Fed Roadmap

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When I think about what’s become of the Fed, it almost makes me sad.

I’m dating myself a bit by saying this, but when I started in this business the Fed was a revered (and sometimes feared) institution.

  • In the early 80s, “with a tear” in his eye, Volker rose interest rates and broke inflation.
  • In the 90s, Greenspan was the “maestro” that helped support the best economic run in decades.
  • In the late 00s, Bernanke was steadfast through the crisis.

So, when I saw the market reaction to yesterday’s “hawkish” statement, it made me a little sad, because the market clearly no longer respects the Fed.

And, that makes me nervous.

I say that because while the Fed has successfully engineered massive rallies in both stocks and bonds (and, to a degree, real estate again), at some point things have to begin to return to normal, otherwise we’re going to get another bubble burst.

Yesterday’s price action was scary because it implied the Fed has potentially lost control of the markets, and if that is the case then we are going to see a bubble further inflate and then burst across all asset classes (stocks, bonds, real estate).

Given how fundamentally overvalued stocks and bonds are right now, it’s not unreasonable to think that we could see a 5%, 10% or even 15% decline in both
stocks and bonds (like last August, but worse) if the Fed does lose control and then tries to rein markets back in through a knee-jerk increase in rates.

Is that going to happen next week, or even next month?

No.

The trend in stocks is still higher, and 2200-2240 in the S&P 500 remains a very reasonable near-term target.

But, most of us aren’t investing for the next few weeks or months, we’re investing for quarters and years, and the bottom line is that yesterday’s reaction in stocks might be good in the short term, but beyond that—and unless something changes—we’ve got two unattractive alternatives:

  1. The Fed continues to lose credibility
    and asset prices simply run higher as the bubble expands, only to ultimately pop at some point.
  2. The Fed realizes it has lost credibility and shocks markets with more rate hikes than expected, potentially undermining the whole catalyst for the stock and bond rally.

No one knows how it’ll go, but the important thing is to be reading someone who recognizes these risks, and someone who is watching specific assets and leading indicators that will give us warning when this unsustainable situation comes to a head (and importantly, provides tactical guidance on how to protect client portfolios).

Over the coming weeks and months, we’re going to be doing that for our subscribers because our goal at The Sevens Report is to wake up each day and help our subscribers navigate these complex markets, and provide the best value in market analysis out there today.

I created this report because I know that most financial advisors and professionals are not glued to blinking screens from 9:00 – 4:00 each day.

They are discussing the financial goals of their clients and mapping a financial course to reach those goals. Most of their time is spent building and fostering relationships, not analyzing Fed commentary, studying the yield curve, or digging through an oil inventory report.

The most successful advisors use The Sevens Report
to stay ahead of the markets (stocks, bonds, currencies and commodities) and to make sure their clients are positioned to both outperform while also being protected from any financial “storm” that may blow up.

Specifically, we take complex macro-economic concepts (like FOMC Policy, Brexit, Jobs Report, Italian Bank Risk, etc.) and tell you:

1) What you need to know,

2) What will move markets, and

3) What will make those events positive or negative for stocks and other asset classes.

Every morning at 7 a.m. we deliver this information, so you can show your clients you’re on top of the markets with a plan to outperform, regardless of the environment.

Yesterday the Fed produced a “hawkish” statement that undoubtedly was designed to get markets to respect the possibility of a rate hike this year, but the effort failed, and while that likely will fuel incremental upside in stocks, it lays the foundation for a potentially violent pullback down the road if the Fed wants to regain the market’s respect.

As a courtesy, we have included both of those pieces of analysis for you today:

Why Was the Fed Hawkish but the Market Dovish?

In a somewhat shocking turn of events, the dollar declined following the Fed statement yesterday and Treasuries (including the Fed-sensitive 2 year) rose, which is the exact opposite of what should have happened based on the FOMC statement.

The reason for this opposite reaction is clear: the market does not believe the Fed anymore.

An old saying on Wall Street is, “Markets always tell the truth.” And the truth is that after a year of policy whipsaws, conflicting statements and consistent dovish excuses, the Fed has lost all hawkish credibility—and with good reason.

