Commodities

The IMF Downgrade is Old News

In a move that should have surprised no one (this would have been useful about three months ago), yesterday’s IMF downgrade of the global growth outlook for 2015 and 2016 did put a dent in some markets. The IMF downgrade cut estimates by 0.20% for each year, respectively.

The IMF downgrade astutely cited emerging markets as anchors on developed markets’ (US, Europe, Great Britain, Japan) recoveries, and stated that downside risks to global growth had become “more pronounced.”

This negative revision to growth did get a lot of attention, but all the IMF downgrade does is bring IMF economists back in line with most of the major research firm’s global growth estimates, so this was not incrementally new negative commentary on the global economy.

From a markets’ standpoint, the IMF downgrade did elicit a response as the dollar got hit on the news and Treasuries rallied. But the IMF growth cuts are not reasons to be more negative on the dollar or positive on Treasuries.

IMF downgrade

The “dovish” response yesterday was because the IMF downgrade will put pressure on the Fed to further delay rate hikes.

Yet in reality, the IMF downgrade isn’t dovish for two main reasons:

  1. As stated, the IMF’s “new” global growth expectations are the same as everyone else’s current growth expectations. So, they are already mostly priced into the dollar at current levels.
  1. If global growth slows further, more central banks will ease policy, making the dollar rise in value (Treasuries will receive some inflows in this scenario but it likely won’t be too materially bullish).

Bottom line, beware bold proclamations for inter-governmental agencies, as they are usually dated, and not particularly useful to solving the problems at hand.

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Delayed Rate Hikes Didn’t Send Stocks Higher

Yesterday I saw in multiple financial news sites (including some of the best like the Wall Street Journal, Financial Times and Reuters) say that stocks were rallying on the hopes of delayed rate hikes and longer 0% interest rates. We and others have (correctly) been saying for months that the “bad” economic data is no longer “good” for stocks, and that remains the case following Friday’s jobs report.

Stocks have not rallied over the past two days because of rising hope of delayed rate hikes and continued ZIRP (Zero Interest Rate Policy). Instead, stocks have rallied because of five primary factors.

1) More than six weeks after the initial break in August, incremental selling exhausted itself last Monday. So, in order for more selling to appear, the fundamental outlook needs to deteriorate further (i.e. all the current bad news has already been priced in).

2) The S&P 500 generally held a “test” of the August lows at 1,867 earlier last week and when the S&P 500 held 1,900 Friday morning it resulted in short covering, which then led to buyers “chasing” markets higher because very few people are positioned for a rally right now, and a lot of PMs are light on stock allocations.

3) The jobs report wasn’t a broadly negative catalyst. While disappointing, it was not “bad” by itself and it didn’t meet our “Too Cold” criteria (headline job adds did, but Unemployment and Wages were in the “Just Right” range).

delayed rate hikes

4) Fundamentally, Friday’s jobs report didn’t change much for the Fed. October was always virtually a zero probability, and there is still a lot of data and time between now and the December meeting. Yes, the soft jobs report made the focus on the domestic economy more acute, but right now the macro situation is fairly priced in the 1,900-2,000 S&P 500 range.

5) Finally, China is showing some initial signs of stabilization, and since much of this market turmoil emanated from China that’s a potentially positive sign.

Bottom line, Friday and Monday’s rally was a lot more about short-term positioning than it was anything really fundamental, and it certainly was not because the market was looking for delayed rate hikes.

If the next round of economic data gets bad, and if that causes delayed rate hikes, that will not be good for stocks.

Strong economic growth and a Fed that feels compelled to raise rates remains the key to a sustainable rally.

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The Market Rollercoaster Continues

The market rollercoaster continued Friday after markets initially gave back all of Thursday’s rally following the disappointing September jobs report, only to recover midday and squeeze higher into the close to finish solidly positive.

So, what does Friday’s turnaround market rollercoaster mean for stocks?

Friday’s turnaround happened for two reasons: First, the jobs report was disappointing, but not awful. And, as Friday moved on it sunk in that the report isn’t materially changing anyone’s outlook on the US economy just yet. Point being, with the S&P 500 basically near the lows for the year, that jobs report wasn’t reason to sell.

