Here are the noteworthy items that crossed my desk during the week ended August 24, 2018:
Market Reaches New High. The market began the year with an extension of the surge that accompanied the passage of the Tax Cut and Jobs Act. The S&P 500 peaked in the third week of January at 2872.87 and then fell sharply to 2532.69 (so far the low for the year) only two weeks later. It then traded sideways for four months (but stealthily retested the February low and established a new pattern of higher lows). Stocks began to take off again in June with a weekly series of measured gains that has continued throughout the summer. This year, it would have been a mistake to sell in May and go away.
In the week just ended (8/24), the S&P 500 finally exceeded the mid-January highs on both an intraday (2876.16) and closing (2874.69) basis. Technically, this marks a continuation of the uptrends from both the January 2016 lows and the March 2009 start of the bull market. Bulls continue to have the benefit of the doubt; bears, the burden of proof.
Supporting the bull case, the S&P 500’s Relative Strength Indicator (RSI) is no longer above 70, which generally defines an overbought condition. The stock market was grossly overbought going into 2018; but the long stretch of sideways trading brought it back to neutral, from which it is better positioned to sustain its long-term uptrend.
Yet with this summer rally, the S&P 500’s RSI (on a weekly basis) has risen steadily, closing last week at 66.2, not far away from that key 70 level.
For what it’s worth, the S&P 500’s daily chart has a slightly lower RSI, but the monthly chart has popped back above 70 just recently. After more than 10 years without a major correction, it is not surprising that stocks would appear as overbought on a long-term (monthly) basis.
Bears might point to the Percentage Price Oscillator (PPO), shown in the bottom panel of the chart above, which has failed to follow the S&P 500 to a new high. This negative divergence might be a sign that something is not quite right in this summer rally.
The PPO, which is similar to MACD[i], is a momentum oscillator that measures the difference between two moving averages (here, the 16-day and 26-day moving averages) as a percentage of the longer moving average (the 26-day). Upward momentum appears when the 16-day moving average is rising faster than the 26-day moving average.
I am not terribly troubled by the PPO’s inability to make a new high here. The market accelerated at a nearly parabolic rate toward the end of 2017 and into 2018, as indicated by the surge in the PPO. That surge was unsustainable; so it is not surprising that this summer’s PPO would fail to register as strongly.
Sector Moves. On the other hand, this summer’s price action across various industry sectors within the S&P 500 has been mixed. The sectors have not been pulling together to get the broader market to that new high. The 7.2% year-to-date gains in the S&P 500 can be attributed mostly to three sectors: technology (up 17.6%), consumer discretionary (including specialty and broadline retailers) (up 16.3%) and health care (up 10.9%). In recent weeks, financials, industrials, materials and energy stocks have lagged the market. Investors seem to be favoring stocks with lower exposure to the global economy.
One possible theme explaining sector performance is the concern about trade wars. Those concerns have weighed more heavily on bourses outside the U.S. Asian markets have seen broad-based declines, driven by concerns about the Chinese economy. Weakness in Latin America has been driven as well by local concerns (e.g. Venezuela, Argentina and Chile). European markets have so far fared better on average; but the performance of individual country markets has been mixed, with Scandinavian and Portugese stocks up but most of the rest of Europe down. Still, the single-digit average decline in Europe stands in stark contrast to U.S. market gains. (Last week’s strong rally in most international markets runs counter to recent trends and so bears watching).
Signs of Weakness in Housing. Last week brought more signs that the housing market has been slipping since the Spring selling season. The seasonally-adjusted annualized pace of existing home sales declined 0.7% in July from June and 1.5% from July 2017. Although the percentage drop was slightly below previous months, this was the fifth consecutive monthly decline in the pace of existing home sales. Meanwhile, inventories of existing homes slipped slightly, by 10,000 units to 1.92 million units; but the supply of inventory remained flat at 4.3 months. The months’ supply of existing homes on the market is up sharply from the lows of a year ago, but it is still down modestly from the five-year average.
Similarly, the pace of new home sales slipped 1.7% in July from June, but was still up 12.8% year-over-year. This marked the third consecutive months of decline in the pace of new home sales. Year-to-date, actual sales are up 7.2%, which is still solid. It is not unusual for sales to taper off after the peak Spring selling season. New homes available for sale rose 5.1% from last year to 309,000 units. The months’ supply of home available for sale has increased from 5.3 in March to 5.9 in July, but that was even with the year-ago figure. While there is some evidence of softening in the new homes market, it appears to be rather modest so far and virtually all builders remain upbeat about the sales outlook. Even so, the combination of steady house price gains coupled with the 50-basis point increase in mortgage rates since the beginning of the year has hurt affordability, taking some first-time buyers out of the market.
