Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: Investors started the week with a bit of optimism thanks to a trade truce between President Trump and President Xi. If Tuesday’s market action was any indication, that optimism has since gone by the wayside. What went so wrong so fast?
Stovall: Well, we saw right from the start the S&P 500 futures climbing close to 60 points, intimating that the primary worry of investors was finally being addressed. But as the futures trading session continued, the jump moderated to an unimpressive level and then we ended up with a run-of-the-mill gain, only to be followed by a thumping on Tuesday. I think like a flat-footed fighter, investors were floored by a flurry of faltering fundamental influences, the lead of which was skepticism toward a near-term resolution to the trade disagreement.
China did not seem to announce the same kind of enthusiasm that President Trump did of a momentous agreement, and so I think investors started to wonder whether something would transpire in the coming 90 days. Since trade is the pivot point for earnings growth for 2019, I think investors again felt that it might be too early to celebrate.
EQ: What impact does this have on the prospects for a year-end rally?
Stovall: Well, I think it’s too early to give up on a positive move for the entire year. The Stock Trader’s Almanac points to the mid-December low through the late-January high as the only free lunch on Wall Street. So, we could be seeing a lot of tax-loss selling ahead of us in the next week or so as investors square their portfolios in anticipation of the New Year.
I think that we are going through a basing process because the S&P 500 hit an intraday low on Oct. 29 and then a closing low on Nov. 23, which still needs to be retested. So, I think we possibly are going through that retesting process now. There is still a potential for a Santa Claus rally in my opinion, but then the real question is, how is the New Year greeted? If it is greeted with green arrows, then I think investors believe that there is still reason to be optimistic as we head into the New Year.
EQ: Another concern adding to the wall of worry was a momentary inversion of the short-term yield curve. While this curve isn’t the 10-year and two-year yield curve, it did sound the alarm bells for at least some on Wall Street. What is the significance of this development, in your opinion?
Stovall: I think it’s implying that the Fed continues to push up short-term rates, and because inflation remains under control, it is keeping a lid on longer-term rates. Right now, the inverted yield curve between the two- and the five-year notes is something to take note of but could also be the result of the government selling the shorter- and intermediate-term notes as well as advisors pushing their clients into these kinds of instruments.
So, it could be more investor demand that is forcing the inverted yield curve rather than economic considerations. Still, it doesn’t mean we stick our heads in the sand and ignore it altogether because the yield curve has traditionally anticipated a recession. However, it was not a good market-timing indicator because usually the 10-year to two-year inversion has taken 11 months prior the beginning of a new recession.
EQ: In this week’s Sector Watch, you looked at the potential conclusion of this current rate-tightening cycle occurring sometime next year. As you noted, expectations are currently for two rate hikes in 2019. How would that compare to similar cycles in the past? Does that provide any insights into how the markets have historically responded?
Stovall: Yes, it’s very interesting how close this rate-tightening cycle might end up being when compared to prior ones going back to 1955. What I have found is that whenever the year-on-year change on core CPI was higher than the starting level of the Fed funds rate, the Fed tended to raise the short-term rate by 107% of that inflation measure. So, the implication is that this time around, since inflation was at 2.1%, the Fed would raise a total of 225 percentage points. Well, that would put us at about 2.5%, which is where we would be if we have two more rate increases. As Mark Twain once said, “History never repeats but it frequently rhymes.” Right now, it’s on tune for what we’ve seen in the past.
As it relates to share price performance going forward, history says that you probably don’t want to get too excited about the end of a rate-tightening program because interest rates are higher, and as a result, the S&P 500 has gained only 6.2% on average versus a more normal 8%-plus in the coming 12-month period, and it was up 56% of the time versus the more normal 72% of the time. So, in general, below average returns typically follow the final rate hike.