Stocks Rally Based On The End Of The Iran Deal?

The S&P 500 was up 0.97% on Wednesday. It’s interesting because the headlines claimed the market rallied because Trump exited the Iran deal. That’s a weird reason for the market to rally as it means more geopolitical uncertainty. I’m not necessarily willing to sell stocks because of this decision, but it wouldn’t make me buy stocks. It’s fair to see energy stocks rally 2.03% as the price of oil is up to $71.21. However, energy wasn’t the only sector rallying as this was a risk on day. The tech sector was up 1.37% and the financials were up 1.5%. On the geopolitical front, I’m actually beginning to feel calmer because Trump was able to negotiate getting 3 American detainees back from North Korea ahead of his meeting with Kim in the next few weeks.

Technicals Are Still Important

The point I’m getting at is the solid earnings season may be what pushed stocks up, rather than the end of the Iran deal. Extraneous headlines may be unable to hold the market down any longer. It’s interesting to see that the 10 year yield was up 2.8 basis points to 3%. Inflation increases with oil prices, so if oil increases, the 10 year yield will increase. I say it’s interesting because a few months ago the market was supposedly crashing because the 10 year yield hit 3%. I have been consistent in saying that all hell won’t break loose if it goes above 3%. There’s nothing magical about the 3% level.

I’m focused on this small movement in the S&P 500 because the market is at a critical technical level. The chart below is an updated version of the chart I’ve been looking at for the past few days. As you can see, the latest close pushes the S&P 500 above the trendline.

I’ll be convinced when the S&P 500 makes a new high. The chart below shows how you can change the angle of the trendline to make the current price below the resistance. The previous high was 2,709 which means a move of less than 1% will end this downtrend. I wouldn’t be surprised to see the energy sector outperform in the next year as this bull market comes to an end. So far, I’ve been wrong about oil because of this recent geopolitical stress. The market isn’t worried about the economic weakness in Europe like I am.

Earnings Growth To Fall?

As I’ve often discussed, the current earnings growth is unusual this late in the cycle. Some parts of the economy, such as manufacturing, saw deceleration in Q1, yet earnings growth has beaten estimates, coming in at above 25%. The chart below gives support for the argument that this boost is temporary and not based on the fundamentals. It compares the year over year South Korean exports to year over year forward EPS estimates. As you can see, South Korean exports are falling as earnings growth rises. The two metrics have a 76.6% correlation since 2010. The correlation has been increasing in each decade. It seems like the earnings growth estimates will follow the South Korean exports lower if the correlation continues.

South Korea isn’t just a coincident indicator for S&P 500 earnings growth. As you can see from  the chart below, the world industrial production often follows the South Korean mining and manufacturing growth. The chart shows mining and manufacturing has been declining which indicates industrial production will fall further. The latest factory orders from Germany and the Italian manufacturing PMI, which I discussed in a previous article, support the notion that industrial production is decelerating.

Global Manufacturing PMI

The chart below shows the global manufacturing PMI. As you can see, it has declined in the past few months. The indicator shows there wasn’t much weakness in April as it was up 2 tenths. The new orders index also was up 2 tenths. Only the future output index was down 8 tenths. However, 64.2 is a very positive reading. I was bearish on manufacturing at the top of this recent cycle simply because there was little room for improvement and this indicator is highly cyclical, so it won’t plateau at such a high level for long.

Capex Expected To Explode In America

I am expecting the tax cuts to help the U.S. economy outperform the other advanced economies, especially Europe. I was expecting the tax cuts to mostly be put into buybacks because that’s what happened after the Bush tax cuts. However, more money is being put into capex than expected. This is a self fulfilling prophesy. Since every business is spending money, the economy expands. The great part about this is it isn’t based on increasing corporate debt. It’s based on government debt. Government debt probably won’t roll over in the next recession.

The chart below shows first quarter capex spending grew 19.4% from last year. That’s almost on par with the 25% increase in earnings. It’s interesting to see that even though earnings grew in Q1 2017, the capex actually fell 5.5%. I was wary of expecting the money to flow into capex because it’s tough to find a place to put an influx of capital. Now that we have evidence that capex increased in Q1, I expect the capex growth to remain strong for the rest of the year as earnings growth remains high.

Conclusion

The good news is it looks like the stock market will end this series of lower highs. That means there’s a high chance this bout of weakness is a correction. Technical analysis is all about percentages not certitude. The other good news is America should outperform the other advanced economies because of the accelerated capex growth. The bad news is South Korean exports and mining are weak which mean bad things for earnings growth and industrial production. The global manufacturing PMI was flat in April. Germany and Italy are leading the manufacturing sector lower.