Small Caps Stall

The stock market was mixed on Tuesday. One of the new trends we’re seeing is weakness from the Russell 2000 which was down 0.34% on Tuesday. It’s now down 7 of the last 10 days. Even with that weakness it’s off less than 1% from its peak. This was to be expected given the powerful run it had been on. The microcaps have also sold off as they’re down about 2% from their recent peak. AAPL has had a great run since I recommended it as it’s up 6.59%. The stock was upgraded on Monday. I think now is the time to take profits as it’s near its all time high right before the iPhone X starts taking pre-orders. Analysts can measure web traffic to get an idea of how sales will be, but until the first orders start coming in, nobody knows what will occur. Samsung has needed to put sales on its devices, so I’m not sure how well the $1,000 iPhone X will sell. Since the Apple iPhone X was announced, Google’s Pixel 2 went on sale.

Fed Chair Pick To Be Made Soon

The latest report is that President Trump has narrowed down his pick for Fed chair to Cohn, Yellen, Powell, Warsh, and Taylor. It’s surprising that the President is considering Yellen and Cohn at all. This ends the interview stage as there won’t be any late comers who might be picked. It’s not surprising to see Neel Kashkari’s name not in the mix because the only person who thought he was going to be the chairperson was Jeffrey Gundlach. The fact that we know all the possibilities should calm the market slightly because the President not caring if candidates had PhDs in economics meant many more possibilities were available. The decision is expected to be made in 2 weeks. It will conveniently come right after the ECB decides on QE for 2018. I think this is more of a coincidence than game theory since the Fed appears to be unwinding the balance sheet no matter who is picked. Yellen and Powell are the doves in the group and they are in favor of the unwind. Secondly, this is a position which will be held for at least a few years, so just basing a decision on 2018 ECB policy would be short sighted.

As for the odds of the next Fed pick, Powell is at 38%, Warsh is 20%, Taylor is at 19%, Yellen is at 18%, and Cohn is at 7%. I don’t expect there to be any big changes in the odds in the next few days unless the decision is leaked to the press. Because of that possibility, it’s important to watch the situation closely. With the decision coming soon, I wouldn’t be surprised if President Trump already made up his mind. Because no one has a majority in the odds, whoever is picked will be a surprise to the market. I’d expect the biggest rally in stocks if Yellen is picked because her policy is known. I expect the biggest selloff in stocks if Cohn is picked because he has no experience in monetary policy. We don’t know what he’ll do. The only thing we know is he’ll probably make a mistake. The other candidates are also well known as Warsh and Taylor are hawks and Powell is a dove. We could see Taylor make a statement that he won’t raise rates aggressively to 3% if the market gets worried after he is picked. President Trump has 2 governors to appoint, so the FOMC could be pushed in a hawkish direction.

One final point worth noting is the President said the decision would come in 2-3 weeks on September 29th. Obviously, that’s not going to happen. He could delay it again, but the deadline is coming up soon so I don’t think he will. When President Trump made that statement, he hadn’t interviewed Taylor. Now that all the interviews are done, it’s easier to give a timetable.

Italian Banks In Trouble

Besides setting monetary policy, the ECB is also in charge of setting regulations. The goal is to get the Italian banking system sorted out before the next recession. While that’s an admirable goal, the chances of success are bleak. Just because a rule is put in place, doesn’t mean it will be followed. The new rule the ECB enacted is for banks to post collateral against the entire unsecured part of non-performing loans within 2 years. Secondly, secured parts of bad loans must be collateralized within 7 years. With the Italian banks having exposure to 326 billion euros in bad loans, it won’t be easy to start taking losses.

The leaders of the country are objecting to these new rules already, saying they will hurt economic growth. This news is being swept under the rug for the most part because the credit market is forgiving. When the credit market is nervous because the economy is weak, these types of new events get front page status as they send the markets down. Then the worries about a possible Italian exit from the E.U. start to stir. As you can see from the chart below, this struggle has caused a modest selloff in Italian banking stocks. It will be a big missed opportunity if these issues aren’t sorted out before the next recession. Unfortunately, because of the political challenges, I don’t expect a solution anytime soon.

(Click on image to enlarge)

Conclusion

The risk on trend for the stock market has allowed some uncertain events like the Italian banking crisis and the Fed chair pick to go unnoticed. The streak without a 3% pullback is 238 days, meaning in 3 days it will tie the record. This market is being driven by earnings. These next few weeks of reports will tell us if the excitement is justified. The reports I’ll be looking at closely are the big tech names: Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL), and Facebook (FB). It will be interesting to see how they react to what should be mostly good results. Netflix sold off about 2% after its earnings beat.