@theMarket: Investors Discover Value Stocks
Value stocks, those equities that have fallen out of favor, have made a comeback this week. These underpriced orphans have become the new darlings of Wall Street, while high-flyers (think software and some tech) have sold off. What does this say about the markets?
The short answer is that we have more room to run. It means, in my opinion, that we will reach and break historical highs in the U.S. averages and that we should have fairly smooth sailing into October. If, at that point, there are breakthroughs in the trade issue and the Federal Reserve Bank cuts interest rates, we could see the markets continue climbing. If, on the other hand, Trump trashes Chinese exports again and/or the Fed disappoints, than be prepared for a rout.
Now, let's handicap this binary event. If one asks Corporate America what's the chances of a deal, some 65 percent of Chief Financial Officers would tell you there is no hope of a deal over the next six months. That was the results of a CNBC Global CFO Council survey released on Friday. The survey included some of the largest public and private companies in the world.
This echoes what has become consensus among investors. The Chinese will wait until after the elections next year before striking a deal in the hopes that Trump loses the election. As a contrarian, that bothers me, so I started looking for what could go right in this area.
This week the White House floated an idea, first denied, and then confirmed. Trump is considering an "interim" trade deal with the Chinese. To me, that makes sense. It allows the president an escape hatch in a trap of his own making. He can claim a shallow victory (but more than anyone else has been able to win from the Chinese) by announcing a deal before the elections. Yes, it may simply be the same deal that the Chinese offered him a year ago, which begs the question of why he didn't take it a year ago and save investors and the world so much anguish? In any case, the tariffs could then be set aside, allowing companies and the economy to recover from a burden they have been under for the last two years.
Of course, President Trump (and everyone else) would rather get a whole trade deal with China, but why not settle for half a loaf and worry about the rest after the election next year? Several additional actions this week support my argument.
First, the president announced he would delay the imposition of tariffs on another $250 billion in Chinese exports "for two weeks." In response, the Chinese Ministry of Commerce, headed by Beijing's hard-liner, Minister Zhong Shan, said it will exempt U.S. agricultural products, such as soybean and pork from additional tariffs. These products have been added to 16 other types of U.S. imports that will be exempt from tariffs.
Does anyone sense a deal in the making?
As for the Fed, I expect at least a 25 basis-point cut in the Fed Funds interest rate. Now that the European Central Bank announced a new stimulus program this week (see yesterday's column on the event), the pressure is on for our central bankers to at least act a bit more dovish.
But back to value stocks and their recent outperformance. Recently, the price divergence between value and momentum/growth stocks has been greater than at any time since the 1990s. The same holds for small-cap companies versus large-caps. The darlings of the investment world, the FANG stocks, for example, have carried the stock market higher for years. A rotation into the sectors that have largely been ignored by investors makes sense to me.
As such, the averages that most investors use to gauge performance may not be telling the whole story. Basic materials, industrials, small cap, even commodities, may outperform, while the growth and momentum names could underperform, at least in the short-term until they catch-up to the markets in terms of valuation.
@theMarket: The Summer of Financial Discontent
As we close out the summer, investors have had anything but a sleepy three months. The volatility caused by the Fed's actions, Donald Trump's tweets, Brexit, and tariff threats had markets gaining and losing billions — if not trillions — of dollars in assets on a weekly, and sometimes, daily basis.
The question you might ask is "Will it continue?" The short answer is yes, at least into October, unless a trade deal is signed. And what are the chances of that happening? Not very high, if you listen to the experts who profess to know and understand China.
A respected Deutsche Bank economist, Yi Xiong, wrote in a recent report that China has made up its mind to play the long game, something I have been warning investors might happen. Rather than come to the table, China will look to strengthen their domestic economy, while enduring any tariffs the Trump Administration might inflict upon them.
In order to understand their decision, you need to realize that China has been working for almost a decade to transform their economy from an export-led economy to a consumer-driven domestic powerhouse. As a result of this transition stage, China's GDP has been cut roughly in half from 12 percent annually to 6-6.5 percent today. The government hopes to complete the transition by 2025 or so.
