Stocks Inch Closer To Last Week’s High

Monday’s action in the markets was all about the bond market, so I’ll only briefly review the stock market action. The S&P 500 was up 0.18% which pushed it close to last week’s high. It’s still far away from the January high if the market is going to continue moving less than 1% per day. There haven’t been any 1% moves, up or down, in July. The Nasdaq will probably increase on Tuesday because Alphabet stock rose after hours after it beat earnings estimates. Utilities were down the most on the day as they fell 0.64%. The financials rallied the most as they were up 1.32%. Both moves were because yields increased. It was the best case scenario for the financials because yields rallied and the curve steepened.

Yields Soar On JCB Action

As I mentioned, all the action was in the treasury market. The 10-year treasury had a monster sell-off as the yield increased 6.1 basis points to 2.9541%. The 30-year treasury yield increased 6.52 basis points to 3.091%, showing there was steepening at the end of the curve. There was also steepening in the middle of the curve as the 2-year yield increased 3.56 basis points to 2.6287% which is the cycle high. The difference between the 10-year yield and the 2-year yield is now 32.54 basis points. The Fed looks vindicated in its hawkishness because the action in the past two days makes it less likely that an inversion will occur this year. To be clear, the 10-year yield increased about 12 bases in 2 days.

The 10-year yield is certainly suppressed by the fact that the other major global central banks are much more dovish than the Fed. If they become more hawkish, the 10-year yield can rise further which will prevent an inversion. A change in policy could cause the 10-year yield to break new cycle highs even if U.S. economic growth decelerates modestly. That’s what happened on Monday as the Bank of Japan began preliminary talks to make changes to its interest rate targeting and stock buying program.

The JCB is the most dovish central bank. Even it has slowed its bond-buying program recently as there has been a modest pickup in inflation and wages. The year over year growth in the Bank of Japan’s balance sheet peaked at 47% in February 2014 and has since slowed to 8% in May 2018. With that context in mind, it’s not surprising to see the JCB moving towards softening its extremely stimulative monetary policy.

It’s interesting that even though the JCB deliberately tried to not spook the market with its actions, it still spooked the market as the 10-year Japanese bond yield increased from 0.035% to 0.086%. Technically, this is a 145.71% move, but it’s silly to look at percentages with such low yields. The better way to look at the bond yield is to say it is the highest yield since February. I think this reaction is too much in the near term because nothing will come out in the next few days, but it is just the start of a move higher in yields in the next few quarters as the JCB looks to partially unwind its extremely dovish policy.

America is the most hawkish behemoth as the Fed has mostly unwound its policy as rates are off the zero bound and the balance sheet is declining. The ECB is second as its QE will end in December and it might raise rates slightly in 2019. The JCB is way behind as it is still buying stocks.

If the JCB keeps pushing up the 10-year U.S. Treasury yield, the curve could avoid an inversion since the Fed is near the end of its hike cycle. Inflation also needs to stay low. The median expectation for the 2020 Fed funds rate is just below 3.5%. The latest odds for 2018 policy show there is a 65.4% chance of at least 2 more hikes. At this point, it’s dovish to see the odds for 2 hikes increase while the hikes for 3 hikes decreases. I mention this because that’s what occurred on Monday.

Worry About Earnings

Investing is all about the future which means the earnings growth in Q2 doesn’t matter much. That doesn’t mean the reports don’t matter. They matter immensely in figuring out the future. One of the biggest worries on Wall Street right now is how large the earnings growth drop off will be. According to FactSet, earnings growth in 2018 is expected to be 20.6% and earnings growth in 2019 is expected to be 10.1%. There will be tough comparisons next year and a potentially slowing economy. The economic boost from the tax cut is expected to be smaller next year. According to FactSet, since June 30th, the estimate for Q3 earnings growth has gone from 21.6% to 21.5%. Falling estimates are a sign that the greatest fears about future earnings growth are true. However, that’s such a small decline and only 94 firms have reported this quarter. More information is needed to go bearish.

The latest numbers on this quarter are from The Earnings Scout. As of the end of the day on Monday, 94 S&P 500 firms have reported earnings. 84% of firms beat their EPS estimates and 78% beat their revenue estimates. The average EPS surprise is 6.63%. The average EPS growth is 27.92% and the average sales growth is 10.64%.

The chart below shows the sector breakdown as of Monday morning when 87 firms had reported earnings. At that point, the financials had the best performance as the average EPS estimate increase in Q3 was 1.48% higher. It had the highest percentage of estimates raised (52%) and the lowest lowered (19%). If the curve flattens and yields rise, the sector will be the best place to put your money. The overall data is slightly different from the FactSet numbers as the Q3 EPS change is up 0.38%. Keep in mind, the estimates for Q3 are already extremely high.

(Click on image to enlarge)