A Huge Week for Stocks

A huge week for stocks... Has the Federal Reserve suddenly turned 'dovish?'... The bottom line on the 'trade war'... Why we're staying cautious for now...

What a difference a week makes...

When I (Justin) last wrote to you before the Thanksgiving holiday, the markets were looking rather shaky.

U.S. stocks had been falling again. They had given up nearly all of November's gains and were threatening to break down to new lows. Worse, the credit markets were suddenly sending warning signs for the first time in several years.

However, by last Friday's close, these worries were a distant memory. The S&P 500 surged almost 5% higher, its best weekly gain in seven years. All told, U.S. stocks have gained 6% since making a "higher low" on November 23.

The recent rally is the result of a 'perfect storm' of sorts...

Regular Digest readers know that investor sentiment has remained relatively subdued during the recent correction. We simply haven't seen the levels of fear and panic that are typically associated with a long-term bottom in stocks.

However, during November's decline, some measures of shorter-term sentiment had reached bearish extremes that typically lead to a rally. And these extremes coincided with a powerful one-two punch of bullish news last week...

First was an unexpectedly 'dovish' message from the Federal Reserve...

As recently as early October, Federal Reserve Chairman Jerome Powell said that short-term interest rates remained a "long way from neutral." In other words, the Fed was unlikely to halt its rate-hike cycle anytime soon.

But during a speech at The Economic Club of New York on Wednesday, Powell surprised the markets with an apparent change of heart. From his speech (emphasis added)...

About three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy.

Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.

This change of phrase, from a "long way" to "just below," was seen as a sign that the Fed could end its tightening cycle early. For some reason – new economic data, or perhaps some cajoling from President Donald Trump – the Fed had reconsidered.

Markets were also optimistic that the U.S. and China could reach a positive resolution in the ongoing 'trade war'...

Here, too, they weren't disappointed. The two countries agreed to a "truce" to ease tensions, with the intention to negotiate a final deal within the next three months. As the Wall Street Journal reported...

According to the White House, the two nations will discuss thorny issues of Chinese economic policy, including forced technology transfer, intellectual-property protection, non-tariff barriers, cyberintrusions and cybertheft, services and agriculture. The two sides would "endeavor" to wrap up the talks in 90 days...

Chinese Foreign Minister Wang Yi and Commerce Vice Minister Wang Shouwen, in a press briefing, said only that the talks would focus on removing all U.S. tariffs and Chinese retaliatory tariffs and made no mention of a deadline.

The deal, which emerged after a dinner between President Trump and President Xi Jinping following a summit of the Group of 20 nations in Argentina, won immediate praise from business groups that oppose tariffs and have urged the administration to take a different path in pressuring Beijing.

The markets are celebrating today, but we suspect the party could be short-lived...

You see, upon closer inspection, we doubt either of these developments are as bullish as they initially appeared.

First, while Fed watchers are focusing on the words "just below," they appear to have missed the second half of Powell's statement: "the broad range of estimates."

Why does this matter? Because this range of estimates – known as the Fed's "dot plot" – is surprisingly wide. Fed officials see the "neutral rate" from as low as 2.25% to as high as 4%. However, the median estimate, which is the best measure we have of what the Fed believes, is above 3%.

In short, Powell's supposed change of heart isn't really that significant. While he was truthful that rates are just below the range of estimates, the data suggest the Fed is still likely to raise rates at least three more times in the year ahead.

We also remain skeptical of a lasting trade truce with China...

While the post-meeting rhetoric from both the U.S. and China was positive, there has been little actual progress so far.

The U.S. reportedly agreed to maintain existing tariffs at 10%, rather than increase them to 25% as originally planned. China has reportedly agreed to remove tariffs on auto imports and to purchase a "very substantial" amount of agricultural, energy, and industrial products from the U.S. Both countries also agreed to a handful of non-trade-related issues, including designating the addictive painkiller fentanyl a controlled substance and working together to get North Korea to give up nuclear weapons.

But a full resolution of the trade war will require big concessions from both governments – something we continue to believe is unlikely. In fact, just today we learned that the White House has appointed U.S. Trade Representative Robert Lighthizer – a longtime China skeptic – to lead its negotiations. From a separate Wall Street Journal report today...

The 71-year-old Mr. Lighthizer, a former steel-industry lawyer, has told colleagues he took the trade-representative job mainly to try to reorient China policy. In op-ed columns dating back to 1997, Mr. Lighthizer opposed China's entry into the World Trade Organization under the terms being negotiated. Mr. Trump has called the WTO a "disaster for this country."

He grew up in the Lake Erie port city of Ashtabula, Ohio, which was battered by imports. He sees himself as blue-collar even though he is a doctor's son who once raced around West Virginia in sports cars.

In trade circles, he is well known for tough tactics. In the mid-1980s, as a U.S. Trade Representative official who negotiated with Japan, he once grew so frustrated he took a Japanese proposal, turned it into a paper airplane and floated it back at the Japanese negotiators. In Japan, he became known as "the missile man."

He has regularly warned Mr. Trump that Beijing was "playing him" with offers to which he felt Beijing wouldn't carry out. The two men value tariffs as ways to pressure countries into concessions.

If a deal can't be reached within 90 days, the White House has already promised to resume increasing tariffs as planned.

But these aren't the only reasons we remain cautious today...

According to data from Bloomberg, there have only been three other instances in the last 20 years where stocks have rallied as much as they did last week alongside a rally in U.S. Treasury bonds. These occurred in the weeks ending September 28, 2001... August 9, 2002... and November 28, 2008.

What do these dates have in common? They all occurred in the midst of ongoing corrections or bear markets. In other words, history suggests the recent rebound is likely a short-covering rally than a resumption of the long bull market.

As always, we never recommend making investment decisions based on any indicator or study alone. But along with our proprietary Complacency Indicator and the recent warnings in the credit markets, it's another good reason to remain cautious and "hedged" for now.

New 52-week highs (as of 11/30/18): Essex Property Trust (ESS), Procter & Gamble (PG), and Service Corporation International (SCI).

In today's mailbag, a longtime subscriber shares his thoughts on Doc's new Advanced Options service. As always, send your notes to feedback@stansberryresearch.com.

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Regards,

Justin Brill
Baltimore, Maryland
December 3, 2018