First, we’ve seen this act before. The Fed was hawkish last July, but balked at hiking in September. Then they were hawkish in December and said to expect three-to-four rate hikes. Then the entire month of May, various Fed speakers chastised the markets for being too dovish (yes, we’re talking to you Rosengren), only to have the FOMC produce a very dovish statement in June. So, the logical question is… “Why should we believe them now?”

Second, who cares about one 25 bps rate hike? Whether there is a rate hike in September or December, the market doesn’t believe the Fed will hike rates consistently beyond that one hike, regardless of what happens to economic growth or inflation. And frankly, why should markets expect it? It’s taken the Fed nearly a year to hike another 25 basis points, so why should anyone think that will change next year, especially after the Fed keeps talking “gradual rate increases.”

What will change it? It’s going to take Fed Chair Yellen basically saying she is in support of a rate hike sooner than later to re-establish credibility with the market, because at this point the market simply thinks that while there may be a growing number of hawks on the FOMC, Yellen is not one of them, and it’s her Fed.

Market Outlook: What’s Next

Safety vs. Cyclicals Update. The last two days have certainly caught my attention with regard to whether this rotation out of safety and into cyclicals has finally begun in earnest, but it’s still not enough for me to settle on the idea that it has.

There have been many false starts in this rotation over the past few years, and if the market is really skeptical about the Fed hiking rates near term, then defensive sectors are still attractive beyond the very short term.

So, we are not materially reducing our medium- and longer-term holdings of defensive sectors and won’t until we see a material breakout higher in the 10-year Treasury yield (paid subscribers know the levels we are watching).

However, we are thankful we bought a specific bank ETF as a near-term hedge against safety sector underperformance. Since we bought our specific bank ETF two weeks ago, it’s risen 2%,
and we will likely add to it over the next few days if it can make a fresh closing higher above $40.57. This sub-sector of the banks remains one of the few areas of historical value in the markets.

Next Key Event to Watch:
The Jackson Hole Fed conference, which takes place in late August, has now become pretty important.

If Yellen is going to try and regain the market’s respect or prep investors for a potential rate hike in September or December, she will likely do it at her speech at that conference.

So, that’s a day to pencil in for a potential disruption to this rally, and we’ll be watching the Fed speak closely over the next month to discern any hints about what Yellen will say, because if she forecasts a rate hike, this market rally is going to reverse in a hurry.

Bottom line, the stakes in this market game of musical chairs keep rising, and the Fed is the one controlling the music, so it’s critical you’ve got an analyst working for you who is focused on helping you navigate the remainder of the year, regardless of what the Fed does with policy!

Our paid subscribers had this analysis at 7 a.m. this morning, so when their clients called today and asked, “What did they Fed mean for my portfolio?” they could answer quickly, directly, and confidently.

That’s how advisors use The Sevens Report
to strengthen relationships and close prospects.

If your broker or subscription research isn’t providing you this type of analysis on a daily basis and helping you build your business by saving you research time, increasing your knowledge about markets and giving investment ideas that can impress prospects and help client outperform, then please consider a quarterly subscription to The Sevens Report.

At just $65/month (billed quarterly) with no penalty to cancel, we are very confident we offer the best value in the subscription research space.
I am continuing to extend a special offer to new subscribers of our full, daily report that we call our “2-week grace period.”

If you subscribe to The Sevens Report
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1) That you are on top of the markets, and

2) That you are in control of their financial situation.

Actual subscribers to The Sevens Report have told me that discussing the information contained in the Report with prospective clients has helped them land accounts as big as $25 Million!

To be certain, 2015 was a
volatile year, and things have gotten worse so far in 2016. Subscribe today and give yourself the market intelligence you need to help strengthen relationships with your current clients, and acquire new ones.

Subscriptions start at just $65 per month, billed quarterly, and with the option to cancel any time prior to the beginning of the next quarter, so there’s simply no reason why you shouldn’t subscribe to The Sevens Report right now.

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Sevens Report right now by simply clicking the button below:

Finally, everything in business is a trade-off between capital and returns.

So, if you commit to an annual subscription, you get one month free, a savings of $65 dollars.  To sign up for an annual subscription, simply click here.

Best,
Tom

Tom Essaye,
Editor, The Sevens Report

Chart of the Day

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“I’ve Got Your Six.”

