Stocks Move Within Striking Distance Of The January Record High

Financial Stocks Power The Market Higher

The stock market went up big on Monday as it continues its recent run. The S&P 500 and the Nasdaq were both up 0.88%. The biggest trend on the day was the outperformance of the Dow compared to the Russell 2000. This shows us the trade war jitters have passed for the moment. The Dow was up 1.31% and the Russell 2000 was up 0.62%. This was a sell the rumor, buy the news trade as stocks were up the most since March 26th.

The best part about this rally is the S&P 500 is just 2.67 points away from the recent June high, while simultaneously not being overbought. The 14 day relative strength index is at 52.37 which is a neutral reading. The CNN Fear and Greed index is at 49 out of 100 which is also a neutral reading. The S&P 500 should have no problem passing the March and June double top. This means this is the going to be the best attempt at surpassing the all-time high in January. Weakness in emerging market stocks suggest it won’t make new highs; the strength in mid-caps and small caps suggest it will make new records.

As I mentioned many times, the S&P 500 needs help from the financials to break out of its 5 month range. It got that help Monday as the financial sector was up 2.29%. If you glance at the 1 year chart of the XLF, this only looks like a blip up in a downtrend, similar to the Shanghai index.

It was an interesting day for other sectors besides the financials. The consumer staples were down 0.38% which is a sizable underperformance. Since the sector’s bottom on May 3rd until Friday, it was up 6.61%. That was an oversold rally. With the ‘risk on’ action today, the sector sold off. Telecom and utilities sold off even worse as they were down 1.42% and 3.13% respectively. To complete the point about how this rally was based on the tariffs being all bark and little bite, the industrials sector was up 1.81%. Caterpillar stock was up 4.11%. That’s a big countertrend reversal as the stock fell 15.02% from June 12th to July 3rd.

Interestingly, the S&P 500 is up 4% year to date which is only slightly below the average S&P 500 performance of 4.9% at this point in the year since 1950. The hype about the volatility is based on recency bias because 2017 was so placid. This is a normal year with almost normal returns.

Treasuries Fall Sharply

In keeping with the excitement about the economy and the new found disregard for tariffs, the treasuries market fell sharply. The 10 year yield went up about three and a half basis points to 2.8564% and the 2 year yield went up over two basis points to 2.559%. This means the curve steepened slightly as the difference between the two yields is 30 basis points.

The chart below shows the 30 year treasury bond yield minus the 3 month treasury bill yield. This is a much wider difference than the 10 year 2 year spread, which means it’s more difficult to invert. As you can see, the difference is over 100 basis points which is about 70 basis points larger than the 10 year 2 year spread. If the latest pace continues, this difference will invert in the next year. This curve inverts later in the cycle which means it occurs closer to recessions. Don’t expect to wait 20 months until the next recession after the difference falls to zero.

Tariffs No Longer Matter?

There have been a few rallies in the market in the past few weeks as earnings and economic reports pushed stocks higher while the tariffs put a lid on how high the market got. The rally on Monday was different because it was a sharp rally in the face of the tariffs being implemented; the firms hurt the most by the tariffs did well. The story about tariffs initially drew a knee jerk reaction from stocks this spring, but when the dust settled the analysis showed the steel and aluminum tariffs would be puny. The only reason stocks continued their volatility was the fear of greater tariffs. By rallying on Monday and the prior few days, the market seems to think the tariffs have reached their limit. If that’s the case, stocks will break the January record. That’s a big uncertainty, however, because the rhetoric is still running hot.

According to Capital Economics, if all governments put a blanket tariff of 25% on all imports, GDP will decline 2% to 3%. That example is probably the worst case scenario. The difficulty in making projections like this is you don’t know the dynamic effect on the economy in terms of businesses being too afraid to expand and tightness in the financial conditions.

I think there’s no chance of a 25% tariff occurring anyway. The fact that such analysis is being done probably quells some worries. It’s like saying, the worst way this can go isn’t that bad. The chart below shows the U.S. effective tariff rate. As you can see, tariffs could go from slightly above 0% to slightly above 5% if the proposed tariffs go through and aren’t revoked. Expecting a 25% tariff would be forecasting a return to the early 1900s.

Conclusion

The tariff situation is very tough to analyze because you are trying to forecast the odds of trade war when we have heightened rhetoric. If you just read the statements politicians make, a trade war is likely. However, no leader wants a trade war, making it unlikely that the situation gets out of control. It’s weird to see stocks rallying after the first bigger tariffs went through because everyone knew they weren’t going to magically stall the economy. On Monday, stocks acted as if investors were surprised the world didn’t end. That makes the rally confusing. I’m on guard for another tariff related sell off.

 

 

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1 Comment

  • James Teh

    July 10, 2018

    Dear Bro Don,

    Many thanks for your advise.

    Thanks much

    Teh