Bears finally have their week in the sun
Bull Market

Bears finally have their week in the sun

Despite a bumpy week, the major indexes are off to their best start to a year in about three decades, up 10% across the board.

So far it looks like stocks are taking a breather within a sturdy uptrend, rather than initiating a new, heavily bearish move lower.

The economic data this week has been mostly negative, though …

New federal data showed Americans pulled back sharply on spending in December, a sign that households were cautious for the holidays.

Consumer spending drives about two-thirds of U.S. economic output. Personal-consumption expenditures, a measure of household spending, fell to a seasonally adjusted 0.5% in December from the prior month.

Moreover, the Institute for Supply Management’s manufacturing index dropped to a near-three-year low. This is a clear sign that U.S. manufacturers are getting hit by the broader global industrial downturn.

Higher interest rates and less stimulus from fiscal policy are combining to slow economic growth.

The decline in the ISM index in February was sharper than most analysts anticipated. But it is still in line with the deterioration seen in most of the timelier regional Fed surveys, according to Capital Economics analysts.

Weaker activity in U.S. manufacturing reflects similar developments overseas, following plunges in both the German and Chinese purchasing managers’ indexes. There were also declines in the new orders index and the employment one. This suggests manufacturing payroll growth slowed further in February.

To be sure, economic activity is weakening. The question for investors is whether the Q4 collapse in equities already discounted the worst of the slowdown and the early 2019 rebound is discounting a recovery.

So far, equity index breadth measures suggest that bulls remain in charge. But don’t let your guard down.

The bright side for optimists: It’s beginning to look like there really might be a formal deal to sign with China when President Xi visits the White House later this month.

China Deal Overblown?

But is a China deal really such a big deal? Many smart analysts are skeptical, suggesting that it will not provide much boost to either country’s economy even after the punitive tariffs levied by both sides are removed.

U.S. economic growth is already slowing this year, as more restrictive monetary and fiscal policy takes its toll.

Let’s say China agrees to boost market access for U.S. firms by cutting tariffs and easing foreign ownership rules, as well as strengthening protection of intellectual property.

Let’s also say China also agrees not to deliberately devalue its currency.

These commitments are unlikely to add up to much in the short term, say Capital Economics analysts.

Sure, those are great goals, but will deliver little if any payoff in the next six months to a year.

Looking at the biggest U.S. exports to China, there may be some scope to increase exports of goods like aircraft and motor vehicles. But agricultural and energy commodities are subject to greater supply constraints, and U.S. firms can’t just ramp up production overnight, CapEcon observes.

A rumored agreement for China to increase purchases of U.S. liquefied natural gas, for example, will reportedly not begin until 2023 while new terminals are built.

For now, increased exports to China could only be achieved by cutting exports to other countries. Meanwhile, a big increase in electronics exports would probably require the removal of long-standing U.S. restrictions on advanced technology exports to China.

This seems unlikely, according to this analysis. The agreement appears to eliminate the threat of further tariffs on Chinese goods, with the potential removal of existing tariffs providing another small positive. But those tariffs don’t appear to have had much impact on the economy anyway, says CapEcon.

Companies absorbed part of the impact by cutting margins. In any case, the tariffs were offset by an appreciation of the dollar against the yuan.

It’s true that U.S. exports to China collapsed in the second half of last year. This was due to direct intervention by Chinese authorities, which cut off purchases of U.S. energy and agriculture.

Even if those tariffs were quickly reversed, it would add only a few tenths to annualized GDP growth.

Nevertheless, the deal provides further reason to surmise the White House has been forced in the negotiations to back down from its protectionist policies.

Having initially pushed for fundamental reforms, leaks from the talks suggest the Trump administration is settling for relatively modest concessions.

If so, that would remove one of the downside risks to the economy this year. But it wouldn’t be enough to prevent higher interest rates and the fading fiscal boost from taking their toll.

Mind the Gap

Meanwhile, data released Wednesday showed the U.S. posted its widest monthly trade gap since 2008 in December and a record annual deficit in goods.

This was due in part to higher spending by U.S. consumers and businesses that was not reciprocated overseas. And it was opposite of what the White House had promised with its policy focused on tariffs and intimidation.

Analysts observe that the widening in the trade deficit to a 10-year high in December confirms that net trade was a drag on GDP growth in fourth quarter, and the weakening global backdrop suggests that drag will intensify in the first quarter.

The widening in the trade deficit to $59.8 billion in December, from $50.3 billon, was driven by a 1.9% month-over-month decline in exports. Shipments of capital goods and industrial supplies fell particularly sharply. Imports rose by 2.1% month-over-month.

The biggest concern now is that trade looks set to be a serious drag on growth in the first quarter. The recent deterioration in global growth suggests a significant rebound is unlikely, which would fit with the latest surveys of new export orders.

With real consumption growth also set to slow following weakness in December, the upshot is that GDP growth remains on course to slow to only around 1.5% annualized in the first quarter at best. The Atlanta Fed is forecasting 0.3% growth. Batten the hatches.

Muddied Momentum

In sync with the slowing growth data, this year’s fantastic stock market momentum is starting to ebb.

Momentum doesn’t die easily, however. Sentiment expert Jason Goepfert notes that when momentum is this evident, investors who sat on the sidelines use the first hint of weakness as their chance to finally get in.

The S&P 500 just ended a remarkable run of closes above its 10-day moving average. After 40 sessions, it finally closed below it this week — one of the longest streaks since 1928.

So what has tended to happen historically after other times the benchmark index ended a streak of 40 or more days above its 10-day average?

Over the next couple of weeks, evidence suggests buyers step in right away, seeing their chance to take advantage of a long-awaited pullback. Two weeks later, the S&P 500 rose 1% on average and suffered a maximum loss that averaged only 0.7%, compared to a maximum gain of 2.4%.

But these get-me-in moments were prone to failure, Goepfert reports.

  • Over the three months following such streak endings, the S&P 500 averaged a negative return, and an unimpressive risk/reward ratio.
  • Over the next six months, the market averaged a gain of just 1.1%, well below the average for any ordinary six-month stretch. If these developments recur, we would be looking at a flattish, trendless environment for the next several months before enthusiasm picks up again.

In summary, bears have a lot of ammunition on their side that includes slowing global growth, faltering earnings estimates, strangely thin equity fund inflows, waning optimism for U.S.-China trade talks and, technically, overhead price resistance from the November and September highs.

But until this week, they have not taken advantage of their opportunities. This is giving bulls a shot of confidence that they can make a sneak attack on the old highs in the next few weeks.

Best wishes,
Jon D. Markman

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