As such, external trade makes up a small portion of their economy, no more than 20 percent of GDP and this percentage keeps shrinking. Contrary to the rhetoric you may be hearing or reading on Twitter, the majority of that trade is not with the U.S. As much as 80 percent of China's exports have gone to other countries, rather than the United States.
As a result, the trade impact thus far on China has barely dented economic growth, contrary to claims made by others. While the overall economy has slowed, most of the decline can be accounted for by China's own actions. In their stated desire to reduce national debt, government investment has declined, as has consumer spending, which accounts for most of the shortfall in their economic growth.
In response to the expected levy of U.S. tariffs on all their exports, China plans to adopt measures to grow their domestic economy. Additional spending on infrastructure and measures to boost domestic consumption have already been announced and are being implemented today.
At the same time, the government is diversifying its supply chain. It is accelerating efforts to open up their economy to other countries, while reducing reliance on the U.S. over the longer term. And as for combating the tariff hit to the price of their export goods to the U.S., China will most likely continue to devalue their currency, the yuan. This last month, the yuan has lost about 3.7 percent against the greenback, the biggest monthly decline since 1994.
What will all this mean for our markets and economy? More of the same, in my opinion. Without a trade deal, U.S. companies will continue to put off investment, which will, in turn, slow our economy (and earnings). Most other regions of the world are already in worse economic shape than we are, so don't count on any spill-over in growth from elsewhere. Interest rates should continue to slide, sparking more and more calls for an imminent recession.
Our side will continue to raise, and lower hopes of a deal (most of which will be simple fabrication), while blaming the Fed for any shortfall in growth. The president will deny that his tariff war has any impact on the economy, while desperately seeking ways to shore up the economy by more tax cuts, etc. If he fails, I expect he can always blame the Fed.
The only saving grace out of all of this may be the central bank and what it decides to do in two weeks. If they cut rates (and by how much), it may give the financial markets some support. In which case, you could see a big spike up as a result. Otherwise, expect more volatility while being trapped in a wide trading range.
@theMarket: Tariff Threat Unsettles Markets
Donald Trump's announcement on Thursday that an additional 10 percent tariff will be levied on the remaining $300 billion in Chinese exports to the U.S. on September 1 did not sit well with investors. The news could very well trigger the stock market decline that I have been expecting.
Regular readers know that I have been waiting for a 5-7 percent pullback in the markets fairly soon. Since the first two weeks of August are usually a bad time in the markets, the pullback this week might be right on cue.
In my last column, I also explained in some detail how it appeared that Donald Trump had no intention of negotiating in good faith with the Chinese this past week during meetings in China. The Chinese, evidently, felt the same way. Nothing was offered to move the negotiations forward by either side.
That suited the president just fine because he was using the potential of a deepening trade war, in my opinion, to pressure the Federal Reserve Bank into a series of interest rate cuts. However, Jerome Powell, the chairman of the Federal Reserve Bank, failed to deliver what he wanted on Wednesday.
Powell is stuck between a rock and a hard place. He did acquiesce (to some degree) to Trump's demands, while attempting to preserve his and the Fed's historical and legal independence. He cut rates by one quarter of one percent, but then left the impression, while talking to reporters in a press conference, that the cut was simply a "mid-cycle adjustment" rather than the beginning of a series of further interest rate cuts.
That disappointed the financial markets. Some investors hoped to have seen even further easing in the months ahead. It also angered the president, who made his displeasure known through his usual channel on Twitter. "What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle, which would keep pace with China, The European Union and other countries around the world," Trump tweeted after the Fed FOMC meeting.
None of this should come as a surprise to you, if you have been reading my columns. Last week I wrote "If the Fed does cut rates, we will see what the president's next move will be. Of course, that is not entirely within his control, since China will have an equal say in what kind of deal is struck and when."
