First Rate Cut - Stocks Could Return Just 2% In The Year Following

First Rate Cut - Stocks Digest Gains

Before getting into the effects of the First Rate Cut, let's review the current market conditions. On Friday the stock market had a modest selloff as it digested the gains of the week and the record high on Thursday. S&P 500 fell 0.13% and VIX rose 4.41% to 15.4. 

That’s a relatively elevated VIX for such a great first half and a great month for stocks. There has been more volatility than 2017 already, but the market is on pace to trounce the gains in that placid year.

CNN fear and greed index spiked 7 points despite the decline in stocks as it is now at 52 out of 100 which is neutral. On Friday the index that measures difference in 20 day stock and bond returns went from fear to greed. CBOE 5 day average put to call ratio went from neutral to greed. 

Most sentiment indicators are in neutral which is surprising given the rally. Fears of a recession are still prevalent. While those fears are preventing euphoria, that doesn’t mean stocks won’t sell off if there is a recession.

Small Caps Underperform

First Rate Cut - To give context to how great the rally has been this year, the S&P 500 hasn’t been up 15% year to date heading into the last week of the first half since 1998. 

On Friday, Nasdaq fell 0.24% and Russell 2000 fell 0.89%. Neither have reached a new record high yet. There’s something to be said about having them hit a record high and tS&P 500 getting out of this triple top range.

Russell 2000 has significantly underperformed S&P 500 since late last year. 

As you can see from the chart below, the ratio between Russell 2000 and S&P 500 is at 0.52 which is the lowest since August 2003. It’s not good to have breadth weaken. S&P 500 might outperform Russell 2000 even more in the rest of the year because the dollar is weakening. 

DXY closed at $96.09 which is the lowest level since March 20th. The low on the year is $95.22. Even with this recent decline, the index is still up 1.67% in the past year and down just 8 basis points year to date. 

Sector Performance

First Rate Cut - Utilities increased again as the sector was up 0.47%. It’s up 17.27% year to date. Somehow bears who think the economy will roll over have done well if they bought utilities. 

Best sector was energy which increased 0.82%. Oil rallied over 9% this week which was its biggest weekly gain since December 2016. It was helped the decline in the dollar and increased tensions between America and Iran. 

Worst 2 sectors were real estate and technology which fell 1.1% and 0.46%.

First Rate Cut - Returns After First Fed Cut

10 year bond yield increased 3 basis points to 2.05%. It should get back above the Fed funds rate after the Fed cuts rates twice in the next few meetings. 2 year bond yield fell 1 basis point. Difference between the two is now 28 basis points. That’s 19 basis points above the flattest point which was in last December. 

Some investors think the inversion moment was in December. If that’s the case, investors should fear steepening. It means the economy is in a recession. Even the very weak Markit PMI doesn’t signal a recession yet. Although one is possible later this year especially if there’s no trade deal.

With the 2 year yield so low, it’s not a surprise to see the market expecting a 100% chance of a cut in July with a 32.3% chance it’s 50 basis points. There is a 65.1% chance the Fed cuts rates at least 3 times this year. I think it’s possible we see a cut in July and one in December. I also think the Fed is either behind the curve or no cuts are necessary. 

If new tariffs are added, there could be a recession by the end of the year. In which case 2-3 cuts aren’t enough. If there is a trade deal, the economy will get a temporary burst which will make cuts unnecessary.

The table below shows the returns of various asset classes after the first Fed cut. As you can see, the best places to be in the next year are the 10 year bond and oil. Stocks still increase 2% in the next year, but more than 100% of those gains are in the first 3 months where they increase 2.9%. That’s probably the last rally before the bear market for some cycles.

Solid Existing Home Sales Report

First Rate Cut - May existing home sales report was solid. Yearly growth rate will be positive in the next few months because of easier comps. Specifically, April’s sales were revised higher from 5.19 million to 5.21 million. 

May’s sales of 5.34 million beat estimates for 5.28 million as you can see from the chart below. Monthly growth was 2.5% and yearly growth was -1.1%. That's a big improvement from the 4.1% yearly decline in April.

3 month average fell 0.9% to 5.253 million. Median home prices were up 4% monthly to $277,700. Yearly growth was 4.8%. Resales were up 4.9% to 1.920 million. Single family resales were up 2.6% to 4.75 million and condos were up 1.7% to 590,000. Northeast and the Midwest had mid single digit gains. South and the West had low single digit growth in resales.

First Rate Cut - Conclusion

This set up is interesting because stocks are running on all cylinders headed into the G-20 summit. If it doesn’t go well, stocks can fall 5% very quickly. I’m not sure what to make of this summit.

 If it doesn’t go well and stocks crash, President Trump can tweet something positive to calm investors’ nerves. Therefore, it’s very difficult to short stocks heading into this meeting. I’m taking a patient approach. If there is a deal, investors will be looking to see how the economic data reacts to it.

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