You may have heard that saying – it’s a military term and it means, “I’m watching your back,” as the “six” refers to your “Six O’clock.”

Here at The Sevens Report, we often say that we’ve got our subscribers’ “six,” and that’s why in today’s paid edition of the Report we alerted them to a potentially very important event that occurred in the markets yesterday.

That event was the dollar breaking out above the post-Brexit peak and hitting a new, four-month high.

Why is that so important?

Because if the dollar keeps rising, it will cause this rally in stocks to stall.

The dollar hit new highs yesterday mainly because Jon Hilsenrath, the WSJ’s resident “Fed Mole,” wrote an article that said the Fed is still open to raising interest rates this year, perhaps as early as September.

And, that’s a problem because the market currently doesn’t expect a rate hike until mid-2017!

Of course, it’d be easy to miss this potential new risk to stocks if you’re just watching CNBC or reading the major financial media sites, because all they wanted to talk about yesterday was NFLX’s subscriber churn or the YHOO sale/debacle.

But those aren’t the things advisors really care about. If you’re like most advisors that subscribe to The Sevens Report, you’re not doing a lot of single stock research or single stock allocations.

Instead, you’re making general, longer-term allocations to sectors or assets, and you need to know:

  • When a material pullback is coming, and
  • When to get more defensive in client portfolios, because avoiding pullbacks is the secret to outperforming in a diversified portfolio.

We understand that – and thousands of financial advisors from virtually every firm on Wall Street subscribe to The Sevens Report, because we are constantly watching for risks—whether those risks come from a rising dollar, Brexit, a declining Chinese yuan, or Italian banks.

It’s not that we’re bearish – we own stocks in our retirement accounts and 529s – but one of our main responsibilities is to watch the risks, because we all know there’s more than enough perma-bull research out there.

So, while everyone is excited that stocks are again beating sandbagged earnings estimates, we’re focused on two major risks to this rally:

  • Higher Interest Rates (That the market is too dovish with regard to the Fed).
  • A Stronger Dollar (It’ll hurt corporate earnings in the coming quarters).

We keep a special focus on risks to the market because we know that sophisticated, ultra-high net worth clients want more than the standard, boiler plate “perma-bull” outlook on stocks.

Ultra-high net worth individuals know there are always risks in the market, and The Sevens Report provides independent talking points for advisors to use in those meetings to show prospects that they aren’t all about “touting the company line.”

And, our independent analysis yields results.

An FA at an independent firm told us that our analysis of a recent stock market selloffs saved his clients a substantial amount of money.

He wrote, “Thanks for your continued insight; it has saved my clients over $2M USD this year… Keep up the great work!”

These are the results our subscribers are achieving with The Sevens Report, the daily macro-economic research report that’s delivered to subscribers every day at 7 a.m., and that quickly identifies the risks and opportunities for:

  • Stocks
  • Bonds
  • Currencies
  • Commodities, and
  • Interprets what economic data means for the market

Despite generally bullish sentiment, there remain legitimate risks to this rally, and we’ve included an excerpt of that research for you below as a courtesy:

Two Risks to This Rally

Risk 1: Interest Rates Go Up (even a little bit).

A surge higher in Treasury yields is now the biggest risk to US stocks near term.

  • Markets currently don’t have a rate hike priced in until the middle of 2017.
  • Fed Fund Futures have only a 13% chance of a rate hike in September, and just a 40% chance of a rate hike in December.

Frankly, that’s too dovish if the economic data stays decent.

And, given that the real reasons stocks have rallied is because investors are using the expectation of forever-low interest rates to justify higher than normal valuations, rising interest rates are a problem as they blow up the entire reason for the rally.

So, right now, the No.1 event that could derail this rally is a surge higher in yields, and that’s not an unreasonable expectation:

In the spring of 2015 German bund yields rocketed from basically 0% to 1% in a few weeks after market expectations became too dovish (causing stocks to drop).

Three years ago, then Fed Chairman Bernanke surprised a very dovish market by hinting QE could end, and it caused the Taper Tantrum of 2013, and Treasury yields spiked and stocks to plummeted over a four-week period.

To monitor this risk, we are watching specific levels in the 10-year Treasury yield (the specific resistance levels are provided only to paying subscribers) and if the 10-year yield breaks that resistance (it’s not far now) that will be a negative signal for stocks and our subscribers will know it.

