The S&P 500 is up 18% and powering toward its biggest first half since 1997. For bulls, things are great. Will they get any better? To a handful of cross-asset strategists who turned skeptical on stocks before this week’s manic sessions, that’s becoming the most pressing question. Increasingly, their answer is: not likely. However spectacular the real-time reaction … gestures like Federal Reserve Chairman Jerome Powell’s dovish pivot don’t engender confidence for the long term, says Sophie Huynh, a cross-asset strategist at Societe Generale in London. They ring more as a warning, she says, perhaps marking the beginning of the end to economic and market cycles that have lasted a decade.
It is one thing for stocks to go up in the middle of a recession because the Fed is lowering rates, which would ordinarily mean there is hope of coming out of recession a little easier. It is the exact opposite when the Fed lowers rates at the end of a recovery when it means the Fed is making a pre-emptive move because it sees recession as likely. Stock market investors do not currently understand that distinction. The Fed quit simply does not ever preemptively lower rates during what it claims is a strong economy when rates are already this low unless it believes a very negative economic shift is likely and imminent.
As I’ve noted several times in recent articles (with graphs to back it up), the Fed’s first rate decrease is typically only a few months ahead of recession at best. To think that its first rate decrease this time around will be any different is to bet against all historic evidence. Yet, that is exactly the bet the market has already fully priced in. Almost all analysts agree that the stock market now sees a July rate decrease as a 100% certainty.
However, live in a time when many market analysts have never seen a rate cut made during a time when recovery is considered to be fully in place and the Fed has been recently raising rates on a protracted basis, ostensibly to keep the economy form overheating. So, we have a lot of wet-behind-the-ears quants and analysts who think that rate decreases can only be good for stocks. They are ignorant of the historic fact I just laid out in the last paragraph. We know what happens to those who are ignorant of history.
However, we also have a lot of old analysts who seem to be absent-mindedly following the same belief — that all rate decreases are good news for stocks. In there case, it must be senility has set in. So, let me spell out the market mechanics involved here: When the Fed starts lowering rates after a recession has hit (as in 2008) and after stocks have crashed (as in 2008), there is mostly nowhere to go but up. When it starts lowering rates when stocks are at an all-time high, it means recession is seen by the Fed as being likely enough for them to retreat on there all-consuming original plan of tightening, so there is nowhere to go but down.
The manic market lift that has come because the Fed just said it may return to delivering medication is an addict’s high, which means it should be seen as= proof of bullish euphoria as well as poor thinking. The stock market has just poked its nose through its eighteen-month economic ceiling, as I said I wouldn’t be surprised to see it do. I’ve also said I believe this will turn out to be a failed test, just as it has been the last two times investors tried to poke through this level, barely succeeded and then fell hard shortly thereafter. There is nothing like peak euphoria to make that happen.
The market also appears to have fully priced in an imminent resolution to the Trump Tariff Wars.
Best-case scenario for the China syndrome
Xi and Trump agree to come out of their meeting sounding like there is hope for a future agreement soon (albeit with nothing specific that has been agreed upon). We all know there is no chance they come out with a deal. So, the best hope is they come out with Trump talking (again) like a deal is imminent and, therefore, he’ll hold off on his tariff increases a little longer. The market feels relief and breaks resoundingly through its eighteen-month ceiling. The remaining indices that have not cleared through their upper barrier manage also to poke through to a new high and manage to hold … for a little while.
Then what? All is roses, right? Well, the market has clearly already priced in a trade agreement being reached — also, with apparently 100% certainty — so hope won’t buy a lot more headroom at the market’s top because it’s the same hope that investors have been spending all along. Buybacks are now temporarily frozen out. Even Crazy Cramer is saying the economy looks worse than what the market thinks, He has even stated that, with all of his many executive contacts, he knows of no company that is not going to come in with lower earnings than last quarter. Economic data has been trending down. Forward projections are already being written ahead of any Chinese trade deal, so they won’t likely go up just because, once again, the Trumpet blares an announcement of a trade deal on the horizon. (The market will go up if Trumps makes such a proclamation (again), but corporate reports aren’t going to change because of it.)
Goldman Sachs notes,
A pause in [tariff] escalation in the near-term could still lead to additional tariffs later this year. In the two analogous leader-to-leader meetings noted earlier, President Trump agreed to postpone further tariffs. However, in both cases, this détente was only temporary, as the White House eventually imposed additional tariffs on imports from China [because] … financial markets do not appear to be an obstacle to tariff escalation… The last two times President Trump seriously escalated trade tensions with China, the S&P 500 was near record highs…. We would expect that the President now views tariff threats as not only a successful negotiating tactic following the immigration agreement with Mexico but also a useful tool in pressing for looser monetary policy. If so, this suggests that the White House will at least threaten further tariff increases and might follow through with some of them….
The stock market, in the best case scenario stalls out at its new top because there is no more good news in the pipeline right now. The Fed’s fully presumed rate increase still lies a month away, so the market is going to be running on fumes in the face of falling earnings and falling projections for the upcoming quarter. Trump badly wants rate reductions from the Fed and may see uncertainty over a trade agreement as a way to press Powell to move on that, given that trade uncertainty seems to be what tipped him in the direction of talking about loosening the financial reins in June. Trump will want to press him from talk to action, and that’s a hard press.