Second, a lot of the de-risking that needed to take place has taken place, so there is a lack of incremental sellers. We saw that when the market rollercoaster held support at 1,900 early Friday, and once it did, shorts began to cover and buyers stepped in. The significance of Friday’s turnaround is that selling pressure may have abated, and a rally back towards the upper end of the trading range (2,000 in the SPX) is possible.

market rollercoaster

The market rollercoaster remains very macro driven, but there are two important micro trends to monitor.

First, biotech and materials stocks are leading indicators for stocks. NBI (biotech index) rebounded from extreme weakness while Glencore (which is now a proxy for systemic risk from the commodity crash) also recovered from early losses last week. Both biotechs broadly, and Glencore/materials stocks, need to continue to stabilize short term.

Second, the banks got hit hard in the market rollercoaster following Friday’s jobs report, and headwinds on banks continue to build short term as Fed rate liftoff gets further delayed. But, unless you think the US is about to enter another recession, we think there is going to be a lot of long-term value in banks once these headwinds start to abate.

So, while we wouldn’t be pounding the table now, longer term we view this weakness as an opportunity.

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September Jobs Report Preview

The importance of this month’s jobs report has been reduced following the September Fed statement, where the FOMC shockingly “moved the goal posts” and made equity market volatility and the international growth outlook primary factors that will decide whether rates increase later this year.

That said, this jobs report is still important for multiple reasons, but the fact is this will have to be a “blow out” number to put an October hike on the table.

Keep in mind that a “Too Hot” or hawkish number is now positive for stocks and risk assets, as it increases the chances of a rate hike in December. Meanwhile, a “Too Cold” or dovish number will be negative for stocks.

“Too Hot” Scenario (What it Takes to Hike in October)

> 300k Job Adds. It’ll take a huge number to put October back on the table, and over 300k jobs added will definitely get the FOMC’s attention.

< 5.0% Unemployment Rate, ≤ 10.0% U-6 Unemployment Rate. In the March statement the Fed lowered “NAIRU” to 5.0% and below, but last month said it could stomach a temporary overshoot. So, it’ll take an unemployment rate with a “4” handle on it to get the FOMC to consider an October hike.

> 2.5% yoy wage increase. Wage inflation picked up a bit in October, but again the FOMC said it’ll tolerate an overshoot near term, so it’ll take another spike in wages to get the Fed to consider moving in October.

“Just Right” Scenario (No Oct. Hike But Dec. Probable)

150k—300k Job Adds, 5.0%-5.3% Unemployment Rate, 2.1% – 2.3% YOY wage increase. The range for this jobs report number to be “just right” or “Goldilocks” is pretty wide, and anything in this range likely means no hike in October but still a decent probability of a hike in December.

“Too Cold” Scenario (No Hike in 2015) 

< 150k Job Adds, ≤ 2.1% yoy wage increase. This will not be a good jobs report number because it’ll imply the US economy may be losing momentum, and it will reduce the chances of a December hike—both of which will be decidedly negative for stocks.

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Headwinds Priced In, and Not Priced In

For the past several weeks, I’ve been telling subscribers to The 7:00’s Report about the headwinds facing the equity market. While some of those can be considered headwinds priced in, others are not priced in, and therefore represent future danger for investors.

Here’s a quick rundown of the headwinds priced in, and not priced in.

Headwinds Priced In: Fed Uncertainty & Slowing Chinese Growth. Fed uncertainty and slowing Chinese growth are responsible for the collapse in markets in Q3, but at this point they are more of an impediment to a rally than a catalyst for further declines.

Potential Market Influence: None to Positive (as they are already priced in) if these headwinds are removed.

Headwinds Priced In (Partially): Slowing Domestic Economic Growth, Lowered 2016 EPS Estimates. So far, the US and most developed economies have withstood the emerging market turmoil, but the longer it goes on, coupled with stock market volatility that will weigh on sentiment, the greater the risk that US economic growth slows.

With earnings, its widely expected 2016 EPS estimates will come down, but the question is by how much. As we approach Q3 earnings season, anything greater than $125 for 2016 is neutral to positive, while anything below $125 will be a headwind.

headwinds priced in

Potential Market Influence: Positive or Negative. Some of these headwinds are at least partially priced into stocks here, so if they fail to materialize it will be a positive. Conversely, if they do materialize, then they are not adequately priced in. How these two issues are resolved will likely determine Q4 performance.