Risk 2: A Stronger US Dollar

For the last two months we’ve told our paid subscribers that the bullish argument is based on a simple equation: A P/E multiple of 17, and a 2017 S&P 500 EPS of $130 means the S&P 500 could trade as high as 2200 (that’s 17 x $130).

That’s the simple equation that’s driving the S&P 500 relentlessly towards 2200.

But, a stronger dollar blows up that equation for two reasons:

  • A stronger US dollar will reduce overall earnings and create downward risk for that 2017 $130 EPS expectation, potentially making the market more expensive.
  • A stronger dollar will pressure oil and other commodities, reducing energy company earnings, and that will create downward risk for that $130 EPS expectation.

To monitor that risk, we are watching the dollar, and if it continues to rally and crosses key technical resistance levels (which we have provided for our paid subscribers) that will be a signal to begin getting more defensive, as the foundation behind this recent rally will start to crack.

What to Do Now

There remains a tremendous amount of noise in the markets today.

Yesterday, the “hawkish” Hilsenrath article caught many people by surprise and caused the mild dip in stocks. At the same time, however, Morgan Stanley produced a report that implied the Fed won’t hike this year… or next year.

Our job is to cut through that noise for our subscribers and stay focused on the real risks to this rally, so we can alert our paid subscribers early to when those risks become great enough to warrant a more defensive allocation.

They know that every day at 7 a.m. they will have one document that provides them the market analysis and macro talking points to “wow” clients and impress prospects.

Most importantly, they know that there will be an independent analyst watching the macro horizon and monitoring risks to their clients’ portfolios, so neither they nor their clients ever get blindsided.

And, we will alert our subscribers to any breakout that occurs in Treasury yields or the dollar and analyze the implications for the market in general, and for equity asset allocations. 

If you do not have one research document that provides macro analysis as well as tactical investment idea generation every day at 7 a.m., please consider a subscription to The Sevens Report.

We firmly believe we offer the best value in the paid research space.

I am continuing to extend a special offer to new subscribers of our full, daily report that we call our “2-week grace period.”

If you subscribe to The Sevens Report
today, and after the first two weeks you are not completely satisfied, we will refund your first quarterly payment, in full, no questions asked.

Click this link to begin your quarterly subscription today.

Increased Market Volatility Will Be an Opportunity for the Informed Advisor and Investor

We aren’t Market Bears, but we said consistently that things were going to be volatile in 2016 and we were right!  

In 2016, the advisor who is able to confidently and directly tell their nervous clients what’s happening with the markets and why stocks are up or down, and what the outlook is beyond the near term (without having to call them back), will be able to retain more clients and close more prospects.

We view volatility as a prime opportunity to help our paying subscribers grow their books of business and outperform markets by making sure that every trading day they know:

1)  What’s driving markets

2)  What it means for all asset classes, and

3)  What to do with client portfolios.

We monitor just about every market on the globe, break down complex topics, tell you what you need to know, and give you ETFs and single stocks that can both outperform the market and protect client portfolios.

All for $65/month with no long term commitment.

I’m not pointing this out because I’m implying we get everything right.

But we have gotten the market right so far in 2016, and it has helped our subscribers outperform their competition and strengthen their relationships with their clients – because we all know the recent volatility has resulted in some nervous client calls.

Our subscribers were able to confidently tell their clients 1) Why the market was selling off, 2) That they had a plan to hedge if things got materially worse and 3) That they were on top of the situation.  

That’s our job. Each and every trading day. 

And, we are good at it.

We watch all asset classes to generate clues and insight into the near-term direction of the markets, but our most important job is to remain vigilant to the next decline.

While we spend a lot of time trying to identify what’s really driving markets so our clients can be properly positioned, we also spend a lot of time identifying tactical, macro-based, fundamental opportunities that can help our clients outperform.

If you want research that comes with no long-term commitment, yet provides independent, value added, plain English analysis of complex macro topics, click the button below to begin your subscription today.

Finally, everything in business is a trade-off between capital and returns.

So, if you commit to an annual subscription, you get one month free, a savings of $65 dollars.  To sign up for an annual subscription, simply click here.