Thursday afternoon, Trump announced that next move by threatening to levy a 10 percent tariff on all the remaining Chinese export goods to the U.S. It was a completely predictable and expected response from the president, given his character. While the markets swooned focusing on the impact of these new potential tariffs on the U.S. and world economy, I've taken a different view.
To me, Trump is simply doubling down on his demand for more rate cuts. Slapping tariffs on the Chinese, he is hoping, will tip the Fed's hand into doing exactly what he wants. And believe me, he will do all he can to institute those tariffs.
It seems clear to me that the Chinese have given up working toward a trade solution with Donald Trump. They realize (according to the official Chinese news agencies) that no deal will be struck any time soon, or at least not until after the 2020 election. They are probably right, unless Trump perceives that he needs a deal to get re-elected.
Instead, their plan is to hunker down, alleviate the impact of these costly tariffs on their economy, and wait it out. They are very good at that. And who knows, Trump might actually lose in 2020, setting the stage for possibly better terms from a future administration.
In the short-term, Trump's willingness to disregard the independence of the Fed, and postpone a U.S./China trade deal, while manipulating financial markets for his own apparent political gain sets a dangerous precedent. Markets, therefore, will continue to gyrate but it is what it is.
So how do you take advantage of all this market noise and manipulation? Stay invested. If I am right, simply wait for the Fed to cut interest rates again in September, (regardless of economic necessity) thanks to Trump's shenanigans, and watch the markets come roaring back.
@theMarket: All Eyes on the Fed
It was a week of chop. That was to be expected, given it was the first week of second-quarter earnings results. While some individual big-name stocks made substantial moves, the overall indexes traded up and down but ended the week about where they started.
It was largely what I predicted would happen. The same will apply to this coming week with all eyes intently focused on the July 31 meeting of the Federal Open Market Committee taking place next Wednesday. Investors expect the Fed to cut the Fed Funds interest rate by at least one quarter percent. Let's hope they do.
In the meantime, aside from earnings announcements, investors were confronted with some bad news out of Washington. After months of waiting, the U.S. Justice Department finally announced that the U.S. government has launched an investigation into the largest U.S. technology companies. Specifically, authorities will be trying to determine if the likes of Facebook, Apple, Google and Amazon are guilty of anticompetitive practices. If they are found guilty, that could lead to antitrust charges.
Actually, I was impressed with how well the markets held up given that the above named "FANG" stocks have been the market leaders for years. The four companies represent a substantial weighting in many of the U.S. indexes, such as the S& P 500 and NASDAQ indexes. While no one knows how long until, or even if, any of the companies will ever be charged, the investigation will cast a pall over the group for some time to come.
So, while investors grabbled with the bad news from this Justice department, over at the U.S. Treasury, Stephen Mnuchin, its Secretary, announced some good news. Both he and the White House's Chief Trade Representative, Robert Leigthizer, are off to China Monday to resuscitate high-level negotiations with their Chinese counterparts on trade.
While traders cheered the China news, my own belief is that talks are going to become even more difficult now that China's Trade Minister Zhong Shan has joined their negotiation team. Shan, while regarded as capable, knowledgeable, and professional, is also considered a "hard-liner." As such, he could make discussions even more difficult and probably will. That might fit into the president's game plan.
It is my own belief that Donald Trump does not want a breakthrough deal announced quite yet. One of the chief reasons investors are expecting the Fed to cut interest rates is the fear that an escalation in the U.S./China trade war would cause havoc with our economy. Until there is a deal, that China threat is hanging over our economy.
Trump is keenly aware of this. The president is also on the record in demanding that the Federal Reserve Bank cut interest rates now in order to grow the economy. But that does not mean a recession is looming in front of us. Friday's second quarter Gross Domestic Product (GDP) report came in at 2.1 percent which was above the expected growth rate of 1.8 percent. While consumer and government spending were strong, business investment slowed.
