop Some Tariffs On China

The market is rallying now that the trade war isn’t holding it back. If the current tariffs are rolled back, it could catalyze further upside in stocks. That’s exactly what’s being discussed currently. In a report by the Financial Times, the White House is considering rolling back the 15% tariffs on $112 billion in Chinese imports. Those were the tariffs implemented on September 1st. This would be a boon to business investment. 

As you can see from the chart below, the manufacturing capex expectations indexes have plummeted as the trade war has escalated. To be clear, the trade war isn’t the only thing hurting manufacturing. It’s just clear to see the trade war has hurt visibility which hurts business investment.  

Review Of Q3 Earnings Season

Q3 earnings season has helped power the stock market to record highs. It has been a solid quarter because Q4 EPS estimates have recently stopped declining sharply. With most of earnings season over, let’s look at the results. 74% of 384 S&P 500 firms have beaten EPS estimates with 3.11% in non-GAAP EPS growth. 67% of firms have had positive EPS growth. 59% of firms have beaten sales estimates on 3.98% growth. 

As you can see from the table below, the average EPS surprise is 3.94% which is below the 3 year average of 5.34%. The average sales surprise is 1.2%. 3 year average sales beat rate is 65% which puts the current beat rate below average.

Conclusion

The stock market barely moved on Tuesday which means it stayed overbought according to the CNN fear and greed index. 10 year bond yield has been increasing as treasury investors are starting to see the potential for a cyclical turnaround in nominal GDP growth. And the yield curve is steepening. 

It’s possible America rescinds some tariffs on China which would be great for businesses as it would increase visibility. Q3 earnings season has had an EPS surprise rate below the 3 year average and fewer firms have beaten sales estimates than the 3 year average. 

However, since October 11th Q4 EPS estimates haven’t fallen, so this earnings season has been a victory for the bulls. Q4 should see mid single digit EPS growth. 

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1 Comment

  • Walt

    November 6, 2019

    Very comprehensive and thorough report TT.
    Excellent