Interest Rates. One of the surprises of the past couple of weeks has been the rally in Treasury securities. Long-term rates have fallen 16-18 basis points since the beginning of the month, with the yield on the 10-year now at 2.82% (from 3.00%). The rally has come despite continuing elevated levels of consumer price inflation. (Year-over-year gains in headline and core (i.e. excluding food and energy) inflation rose again in July to 2.95% and 2.35%, respectively; but while most economists project a further modest rise in CPI over the next several months, they also expect that consumer inflation will ease in 2019 and beyond.) This week’s report on personal income will bring the July data on the personal consumption expenditures (PCE) deflator, which is the Fed’s preferred measure of inflation.
While the long-end of the yield curve rallied, yields on the very short end continued to rise, though modestly, in anticipation of the Fed’s next rate hike in September. The two-year Treasury yield has slipped by four basis points since the beginning of the month to 2.63% and the spread between the 10-year and 2-year yields declined from 33 basis points to just 19 basis points.
If the Fed raises the Fed Funds target rate in September and December, as expected, short-term rates will continue to rise; but unless long-term rates also rise in step, the Treasury yield curve will move closer to an inversion.
The long-end of the curve seems to be reflecting a view that developing weakness in the global economy will keep inflation at bay and thus interest rates low for the foreseeable future; but so far, the Fed remains committed to continuing the process of interest rate normalization.
Fed Chairman Powell speaks. Mr. Powell gave a speech entitled “Monetary Policy in a Changing Economy” at the annual symposium held by the Federal Reserve Bank of Kansas City in Jackson Hole Wyoming. In that speech, he highlighted the difficulties in determining the natural rate of unemployment (which most economists think is somewhat above the current rate of employment) and the neutral real rate of interest (which the Fed thinks is now about 75 basis points). In a dynamic economy, these neutral rates can and do shift and there is considerable uncertainty in determining where they are. Yet, they can have a decisive impact on both the current rate of inflation and over-time, on long-term inflation expectations. In the face of that uncertainty, conventional wisdom suggests that the Fed should take small steps in adjusting monetary policy to avoid making significant errors.
Mr. Powell described the actions of the Federal Reserve in two different eras – the late 1960s and the late 1990s – that illustrate these challenges. In the early 1960s, he argues that the Fed misjudged the neutral rate of unemployment and so kept interest rates too low for too long, unleashing the “Great Inflation” that continued until the early 1980s.
In the late 1990s, however, the Fed, under Chairman Alan Greenspan, kept interest rates low when unemployment was low because he argued that strong productivity gains would keep inflation at bay. Under his direction, the FOMC stood ready at each meeting to raise rates if necessary if signs of higher inflation began to appear. It turned out, however, that those signs never came. (Instead, inflation did appear in the form of rising house and stock prices, which would prove consequential in the 2008 financial crisis.)
Accordingly, with the economy in good condition, inflation near the Fed’s two percent objective and most people who want a job able to find one, Mr. Powell said that the FOMC would proceed at a measured pace to continue the process of interest rate normalization. That suggests that the Feds Fund rate will eventually rise to about 2.75%, according to the Fed’s own assessment of the neutral real rate of interest. The FOMC stands ready to adjust its approach based upon incoming data.
In his remarks, Mr. Powell did not take note of the impact of trade tensions on the global economy and the related declines in emerging market currencies, which are putting pressure on those economies. He also did not discuss the flattening of the yield curve or the developing weakness in housing, which are attributable at least in part to recent increases in interest rates.
The Mid-Term Elections. Over the next couple of months, the approaching mid-term elections are likely to play an important role in actions taken by the Trump administration with respect to the economy, specifically on foreign trade. Last week, negotiations with the Chinese over trade policies ended with no apparent signs of progress. Reporting by the WSJ suggested that one camp, led by Treasury Secretary Mnuchin, would like to reach an agreement as soon as possible. Hardliners, however, want to keep piling on the tariffs until the Chinese move closer to U.S. demands.
An escalating trade war with China may eventually have a greater negative impact on the U.S. markets. Today, however, stocks are up reportedly on expectations that the U.S. and Mexico are close to an agreement on NAFTA. If an agreement is reached, investors may take some comfort that the tough tactics used by the Trump administration can produce positive results.
Where to from Here? In the absence of any meaningful resolution of these outstanding issues and without greater participation from the lagging S&P industry sectors, I think that it will be difficult for the stock market to post meaningfully higher gains. The impact of trade negotiations seems to have the greatest weight currently, but interest rate increases and weakness in housing could weigh more heavily on U.S. stocks over time. I personally would prefer to see the Fed pause after the September rate hike at least until the trade negotiations are resolved.
For now, rather than being solid evidence of a continuation of the bull market, I think that the new high in the S&P 500 will serve as a placeholder – a reminder that the trend is still up, even if the market should trade sideways for a while or suffer a more meaningful correction.
August 27, 2018
Stephen P. Percoco
839 Dewitt Street
Linden, New Jersey 07036
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[i] Like PPO, the Moving Average Convergence-Divergence (MACD) indicator is a measure of the difference between long and short moving averages. MACD calculates that actual difference between the two moving averages, whereas PPO is a percentage calculated by dividing that difference by the longer moving average.