Market Hitting New Highs

In the past few quarters, hitting new highs meant new all-time highs, but now it just means the highest prices since March. The S&P 500 was up 0.74% which means it is at the highest price since March 15th. The S&P 500 is now up 2.22% year to date. The next key price is 2,877 which was the March peak. That was the first peak that failed to reach the all-time high set in January. The CNN Fear and Greed Index is now at 57 out of 100 which signals greed. However, I’m still bullish on stocks as the economic data has been good. I expect a slow trudge higher in the next few weeks. Interestingly, even though stocks aren’t at the highs made in March, the CNN Fear and Greed Index has surpassed that level.

China Trade Negotiations Going Well

The reason for the rally according to the headlines was the improvement in the trade talks with China. China plans to import more energy and agriculture products to lower the U.S.’s $335 billion trade deficit with it. Mnuchin stated that China and America have made meaningful progress on trade which now simply needs to be implemented. As I mentioned in a previous article, implementing the deal is easier said than done because ramping up production won’t be easy.

Trying to lower the trade deficit is an artificial government action to solve a problem which might not exist. It’s not as if the country is desperate for jobs. Demand for commodities also isn’t low. China could end up spending its capital on American production instead of investing in American firms. This could create inefficiencies if the production goals can’t be achieved. These trade actions appear to be helping manufacturing which has already been strong, but still represents a marginal amount of the labor force relative to the services sector.

Regardless of whether this action helps the economy, it’s clear tariffs or a trade war would hurt growth. The fact that tariff threats have been suspended means the risk of a trade war has been taken off the table. The biggest geopolitical risk now is the Trump-Kim meeting which is supposed to happen on June 12th which is in 3 weeks. The other smaller issue on trade is that America will apply the steel and aluminum tariffs on the E.U. by month end if there’s not a new deal in place. I don’t think this is a big issue for the overall economy, but it will affect the metals stocks. The goal for market bulls is for the threat of the trade war to decrease to as low as possible. Then the bullish economic data and earnings reports can be allowed to push the S&P 500 closer to new all-time highs like has been happening in the past 2 weeks.

Fed Rate Hike Decision

The current monetary policy situation is the best possible for the stock market because the Fed isn’t raising rates too quickly and the policy is becoming clearer. As you can see from the chart below, the policy prescription for 2018 was murky in February as many options were on the table. Now, it’s very clear the Fed will either raise rates two or three more times. Furthermore, the newest addition to the list of reasons the Fed is helpful to stocks is the 10 year yield is rallying. This means that rate hikes are less likely to flatten the yield curve, pushing off the signal for a recession for at least another few weeks. There was a slight flattening of the yield curve on Monday. The latest difference between the 10 year yield and the 2 year yield is 49 basis points. That’s the same difference as late March. The curve is going to invert at some point; I view no change as a win as it delays the next recession.

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3% 10 Year Yield Still Hasn’t Caused ‘All Hell To Break Loose’

There’s clearly a marketing bent to the financial news as they try to formulate reasons for you to watch it. There is a blurry distinction between legitimate predictions and market calls that draw headlines and ratings. Sometimes this is white noise and other times people believe it enough that there is a reaction in the markets. The most discussed topic which hasn’t lead to anything has been whether the 10 year bond yield hitting 3% would cause a correction in stocks.

As I mentioned in a previous article, short term action can birth a narrative which makes no sense. In this case it was the rise in the 10 year yield causing stocks to fall in February. Every single market move during that time can be blamed for the sell-off, but basic research tells you before that point yields had risen while stocks rose. Furthermore, I’d argue rising yields are good news because they mean growth is improving. As you can see from the chart below, the nominal 10 year yield has a 77% correlation with the 3 year average of the year over year nominal GDP growth. The stock market will like improved economic growth. It takes more in depth analysis than fearing round numbers to make money in the market.

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The chart below provides evidence that this time is different in terms of increasing yields causing stocks to get cheaper. As you can see, from 1976 to 1998, there was a strong inverse correlation between the next twelve months PE multiple of the S&P 500 and the 10 year treasury yield. Since 1999, the 10 year yield and the forward PE of the market have had a low correlation. Higher yields haven’t caused stocks to fall. This is similar to the CAPE which has been high for the past 25 years. A high CAPE would normally be a bearish signal for long term performance, but the correlation hasn’t held. Higher margins have made the CAPE less viable. Some investors believe the inverse correlation between the 10 year yield and stocks will return after yields reach a certain threshold which might be 4% or higher. As for now, there’s little chance of it reaching those levels.

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