Coin Toss
Today's U.S. midterm election will soon be a spent force, in market terms. What ever the outcome, uncertainty will diminish and the negative effects, whatever they may seem to be, will be priced in. Does that mean the worst is over for the market? I think it's still a coin toss.
Despite the bounce in the broad averages, this market has yet to prove itself. Last week's 5% bounce in the S&P 500 seems more like wishful thinking than a lasting bottom. The prospects of reversing the two most important market problems, China trade and rising rates, have not have improved at all.
Bulls will say the the positive effects of deregulation and tax reform are enough. A potentially gridlocked Congress doesn't matter in an era of Executive Orders, and Twitter Diplomacy. Under a split Congress, the most likely outcome, the potential for legislative inertia is irrelevant to markets. Democrats might even be convinced to vote for enhanced spending on infrastructure, given the job creation aspects of these programs.
But with last week's strong employment numbers further reinforcing the prevailing view of rising rates, the FED is on rate-hike autopilot until hard evidence of deterioration in the economy is presented to them. And despite the conflicting reports of a potential truce in the ongoing trade war with China, detente remains ephemeral. If a simple retread of NAFTA took 2 years, how long does it take Trump to work his art-of-the-deal magic on a Chinese hard-liner like Xi?
Meanwhile, back at the economy, the growth deceleration continues to weigh on investors minds. Economic surprises have declined throughout the year, reflecting the inherent conflict between pro-growth tax reform and anti-growth tariff decisions. (see below)
Citi Economic Surprise Index
With U.S. companies in a permanent state of cognitive dissonance, CEOs are finding it difficult to invest with any degree of confidence. Their fortunes have ebbed and flowed depending on their sensitivity to trade. The global macro effect of this policy uncertainty has been universally negative. Emerging market underperformance reflects this angst.
Accordingly, the performance of the stock market has become randomized, prompting a sharp reversal of the correlation coefficient of individual stocks to the market.
Corrective phases often reveal potential clues as to the future of leadership in the subsequent bull phase. In this sell-off, Small Cap has underperformed, and Growth has corrected more violently than Value. A conclusion arises; Large Cap Value is gaining credibility as the new leadership factor. That may be simply reflecting a profit-taking mentality after such strong FANG dominance. But it may also be a tell on how a now-decelerating U.S. economy, is losing earnings momentum.
The stronger wage data in last week's Employment Report, has put companies in a cost bind. I recently talked about Amazon losing leadership. The company has disclosed a rising cost of goods sold story as their delivery system struggles to maintain the labour advantage inherent in e-comerce. And now they are talking about two new headquarters instead of one. I always have a suspicion about a company that builds new office space this late in a business cycle - and these guys are doubling the bet!
Amazon's recent earnings report that universally disappointed the street is prima facie evidence on the employment cost squeeze that is about to hit U.S. employers.
Apple's report also showed a sharp deceleration in consumer's previously inelastic demand for expensive gadgets. Cost-volume-profit models don't lie. Cue the negative revisions and downgrades.
The earnings optimism that was so pervasive just two months ago has been replaced with an increasing wave of downward revisions for 2019 earnings. Unfortunately, this is feeding into the market just as the rising rate environment has crimped valuations. Ten year yields are breaking out this morning, suggesting the valuation pressure is back on.
It's hard to see this construct changing meaningfully in the next two quarters. I'm not convinced the economy will easily transition to the higher cost world that is shaping up. I'm now predicting a phase of muddling through, a perfect backdrop for choppy, trend-less markets.
I'm not chasing the bounce here and might even short a post election relief rally. No wonder safety bets like Consumer Staples and Health Care are leading the market here. Beta-down my friends, beta-down. I don't bet on coin tosses.
Risk Model: 2/5 - Risk Off
The bounce last week gained us two positives for the model, but both are reflective of a deeply oversold condition getting temporary relief. The RSI rallied above the 45 lower limit and the 200 DMA differential was restored to the bullish range of 95 to 110%.
Unfortunately, we do not have the all clear from the Bull/Bear ratio, the Copper/Gold indicator or the 3 Month Vix. These components were all severely damaged in the correction last month and will take time to fully repair.
This fits my view of this market as one that has not finished dealing with the valuation and earnings growth re-set that has unfolded. No rush here to buy, and the downside risk to last month's lows is still to be respected.