Headwinds Not Priced In:

1) The Commodity Crash Becomes a Systemic Issue.

2) The Junk Bond Market Declines Further, Putting Funding Stress on Companies.

3) Government Shutdown in December.

Each of these represents remote possibilities, but they cannot be ruled out.

Potential Market Influence: Very Negative. None of these events are priced into stocks right now, and there’s only one way it will influence: downward.

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A Second Phase of Selling

Yesterday’s selling was uglier than it should have been given the news and fundamentals, and I am now getting concerned that this decline in stocks may be entering a second phase of selling where price action itself is the downside influence.

Specifically, extreme weakness in the biotech stocks (and healthcare more generally) and the industrial miners has been the reason for this second phase of selling and steep decline since Friday.

And, disconcertingly, yesterday I read a few articles warning about so-called “counterparty risk” re: mining and trading giant Glencore (although to be clear, that’s still just a general concern at this point).

The bottom line is that fundamentally there is no reason 1,867 in the S&P 500 Index should be violated, and I remain of the opinion that it won’t be.

second phase of selling

If anything, we’ve had slightly incremental progress in China and with the Fed since last week. However, the biotech sectors and industrial miners need to stabilize to end this second phase of selling.

If they do not, then fundamentals won’t matter in the very near term because the second phase of selling in those sectors is starting to feed on itself. NBI (the Biotech Index) is now another leading indicator to watch along with JNK and DBC.

second phase of selling

From a protection standpoint, EUM remains the best pure-play hedge out there for this market (up another 2.33% yesterday). This remains a good, liquid alternative if you are looking for a hedge (and at this point we should all have hedges at least on our radar).

Plainly, this market needs some good news to break the cycle of negativity, to end the second phase of selling and to refocus investors, but the calendar isn’t helping/. The next major catalyst for stocks is Q3 earnings season, which begins in earnest two weeks from now (week of October 12).

Until then, 1,867 is now very critical support, and must hold if this second phase of selling is to cease.

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Market Headwinds: Step Forward, Step Back

Two major market headwinds remain for equities: Lack of Fed clarity and concerns about Chinese growth. While there was some slight progress in both last week (which was incrementally positive), it was counteracted by renewed uncertainty in Washington following the news that House Speaker John Boehner had resigned. So, it was one step forward, one step back for market headwinds.

The major takeaway from the Boehner resignation is that the chances of another government shutdown/debt ceiling drama in December are now high, although near term the chances of a shutdown are minimal, the uncertainty still represents another form of market headwinds.

Starting with the one step forward, Fed Chair Janet Yellen and the other Fed officials that spoke last week did undo some of the damage from the September FOMC meeting, and the likelihood of a rate hike in December rose slightly.

However, a rate hike in December is not a certainty (an imminent rate hike is needed for stocks to move materially higher) and Fed credibility has still suffered (needing to further explain your own statement less than a week later does not inspire general confidence).

In China, manufacturing PMIs were light but Nike (NKE) earnings underscored the strength of the Chinese consumer, and with a lot of stimulus in the pipeline China is not one of the macro market headwinds that is was back in August.

market headwinds

Even ignoring Washington for a moment, though, those two incremental positives are not enough to warrant more aggressively buying this dip in markets.

As a result, we remain “Neutral” on stocks. While near-term downside risks from market headwinds have diminished (1,867 should hold barring a government shutdown in December or a horrible Q3 earnings season) stocks still won’t be able to mount a decent rally until the two aforementioned market headwinds are removed.

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An Interest Rate Hike While the World Eases

In her speech last night, Fed Chair Janet Yellen identified herself as one of the FOMC members who did expect an interest rate hike by year end, which is “hawkish,” and good for stocks. Yellen also nearly fainted at the end of her speech, but apparently she’s fine.

Interestingly, the speech comes on the same day that the central banks of Norway and Taiwan both surprisingly cut their respective benchmark interest rate, joining a growing list of global central banks to cut their interest rate or ease policy in 2015.

The Norwegian Central Bank cut its interest rate to a new all-time low at 0.75% while the Taiwanese Central Bank cut interest rate for the first time since 2009 to 1.75% from 1.875%.

