Stocks Primed For A Rally

The stock market is uncertain about the possibility of a trade war and a hawkish Fed.

However, I think a trade deal will be struck and the Fed will pull back on its hawkish 2019 guidance. Specifically, I expect the Fed to hike rates on Wednesday and guide for either 1 or 2 hikes in 2019.

If the Fed guides for no hikes in 2019, stocks will rally sharply. Powell seems to be less concerned with the stock market than Yellen. But it would be highly unusual for him to ignore the latest volatility.

As you can see from the chart below, the S&P 500’s 9.3% decline intra-meeting is the largest since October 2008. We’ve seen the Fed react to declines that were smaller than this.

Stocks Primed - Any dovish change should placate markets. 

If selling drives the Fed to be more dovish, lower prices will bring out buyers.

The chart below shows the S&P 500’s returns slightly differently but brings us to the same conclusion. As you can see, the last time the S&P 500 was this much off its record high, the Fed backed off from its hawkish guidance.

Specifically, the Fed expected to hike rates 4 times in 2016 but only ended up with 1 because of the volatility in late 2015 and early 2016. If the Fed goes with 3 fewer hikes rates than it guided for in September, there will be 0 hikes in 2019.

I think this December hike could be the last one of this cycle. But I wouldn’t be surprised if the Fed still guides for 1 or 2 more in this meeting.

If economic growth slows further, the other hikes will come off the table. Keep in mind, that the Fed funds futures market has been wrong about intermediate-term times.

The problem with using it even for the December decision is that it’s right on the borderline (70%) of whether to expect a hike or not. Markets have had much more conviction about the last 8 hikes.

The lowest percentage chance before those meetings was 83% in December 2015. It is currently 68%. A big takeaway from these charts is that the Fed will react to the stock market decline by moving in the dovish direction.

Stocks Primed - Last Thoughts On Rate Hike Guidance

The chart below shows how the Fed is likely to change its guidance based on its dot plot. The dot plot is made up of individual FMOC member’s projections.

Based on the previous plot, there only needs to be one change for the Fed to lower its 2019 guidance. It would be very easy for the Fed to project 2 rate hikes next year.

Stocks Primed - The End Of This Rally?

The chart below is an extremely bearish take on potential stock market returns.

Firstly, it shows the Smoot-Hawley tariff ended up leading to a 25-year drawdown. Furthermore, it shows for the stock market returns to come back to the 118 year average, the Dow needs to fall to 13,055. I wouldn’t call the recent bull market a tax cut fueled mania unless you think taxes will be raised again.

That’s a possibility if the Democrats win the 2020 election. The scary part of this scenario is stock market declines make it more likely the Dems will win.

Selling would beget negative fundamentals. Higher taxes, tariffs, and a slowing economy are a recipe for lower stock prices. This is the scenario where everything goes wrong. I don’t think the Dow will fall to 13,055 anytime soon, but it’s worth a look at the worst case scenario.

Stocks Primed - Not A Great November Industrial Production Report

The industrial production report wasn’t great. Especially when you consider the negative revisions and the manufacturing weakness.

Specifically, production was up 0.6% month over month as you can see from the chart below. The consensus was for 0.3% growth, so it beat estimates. However, it was helped by the negative revision as October growth went from 0.1% to -0.2%.

Manufacturing growth was 0% month over month which missed estimates for 0.2%. The October report was revised from 0.3% growth to -0.1%. Headline growth was driven by utilities and mining. Utility output was up 3.3% after two months of weak results because of hurricane disruptions.

Stocks Primed - This monthly growth probably won’t continue. 

Mining output growth was 1.7% after falling sharply in October. It’s hard to see mining output growth accelerating given the weakness in oil prices.

Hi-tech production was up 1.6%, and motor vehicles were up 0.3%. They couldn’t push manufacturing growth positive. Manufacturing slowdown is well underway.

The capacity to utilization rate increased from 78.1% to 78.5% which met estimates. The rate is well below the peak of 79.6% in November 2014. However, the manufacturing sector’s biggest worry isn’t capacity issues. It’s a global economic slowdown.

Stocks Primed - Weak Empire Fed Index

The December Empire Fed reading wasn’t great. It supports the thesis that manufacturing growth is slowing. This report alone doesn’t tell us much. But when paired with the recent Markit PMI and the industrial production report, it’s safe to say the macro outlook is challenged.

The Empire Fed general conditions index was 10.9 which fell from 23.3 and missed the consensus for 21 as you can see from the chart below.

It was worse than the lowest expectation which was 18. New orders index fell 5.9 points to 14.5, and the shipments index fell 7 points to 21. Inflation fell slightly as the prices paid and prices received indexes fell 4.8 and 0.3 to 39.7 and 12.8.

The 6 month forward-looking index wasn’t terrible, but it fell 3 points to 30.6 from 33.6. New orders and shipments fell 5.5 and 2.9 points to 34.2 and 34.3.

The good news is the capex and technology spending indexes rose sharply to near cycle highs. Capex index increased 6.4 points to 31.2. And the technology spending index increased 6.4 points to 26.1.

It’s tough to say if investors should read into those indexes at all. Overall, this was a weak report which supports other negative manufacturing indicators.