Best,
Tom

Tom Essaye,
Editor of The 7:00’s Report

The Real Reason Why Stocks Are Rallying

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The music is back on.

Several times over the past few years I’ve referred to the markets as a real life game of “musical chairs.”

We all know the children’s game: When the music plays you run around the chairs and you hope that you have a place to sit when the music stops, otherwise you’re out.

It’s the same thing for central-bank-driven stock markets.

When the Fed is ultra-dovish, you have to “Run” (i.e. be in stocks) because stocks tend to go up regardless of economic fundamentals. But, you just have to hope that you have a seat when the music stops (i.e. the Fed actually gets serious about raising rates or the market finally realizes the Fed is out of bullets).

On Friday, following the jobs report, the “music” started again and investors piled back into stocks.

But, contrary to what you may have read in the financial media, Friday’s stock rally was not because of the strong jobs report. Yes, the headline was good, but the trend in job additions has been decidedly lower throughout 2016.

Instead, the reason for this huge rally in stocks is bonds – specifically that Treasuries went UP and yields went DOWN after the jobs report. Additionally, the Dollar was flat despite the strong jobs report.

That told investors that the market is now totally convinced that the Fed won’t raise rates this year, regardless of what happens in the economy, and as a result they piled into stocks.

So, it is the expectation of forever-low interest rates that is driving this stock rally – not any improvement in fundamentals.

Now, do we think this rally is heralding a new bull market in stocks?

No, we don’t.

The risks to this market are generally unchanged from three weeks ago, and we’re continuing to monitor those risks for our subscribers.

But clearly, the near-term trend is higher, and you learn quickly in this business you have to invest in the market you’ve got—and not the one you think you should have!

So, the question now is whether investors need to abandon those defensive equity positions and rotate into higher-growth/higher-beta sectors like tech/consumer discretionary and basic materials?

That’s a pretty important question from a performance standpoint, because defensive sectors have massively outperformed cyclical sectors in 2016 – and if we are going to see a massive rotation back in to cyclicals, then advisors need to know that to maintain outperformance.

We discussed the potential for that rotation in a recent edition of The 7:00’s Report and have included an excerpt for you below.

Are We Going to Witness a Great Rotation?

Most of the free excerpts you receive focus on macro topics, but in the paid edition of The 7:00’s Report
we include a general asset allocation model and list of tactical investment ideas we think can outperform over the medium term.

Throughout 2016, our general equity view has been “Cautious” where we advocate 2/3 allocation to defensive sectors (represented in the Report by SPLV) and 1/3 to higher-beta sectors (represented by SPHV).

Even with the S&P 500 hitting new highs, that allocation has handily outperformed the S&P 500 in 2016, as SPLV has risen 14% year to date, not including dividends, while SPHB has risen 1.4%, giving our “Cautious” allocation a weighed return of 9.6%, doubling the S&P 500’s 4.7% 2016 return.

But, right now, with stocks breaking out and people piling into equities, the question most advisors are asking is whether to rotate into more cyclical/higher-beta sectors.

That’s really important, because anyone who has been in defensive sectors has massively outperformed cyclical sectors year to date and knowing whether to stay in those sectors or rotate into cyclicals will be critical to outperforming for the remainder of 2016.

As we told subscribers earlier this week, we do not think this massive rotation is going to occur and currently we are advocating holding allocations to defensive sectors for anyone other than a short-term investor.

The reasoning behind that conclusion is fairly simple.

This rally is being driven by the idea that interest rates will stay low forever, regardless of the economy. And, as a result, that will continue to favor more income-oriented sectors (beyond the short term).

So, if the main justification for that breakout in stocks was that low interest rates have indeed made it “different this time” from a stock valuation standpoint, and because of record-low Treasury yields and the prospect of no rate hikes in the future, acceptable stock valuations are now higher than previous history.

So, if that is the reason that people are buying stocks, then it negates the “overvalued” argument towards defensive sectors (staples, utilities, REITs).

Yes, those sectors are overvalued compared to historical norms, but now so is the stock market, and if perma-low interest rates justify the valuation extension in the S&P 500, it must also justify the valuation extension in these defensive sectors.

And, so far, the price action has validated our thesis.

