Investment sentiment is extremely low, often a precursor to a bottom. Bottoms can be hard to time precisely but with stocks now fairly valued or modestly undervalued, it may be time to start nibbling.
Stocks have been mixed for the past two days. Strength continues within the defensive stocks while energy and financial names continue to be very weak performers. Tax selling serves to accentuate the downward moves in some of the names at or near 52-week lows.
Overnight, weak retail trade data out of China sent Asian stocks down and that weakness has spread first across Europe and then to our pre-markets. In early going, it appears equities are likely to open down about 1% while bond yields are down one or two basis points. But the big action is likely to come next week associated with the FOMC meeting that concludes on Wednesday and the big quarterly option exploration that comes on Friday. Given recent volatility and the possibility that leveraged bets can make up for some of 2018’s losses, one should expect heavy option action this cycle. The major put-call action on the broad market seems focused around the 2600 level on the S&P 500, about 2% below last night’s close. I have never been able to understand market action immediately after a Fed rate announcement. Whatever bets traders make in front of the news need to get quickly unwound, win or lose, right afterwards. Thus, all I can speculate is that next Wednesday and Thursday are also certain to be volatile with high volume. But once the Fed does its thing, whether it raises rates or not, the result will quickly get baked into stock prices and traders will look forward, not backwards.
If one looks at the Fed Futures market, there is about an 80% chance that rates will be raised 25 basis points next week. The obvious conclusion is that there is a 20% chance it does nothing. Absolutely no one believes there will be a rate increase higher than 25 basis points and no one believes the Fed will cut rates. Obviously, by Wednesday afternoon, whatever the Fed does, there will be certainty. The 80% probability embedded in prices will be adjusted up immediately to 100% or adjusted down to zero. While it is possible the Fed will hike rates 25 basis points and stick to its September tone strongly suggesting 3 or more rate increases next year, recent statements by a wide variety of Federal Reserve officials point to a significant moderation of tone. This time around, if there is a 25-basis point rate increase, it will be accompanied by statements suggesting any future increase will be subject to market conditions at the time of subsequent FOMC meetings. The media and investors can twist whatever words come out of Chairman Powell’s mouth at the post-meeting press conference to be more dovish or hawkish than I just noted but the conclusion everyone should reach is that every Fed meeting going forward is active and any rate decision will be based on the circumstances at the time of the meeting.
Markets today expect no further rate increases until the fall of 2019 at the earliest. Given early signs of economic deceleration in the U.S. and more obvious signs overseas, that appears to be a reasonable assessment. Mr. Power is a pragmatic Fed leader with a business, not an economic, background. Ask him what he might do in 12 months and he will say every time that it depends on conditions 12 months from now. He might say, all things being equal that he would like to raise rates 1 or 2 more times if the economy is strong enough but that isn’t a prediction of future rate hikes. We can dissect every nuanced word, but the stark reality is that whatever the Fed does on Wednesday is the last action it will take regarding rates for many months.
The Fed is also in the process of reducing the size of its balance sheet. It will reduce it by about 10% in 2018 and could reduce it another 15% in 2019 again subject to market conditions. Recent heightened volatility in all financial markets point to some increased stress at least compared to recent periods of excess liquidity. The Fed has to be mindful that it doesn’t overplay its hand and remove too much liquidity from jittery markets. No doubt the question will be raised at Mr. Powell’s post-meeting press conference and he will respond yet again that market conditions will help to dictate speed at which the Fed reduces the size of its balance sheet.
Perhaps lost in the news flow overnight and apprehension about the reaction to the pending FOMC meeting, China cut auto tariffs, a clear sign that it wants to move forward toward a peaceful resolution of the trade conflict. Since China didn’t start the battle, however, it will be up to President Trump whether steps taken going forward are sufficient to defuse to war. With that said, Trump, a true Narcissist if there ever was one, wants to be loved. An escalated trade war won’t raise his popularity with anyone, except possibly Peter Navarro. Thus, the odds still favor peace more than war.
Last week, according to Lipper surveys, Americans withdrew $46 billion from equity funds and $13 billion from fixed income funds. Investor sentiment surveys are now at their most negative levels in years. It is hard to find anyone who wants to buy securities in front of next week’s expected volatility. It is hard to find anyone who wants to but securities in front of next week’s expected volatility. Institutions are making extended leveraged bets, probably more to the negative side. But extended market declines require more than simple fear or negative sentiment. While data overseas points to slowing in many markets, consumer spending is solid, employment growth continues, inflation remains in check and manufacturing activity continues to expand. Leading indicators are still rising. Unemployment claims last week fell sharply. We are probably headed for a period of slower growth but for a full blown bear market to happen, the odds of recession have to increase significantly. So far, any such signs are few and far between. Investor sentiment can swing from very positive to very negative and back again quickly. I am not forecasting a switch per se. That would almost certainly be hazardous to my health. Maybe we still face on of those sharp blowoffs so characteristic of market bottoms. Or maybe we just move sideways in a volatile fashion as we have for some weeks until the selling exhausts itself. Either way, barring a sudden change in economic circumstances, the rolling correction of 2018 appears to be in its 7th or 8th inning, if not later. One doesn’t have to be a hero and dive into a shallow pool from 30 feet. One can nibble at bargains and add on further dips or on subsequent recoveries. Stocks are not supercheap but that are, at least in our estimation, now below fair value. In some sectors, they are well below fair value. Don’t guess the bottom. Instead, isolate a bargain or two and start nibbling between now and year end. Conservative investors may want to wait for the outcome of the Fed meeting and options expiration but the time to buy is when stocks are cheap, not when they are expensive.
Former Brazilian President Dilma Rousseff is 71 today.
James M. Meyer, CFA 610-260-2220
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