Fed Acknowledges Risk Factors In Minutes

Fed - Stocks Are Getting Overbought

Before getting into the Fed, let's review the market. With the 0.41% rally in the S&P 500, the index reached a 4 day winning streak on Wednesday. More importantly, the S&P 500 is up 9.95% since the bottom on Christmas Eve.

The stock market is now overbought in my eyes. This statement is shocking because stocks were extremely oversold just a few weeks ago. The S&P 500 is already up 3.12% year to date as it inches closer to many year end targets even though the first month of the year isn’t over yet.

It’s important to recognize that the decline in earnings estimates, weak economic reports, and trade war mean the stock market shouldn’t surpass the September record high.

I’m now neutral on stocks in the short term and intermediate term. If stocks rally further, I will become bearish. CNN Fear and Greed index has finally exited the extreme fear category. It increased from 24 to 27 which is fear.

Nasdaq increased 0.87%, the Russell 2000 was up 0.86%, and the VIX was down 2.39%. Russell 2000 is up 13.57% from the bottom last month. Netflix stock is up 36.81% from its recent low. It has been helped by the success of its “Bird Box” film.

Homebuilder Stocks Explode Higher

Homebuilder stocks were the biggest winners on Wednesday as Lennar was up 7.9% and D.R. Horton was up 6.3%. XHB homebuilders ETF was up 2.1%. The index is up 15.22% from its December low. This is the biggest rally since the index peaked in January of last year.

Lennar stock was up because of its earnings report. Q4 non-GAAP EPS of $1.96 beat estimates by 3 cents. GAAP EPS of $2.42 beat estimates by 49 cents. Revenue of $6.46 billion, which was up 70.4% year over year, missed estimates by $20 million.

Interestingly, the firm deferred giving 2019 guidance because of "continued softness and uncertainty at this seasonally slower time of year."

The firm won’t give guidance until "markets further define themselves." This is the worst case scenario for investors because it gives them no certainty.

However, this was expected, so the stock rallied. It’s amazing how sentiment has shifted. Any news was considered bad news for this industry last year. Now bad news is met a rising stock price. That’s because the huge selloff last year priced in a weak housing market this year.

Q4 gross margins on house sales fell from 22.4% to 21.4%. Operating margins fell from 14% to 13.5%. The average sales price increased from $385,000 last year to $397,000. However, this is down from $415,000 in the previous quarter.

Fed - Utilities Fall Again

Best two sectors on the day were technology and energy which increased 1.24% and 1.5%. Worst two sectors were utilities and consumer staples which fell 0.65% and 0.97%. The utilities sector was extremely expensive during the middle of the correction as investors were hiding out in the defensive names.

Since December 13th, the utilities sector is down 7.36%. The sector was positive in 2018 even with mediocre earnings growth.

Fed - Treasury Curve Steepens

Good news for bullish investors is the treasury curve has steepened. Bad news is yields are falling. Lower short term bond yields mean lower expectations for rate hikes; lower long bond yields either mean lower inflation expectations or lower growth estimates.

10 year yield has fallen from 2.73% on Tuesday to 2.7%. 2 year yield has fallen 6 basis points since then to 2.53%. The difference between the 2 bond yields is now 17 basis points. One of the biggest factors affecting treasuries on Wednesday was the Fed Minutes which I will discuss now.

Fed Minutes

Fed Minutes confirm what we’ve known about Fed policy for a couple weeks. The Fed has become much more dovish than when it considered hiking rates 4 times in 2019 a couple months ago. Fed acknowledges the risks facing the economy and markets.

Powell has blinked which means the Fed won’t hike rates if risks like a weakening global economy and the trade war come to fruition. This is good news as the Fed won’t pile onto a weak market.

The bad news is either negative catalysts are activated and the Fed does nothing or the negative catalysts don’t occur and the Fed raises rates. Either we have negative catalysts or a hawkish Fed. That’s the opposite of a Goldilocks scenario.

A big issue is the Fed is close to the neutral rate. A good economy can’t be met with rate hikes that don’t hurt the economy.

As I mentioned, the Fed now acknowledges the risk factors facing the economy. In the Minutes, the Fed stated, “With an increase in the target range at this meeting, the federal funds rate would be at or close to the lower end of the range of estimates of the longer-run neutral interest rate, and participants expressed that recent developments, including the volatility in financial markets and the increased concerns about global growth, made the appropriate extent and timing of future policy firming less clear than earlier.”

Policy being less clear is good news because it lowers the odds the Fed will stick to its guidance of hiking rates twice this year.

Fed Funds Futures Market

The Fed funds futures market shows the market thinks there’s almost no chance of 2 hikes this year. Specifically, there is a 0.8% chance the Fed hikes rates twice. There is a 70.7% chance the Fed does nothing. There is a 15.5% chance the Fed cuts rates and a 13.9% chance the Fed hikes rates in 2019.

Fed - Conclusion

Stocks are now overbought as they are up almost 10% from the December low. We received a reminder of one of the reasons stocks rebounded when the Fed Minutes from the December meeting came out. The Fed is now on the side of the market. The bad news is if the fundamentals improve, the Fed will hike rates closer to the neutral rate. The Fed probably won’t hike rates in 2019. I don’t think there is much upside in stocks left this year unless the economic data turns around.

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