Despite the fact that consumer staples, utilities and REITs are basically at all-time highs, the relative underperformance since Friday is not nearly as big as it could have been given how “overbought” most people think utilities/staples and REITs currently are.

In fact, we were actually relatively impressed with the performance of consumer staples (XLP/FXG) on Friday, as given their recent outperformance we could have easily seen outright declines in both those sectors following that strong jobs report.

Getting this potential rotation “right” for subscribers will be very important, and it’s obviously going to be a fluid situation. So, to make sure we get this “right” for subscribers we are watching a single indicator to tell us whether this rotation is gaining steam.

Until we see a material break lower in the belly and long end of the Treasury curve, the income provided by staples, utilities, REITs and other defensive sectors will remain critical to outperforming in this market.

And, we will alert our subscribers to any break that occurs in Treasury yields and analyze the implications for the market in general and for equity asset allocations.

If you do not have one research document that provides macro analysis as well as tactical investment idea generation every day at 7 a.m., please consider a subscription to The Sevens Report.

We firmly believe we offer the best value in the paid research space.

I am continuing to extend a special offer to new subscribers of our full, daily report that we call our “2-week grace period.”

If you subscribe to The Sevens Report today, and after the first two weeks you are not completely satisfied, we will refund your first quarterly payment, in full, no questions asked.

Click this link to begin your quarterly subscription today.

 

Value Add Research That Can Help You Grow Your Business in 2016

Our subscribers have told us how our focus on medium term, tactical opportunities and risks has helped them outperform for clients and grow their books of business.

We continue to get strong feedback that our report is: Providing value, Helping our clients outperform markets, and Helping them build their business:

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Subscriptions start at just $65 per month, billed quarterly, and with the option to cancel any time prior to the beginning of the next quarter, there’s simply no reason why you shouldn’t subscribe to The 7:00’s Report right now.

Begin your subscription to The 7:00’s Report right now by clicking this link and being redirected to our secure order form.

Finally, everything in business is a trade-off between capital and returns.

So, if you commit to an annual subscription, you get one month free, a savings of $65 dollars.  To sign up for an annual subscription, simply click here.

Best,
Tom

Tom Essaye,
Editor of The 7:00’s Report

Stock Market Update: 7/11/2016

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Stocks surged last week thanks almost entirely to the post-jobs-report Friday rally. The S&P 500 rose 1.28% on the week, and is up 4.21% year to date, and now is within a few points of its all-time high.

Despite the gains, the week started with some volatility as the S&P 500 dropped 1% Tuesday following a plunge in European financials stemming from worries about Italian banks and fund redemption halts at British commercial property funds. But, the market acted resilient and stocks rallied during the final hour of trading to close the day down modestly.

A good June ISM Non-Manufacturing PMI helped stocks rally Tuesday as markets ignored more weakness in European bank stocks (an important European bank index broke to multi-year lows), and the S&P 500 rallied and recouped almost all of the Tuesday declines. Thursday stocks basically drifted sideways ahead of the jobs report, as a drop in oil to one-month lows helped offset more positive economic data (good jobless claims) and a good earnings report from PEP.

Then, stocks exploded higher Friday as the blowout jobs report combined with a lack of selling in bonds and no rally in the dollar created a short squeeze higher that built on itself throughout the trading day amidst low volumes. Stocks moved steadily higher throughout the morning and afternoon, and traded to multi-month highs, closing just below the all-time high.

Trading Color

Cyclical sectors outperformed last week, but that was due almost entirely to Friday’s big rally, which came on low volumes and consisted of faster money managers chasing stocks higher via higher-beta cyclicals. Not to pooh-pooh the rally, but it didn’t come on strong volumes or with a lot of conviction.

From an internals standpoint, easily the biggest question facing advisors and investors over the next few weeks will be whether we see a large rotation out of defensive/yield-oriented sectors (utilities, staples, REITs) and into cyclicals (banks, materials, consumer discretionary). There certainly was some of that on Friday as cyclical sectors did outperform, but it was not nearly as big as it could have been given how “overbought” most people think utilities/staples and REITs currently are.

