October 12, 2018
Stock market candlestick financial growth chart.
I sincerely hope that everyone in the path of Hurricane Michael are safe and that your electricity will be restored soon.
The big sell off on Wednesday was triggered by dramatically rising interest rates in China as well as the fact that Treasury bond yields did not significantly fall in a flight to quality and that further “spooked” financial markets. On my Wednesday podcast, I explained that we need to see (1) Treasury yields fall significantly to extinguish interest rate fears, (2) capitulation from panic selling, (3) a high volume reversal and then (4) an inevitable “retest,” so investors can make sure that the recent low is really a low. Here is a link to my Wednesday podcast:
Fortunately, Treasury bond yields started to decline on Thursday, which then allowed me to become much more positive and “see the light at the end of the tunnel” on my Thursday podcast:
Triggering the Wednesday selloff were escalating emerging market and global GDP fears, because the Chinese yuan remains weak and hit its lowest level since January 2017 this week. The real catalyst that spooked financial markets was The Wall Street Journal reported that overnight lending rates in China on Tuesday soared from 1.745% to 5%, while one-week rates have surged from 4% to 7.6%. Although the People’s Bank of China has not taken any action, the private credit in China that dominates lending has suddenly become incredibly expensive.
The People’s Bank of China has been allowing the yuan to steadily depreciate to keep China competitive, despite three separate waves of U.S. tariffs. Naturally, a weaker yuan is inflationary for imported goods, like commodities that are priced in U.S. dollars, so interest rates in China are rising. However, if credit is effectively cut off in China, its economic slowdown is expected to accelerate, which is naturally a threat to overall global GDP growth.
Speaking of interest rates, U.S. mortgage rates are now over 5% (the highest level in almost 8 years), so home price appreciation will likely stall sooner than later, despite tight inventories. Existing home sales have been slowing down and higher mortgage rates are expected to further slow down sales, since it raises the cost of home affordability. Overall, as the housing market continues to cool, it will eventually impact economic growth, but right now there is no evidence that GDP growth has been adversely impacted by slowing home sales.
President Trump has become increasingly outspoken about not liking rising interest rates, especially since inflation has not accelerated. Interestingly, President Trump has also said that he will not interfere with the Fed, even though his comments obviously have some influence. However, on Wednesday, when walking off of Air Force One, President Trump said the Fed “has gone crazy” by continuing to raise key interest rates. Clearly, President Trump wants a higher stock market heading into the mid-term elections, so the Fed is now the official culprit for the stock market correction and higher Treasury yields. It will be interesting how this White House versus the Fed battle ensues, but I suspect the Fed Chairman, Jerome Powell, will soon have some reassuring comments to calm down both President Trump and financial markets.
Selected Fed Presidents remain outspoken about the course of interest rates with the hawks apparently outnumbering many outspoken doves. However, Dallas Fed President Robert Kaplan, who favors three more key interest rate increases, also cautioned this week that he is hopeful that the Federal Open Market Committee (FOMC) will not invert the yield curve. Specifically, Kaplan said that “I do not want to knowingly invert the yield curve” and then added that inversions are a “good forward indicator” of recession. Kapan elaborated that “If you get in a situation where a financial intermediary cannot borrow short and lend long and make a spread because of inversion, it’s logical to me that it’s going to put strains on credit creation.” Translated from Fedspeak, the FOMC definitely does not want to invert the yield curve, since it will effectively cut off access to credit.
There is a fear that higher interest rates will cause stock buybacks to dry up, but so far there is no evidence of buybacks slowing. According to Goldman Sachs, stock buybacks so far this year are running a whopping 88% higher than they were during the same period a year ago. Specifically, so far through mid-September, $762 billion in stock buybacks have been authorized, so $1 trillion in stock buybacks remain possible in 2018. Corporate cash flow remains very healthy and typically high return on equity (ROE) companies will continue to use some of their cash to buyback share and boost their underlying earnings per share. Furthermore, as I mentioned in my Wednesday podcast, I expect that some big stock buyback announcements will help the overall stock market find firmer footing.
The stock market is now turning its focus from recent interest rate gyrations to the third quarter announcement season. Fortunately, the estimate earnings for the S&P 500/400/600 indices continue to steadily rise. The S&P 500 is expected to post 21.5% annual third quarter earnings growth, while the S&P 400 (mid cap) is forecasted to post 23.4% and the S&P 600 (small cap) is expected to post 35.3% annual third quarter earnings growth. In other words, as you go down the capitalization ladder, the underlying earnings environment gets stronger.
You might find it ironic that mid and small capitalization stocks have gotten off the a rough start in October, but short sellers love to try to hit powerful stocks before earnings announcements and will most likely be hiding in the upcoming weeks as that third quarter announcement season heats up. The strongest S&P sectors for third quarter earnings are expected to be Energy (up 101.5%), Financials (up 40.8%), Materials (up 28.8%), Technology (up 20.5%), Industrials (up 16.9%), Communications (up 14.8%), Consumer Discretionary (up 12.7%) Healthcare (up 10.8%) and Consumer Staples (up 7.3%). Utilities (up 4.8%) and Real Estate (up 4.3%) are also expected to post positive third quarter earnings, but are largely high dividend value stocks.
On Wednesday, the Labor Department reported that the Producer Price Index (PPI) rose 0.2% in September, which was in-line with economists’ consensus estimate. During the past 12 months the PPI has decelerated to a 2.6% annual pace, down from 2.8% in August and 3.4% in May. The core PPI, excluding food, energy and trade margins, rose 0.4% in September and has risen 2.9% in the past 12 months. Trade margins and service are responsible for virtually all the rise in the core PPI, since both wholesale food and energy prices declined in September. In fact, the overall cost of wholesale goods based on final demand prices actually declined 0.1% in September, which represents the first monthly decline since May 2017, so there is no reason to be scared of any imminent inflation on the wholesale level.
On Thursday, the Labor Department reported that the Consumer Price Index (CPI) rose 0.1% in September, which was significantly below economists’ consensus expectation of 0.2%. The core CPI, excluding food and energy, also rose 0.1% in September and was also below economists’ consensus expectation of 0.2%. Food prices were unchanged in September and gasoline prices slipped 0.2%. In the past 12 months, the CPI and core CPI rose 2.3% and 2.2%, respectively. The annual pace of inflation continues to decelerate and remains within the Fed’s inflation target.
Overall, I cannot wait for the third quarter earnings announcement season to commence, since I am expecting wave after wave of positive sales and earnings surprises, as well as positive guidance. I will be assessing how each stock reacts to their respective earnings announcements and if some stocks do not react properly and get too volatile, then I will look for good exit points. The conundrum that many socks have is that liquidity is pulsing in and out, causing many stocks to move in a herky-jerky manner, so it is best to strive to sell selected stocks into near-term strength. The liquidity drought that suddenly materialized in October and was exasperated by the algorithmic selling pressure in the Russell 2000 as well as other indices should dissipate as Wall Street refocuses on wave after wave of positive third quarter announcements in the upcoming weeks.
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