The probability of a U.S. recession over the next 12 months is less than 33 percent, according to research released by the New York Federal Reserve Bank. As such, the Fed's expected interest rate cut next week (if it occurs) is believed to be little more than monetary "insurance" just in case talks break down, in which case, Trump has threatened to then levy another 25 percent tariff on the remaining $350 billion of Chinese exports to the U.S.
If the Fed does cut rates, we will see what the president's next move will be. Of course, that is not entirely within his control, since China will have an equal say in what kind of deal is struck and when. As for the markets, enjoy the ride, but be aware that some time soon we could see another 5-7 percent pullback.
@theMarket: Looking Ahead
Will the second half of the year be as good as the first half for the markets?
The S&P 500 Index finished up 18 percent for the six months ending June 30. That was the best first half since 1997. Historically, that kind of return is three times the gains investors can normally expect from the market in an average year. The chance of a repeat performance in the next six months is, at best, remote.
That doesn't necessarily mean this is as good as it gets for stock investors. My near-term target for the S&P 500 Index is somewhere around 3,050, which is a further 4 percent gain from here. From my vantage point, as long as interest rates continue to decline and the Fed stays at least neutral, we go higher.
For the time being, the China trade tariff worries are off the table. As I predicted last week before the G-20 meeting, Donald Trump adhered to his "speak loudly, but carry a little stick" foreign policy. He relented on a number of issues, including holding off on any further tariffs on China, at least for the time being.
While the markets rallied on Monday as a result, they quickly gave back their gains since investors are beginning to learn that not everything that our president says will necessarily be accurate, or when it is, his statements are almost always an exaggeration of reality. The Fed, on the other hand, is a different kettle of fish.
You might ask why the markets are continuing to rise when economic growth here and abroad continues to slow. First, recognize that the economy and the stock market are two different entities. What may not be good for Main Street (slowing employment gains, sluggish business investments, weakening quarterly earnings), in this case, increases the chances that the Fed will cut interest rates as early as this month and that would be good for the markets.
At this point, despite the Fed's refusal to confirm or deny an interest rate cut, the financial markets are convinced they will cut. The odds of a Fed interest rate cut by July 31 have surged to 100 percent. While 72 percent of traders are counting on a quarter-point cut, almost 28 percent of traders are expecting a half-point cut. That in itself is astounding, since the Fed has not cut rates by that much in many years. Over 60 percent of bond traders are also counting on another rate cut as early as September, according to CME Fedwatch.
Whenever the markets are unanimous about anything, I usually feel the hairs on my neck begin to tingle. Given that the stock markets are climbing, based on that interest rate assumption, it behooves the investor to ask what will happen if everyone has it wrong and the Fed doesn't cut? The short answer would be look out below.
And as we close out this holiday-shortened week, remember that when we get back second-quarter earnings season will be upon us. Right now, consensus for second-quarter earnings results for the S&P 500 is a scant 0.2 percent. Third quarter estimates are not much better ( 0.7 percent gains). What is concerning to me is how corporate managements are going to spin the impact of the existing tariffs on their bottom line.
In past quarters, analysts have ratcheted down their earnings expectations to such a low levels that investors were pleasantly surprised when companies announced better than expected earnings and sales guidance. It could happen again, so let's say I am neutral on earnings results until we see how many beats versus misses happen early on.
In any case, it appears the administration is bringing out the Big Guns to pressure the Fed into cutting rates this month. Don't underestimate Trump's ability to influence events in that area. Trump believes that the Fed should be his policy instrument and an extension of his presidential power in the financial arena. He has already threatened to fire, replace, or demote the Fed's Chair, Jerome Powell (his appointee), several times.
In a further attempt at bringing the Fed under his control, this week Trump has proposed two more additions to the Federal Reserve Board, Christopher Waller and Judy Shelton. Both candidates appear to be far less independent than past candidates for the job. One of the two (Shelton) has already expressed a desire to see interest rates in the U.S. at 0 percent within the next year or two. That should be music to the ears of the president.
In any case, enjoy the markets, enjoy the Fourth of July, and I'll see you after the holiday.