I point this out not because either move will impact the dollar directly or help stimulate global growth, but instead because it’s a reminder that seemingly the entire developed (ex-US & UK) and emerging world is in an interest rate cutting cycle.

interest rate

As we have seen over the past week, being “dovish” will slow the rise of the dollar, but it won’t depress it, not with the rest of the world an interest rate cutting cycle. So, to a point, the “virtues” of the Fed being “dovish” via a weaker currency can’t be attained, and they are coming at the expense of clarity on policy and credibility.

I’m oversimplifying it, but a policy where you get little to none of the main benefit (a weaker dollar) and all of the cost (Fed uncertainty and loss of credibility) isn’t a particularly good one, and that’s why the Fed remains a headwind on stocks.

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Why a Hawkish Fed is Good for Stocks

The last big Fed event this week comes from Fed Chair Yellen this afternoon, where she will give remarks on the economy and monetary policy. While I and others hold out hope that she will further clarify the FOMC’s position on rates, and that she sounds more “hawkish,” I don’t think that is going to happen. As a result, Fed uncertainty will remain a headwind on stocks going forward.

From a market standpoint it’s important to realize why a hawkish Fed is now a positive for stocks. We saw that Monday when hawkish Fed rhetoric from three Fed officials over the weekend, and again Monday morning, was a major influence on the initial stock rebound.

As you likely know by now, Messrs. Bullard, Williams and Lacker all stated that the vote on whether to hike rates was “very close,” and that all expected a more hawkish Fed turn that would hike rates in 2015—somewhat contradicting the very dovish FOMC statement, projections and press conference.

So, markets will welcome a hawkish Fed because the market is getting increasingly more desperate in demanding a rate hike, and it’s for good reason.

First, banks, which largely led the rally this year, need to have credible chances of a rate hike in order to sustain their rally. And, it’s not coincidence that the big break in stocks that was led by the banks happened August 20, the day after exceedingly dovish FOMC Minutes.

hawkish Fed

Second, a rate hike will lead to a rally in the dollar which will pressure emerging market currencies, and that’s exactly what’s needed to help create economic growth in those countries as the commodity rout continues.

Third, a hawkish Fed that finally hikes would in some ways act as a rate cut. Fed uncertainty and doubt about the global economy is causing natural tightening by the market, as banks, businesses and potentially consumers begin to react to continued emerging market turmoil, policy uncertainty and US and European stock market volatility.

By hiking rates, projecting confidence and giving clarity, the Fed would provide certainty on policy that organizations need—and in some ways that would create a “phantom cut.”

Sadly, our confidence in this occurring before December (at the earliest) is low.

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Is Market Valuation Cheap, Fair or Rich?

Now that rate liftoff is basically off the table until December, and with Chinese growth issues well known by the market, the issue of market valuation is emerging as the key unknown major influence that will influence stocks between now and year end.

Having an idea of current market valuation (and the potential movements) is also very important given the random and violent nature of the current selloffs.

Case in point, nothing happened to cause Tuesday’s volatility, but the market still dropped by more than 2%. Having a market valuation guide will allow us to keep our heads about us should we see a repeat of late August (and hopefully allow us to buy longer-term value).

The major question facing stocks from a market valuation standpoint is: “What is the right FY 2016 S&P 500 earnings number?” It’s been falling all year, but the general consensus now is that it’s $130 (so, if you totaled up all the full-year EPS of each of the S&P 500 companies, you’d get $130).

Market valuation

That means that right now, the S&P 500 is trading a little less than 15X earnings (14.86 to be exact). Given GDP and employment, that’s actually cheap, historically speaking.

The problem is that most people don’t expect 2016 EPS to stay at $130. Instead, it’s expected they will drop to $125, or maybe even $120.

If that happens, then market valuation is no longer “cheap” because at $125 FY S&P 500 earnings, the S&P 500 is trading at 15.5X earnings, which is a bit under fair value. If 2016 EPS is 120, then the S&P 500 is trading at 16X earnings.

So, whether this market is “cheap” at current levels depends on 2016 EPS, which are in flux.

We haven’t seen anyone who thinks 2016 EPS will drop below $120 (that would probably take a recession).

We view any market valuation below 15X earnings as long-term “Cheap;” anything above 16X as “Fair Value,” and anything above 17X as “Rich.” Above 18X and it’s just plain “Expensive.”

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