In fact, we were actually relatively impressed with the performance of consumer staples (XLP/FXG) on Friday, as given their recent outperformance we could have easily seen outright declines in both those sectors following that strong jobs report. To that point, there will be a lot written about a potential massive rotation out of defensive sectors and into growth over the coming weeks, but until we see a material break lower in the belly and long-end of the Treasury curve, the income provided by staples, utilities, REITs and other defensive sectors will remain critical to outperforming in a choppy market.

On the charts, the S&P 500 broke through several levels of resistance and nearly notched a new intra-day high—2134 is now the next near-term resistance level while support sits lower at 2100.

Bottom Line

Two and a half weeks ago the S&P 500 plunged temporarily below 2000 on Brexit fears, but in less than three weeks the market totally recouped those losses and traded to near-18-month highs. Yet despite all this whipsaw activity, the outlook for stocks has remained largely unchanged, and the bull and bear arguments remarkably static.

So, despite the rising chorus of optimism (which is largely based on very resilient price action) we remain generally cautious on stocks as fundamentals have not materially improved, and because of that we would not be chasing markets at these levels and would resist adding significant capital into stocks broadly, or re-adjusting allocations into higher-growth/cyclical sectors.

Looking at the bull’s argument, it has been bolstered by strong data so far in June, but with unknown Brexit effects looming, any well-reasoned bull is still solely relying on the $130 2017 S&P 500 EPS to justify allocating new capital to stocks. That’s the same argument we’ve had since April. And, in the meantime, the dollar is higher (which will weigh on earnings in the coming quarters) and oil looks heavy. To boot, if the bulls are right and we see a 17X $130 number, that’s only 2210 on the S&P 500, which is less than 4% from current levels. 2000 (which we hit less than three weeks ago) is now about 6% from current levels, so the risk/reward is not attractive.

Now, to be clear, I’m not advocating shorting stocks or selling everything. This tape is strong and that must be respected. But, from a “what do we do now” allocation standpoint, we are staying relatively unchanged in our proprietary accounts. We are not materially adding more cash to stocks, nor are we rotating out of defensive sectors and into cyclicals like materials or consumer discretionary.

Looking at other assets, the markets continue to send “Caution” signals. Treasury yields remain near all-time lows, the pound remains weak and Brexit is not “over” as an influence, the 10’s-2’s Treasury yield spread hit greater than 10-year lows last week while gold remains elevated and European (especially Italian) banks remain under pressure. Again, the odd man out in this cross asset analysis is US stocks, which are just off all time highs, so either the US stock market is “right” and everything else is wrong, or stocks are simply pricing in a very optimistic scenario right now. Regardless, despite the optimism we remain cautious.

 

Boring But Important: Italian Banks

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Since the Brexit vote we’ve been focused on watching European banks, as they will tell us when potential anti-EU political contagion morphs into actual financial contagion (which would be a bearish game changer). And while far from an “all clear,” there have been a few positives for European banks last week.

First, the SX7P, the STOXX Bank Index, has held that 117.53 low last Thursday, which is a general positive. Second, as mentioned, there was a quietly important article from the WSJ that detailed how the European Commibankitallyssion is allowing the Italian government to support any troubled Italian banks, if help is needed.

Generally speaking, in the short term at least, that is a positive as Italian banks are generally considered some of the weakest in all of Europe, with badly performing loans, terrible margins and weak balance sheets. So, this authority helped reduce the chances of an immediate issue.

However, at the same time, I do find it disconcerting this had to be done. First, it’s a bit of a validation of fears about how weak Italian banks have become. Second, Spanish and Portuguese banks are not much better than Italian banks (from a strength standpoint) so in some ways this raises concerns about them as well. Finally, unlike in the US, a European country being able to guarantee banks is not always a panacea.

Remember, the Irish government was bankrupted (basically) because they guaranteed bad Irish banks, whose liabilities exceeded the government’s assets! That’s why Ireland needed a bailout.

I’m not saying the same thing will happen in Italy, and we’re a long way from that point, but when governments who can’t print their own money start guaranteeing banks, I’m afraid I get a touch nervous.

So, bottom line, we saw a short-term step forward, but it doesn’t make me any less nervous about European banks more generally.

Bottom line, sentiment is better and that’s positive, but European banks remain “Ground Zero” for any signs of contagion from Brexit, and we’ll continue to watch SX7P closely.