If the almost-always-optimistic Cramer is right, GDP will be coming in lower because lower earnings everywhere almost certainly go with lower GDP. (And I only reference Crazy Cramer because he is almost always bullish and optimistic; so, if he says he knows of no hope anywhere for higher earnings and states that he would rather believe the economy than the market right now, that is a statement strongly against his natural bias.)
And then more tariffs eventually come anyway if history is any predictor of the future. Whether they do or not, the market is clearly going to be bucking a lot of headwinds throughout the July corporate reporting season, so the fumes of Chinese trade hopes are not likely to sustain much lift when they are already priced in. So, in the best-case scenario, the market rises briefly, then struggles to hold against all these winds to await the Fed’s actions.
Worst-case scenario for the China syndrome
Xi and Trump come out of their meeting like the last meeting ended with things looking sour. Not altogether unlikely, given that China said this weekend, “The U.S. must drop all tariffs imposed on China if it wants to negotiate on trade.” Trump is not going to drop any tariffs until a deal is done. So, China might walk like Trump did last time to try to score the same kind of points Trump scored by walking and to show him they can do that, too. (That would stray far from the usual polite form of Chinese diplomacy. Still, China may be returning to the table just to tip Trump off balance in the same way he tried to tip them.)
The market has a long way to fall from precarious heights with a lot of bad news likely in the pipeline ready to help stuff it down and no buybacks available for a month to prop up share prices. GDP for the second quarter comes in with a sharp decline if Cramer’s industry contacts are right about earnings everywhere being down, and we have to wait until the end of July for the Fed to give the boost that has already been fully priced in by the market. So, the mere hope of that boost probably cannot do much more fueling than it has already done; but there is a lot of room for the market to crash if that hope is miscalculated and doesn’t come about at the end of July.
Most importantly, the Fed never said it is likely to lower interest in July. Not even close! It actually said it did not anticipate a rate drop until 2020. It merely hinted it was open to rate drops and only if merited (MEANING only if the economy is sinking). Yet, the market is assuming it will be merited as early as July, 2019. That means, underneath all the market mania, the market must be schizophrenically anticipating news will be so bad over the course of the next month to kick the Fed in the butt and get them to drop their pants (or at least their interest).
Trump is now confident in the stock market, which will help him hold a tough line with China:
Stock Market is on track to have the best June in over 50 years! Thank you Mr. President! @WSJ
— Donald J. Trump (@realDonaldTrump) June 22, 2019
I think Trump will likely try to use trade uncertainty to push Powell into making a rate cut in July, given that Powell has now indicated some willingness but is far from having said the Fed will do anything soon.
If Xi and Trump come out of their meeting empty-handed and, so, Trump decides to actually kick in the broader and higher tariffs, you had better run for your life if you’re invested in the market because hope will come sputtering out of the market like that flatulent sound of a balloon when someone lets go of the business end.
This is a high-rollers, high-risk game this week. You had better be willing to risk losing a lot of money in the hope of making a lot of money; but can you make a lot of money when the money is already priced in? Worse still, if the Fed doesn’t give its rate drop at the end of July, as it has indicated it will not, where is the bottom?
With that deep risk noted, I have said and still believe the Fed will drop rates in July because things will be so perilous by the end of July that it will have no choice, and Trump will do all he can to box Powell into that corner. In fact, I think it will be clear by then that the Fed already waited too long.
However, that also means, by the end of July, the market may already be well on its way toward that bottom, and the Fed’s rate cut will be desperate salvation at that point. In which case, Trump will have overplayed his hand and will watch his precious badge (the stock market) fall to pieces. That is almost certain, under the worse-case scenario where this trade meeting ends like the last one.
While I don’t think is the most likely scenario, such a market crash could happen even in the best-case scenario if corporate reports are bad enough late next month to indicate recession is at our doorstep, and GDP falls while buybacks are halted and Trump tries to create more uncertainty about a trade deal because he is currently confident in the market and wants to pressure Powell.
As is true for most equity bears, the relentless decline in Treasury yields provides reason enough to lighten up on stocks, pointing to gathering economic weakness. And while Powell’s dovishness has been enough to revive financial markets, expecting monetary policy to do the same for the economy is asking too much.
Regardless of whether stocks fall or continue to rise into the stratosphere because bond yields are so low and unattractive, at the end of the day, the economy wins the argument, and the economy is going down. It takes the Fed years to turn the economy around with the help of fiscal stimulus, and both are tapped out now anyway. So, we are coming to that summer inflection point that I have been warning you about all year. (Remember when it happens that you heard that timing here first.)
I just read an article that made the following bizarre claim while also claiming to be a contrarian position:=
An economic slowdown is now beyond fully priced into the financial markets…. However, we already are at a peak in pessimism.
While I agree that “Bull markets are born on pessimism … and die on euphoria,” as the author also quoted from Sir John Templeton, I think this author’s own take that we are now at peak pessimism is, in itself, about the most insanely euphoric statement I could have read this week.
The stock market is now at peak euphoria. Stocks are clearly at or near peak Price/Earnings ratios, especially CAPE. They are, in fact, priced to perfection. The market has fully priced in its hopes that 1) a China trade deal will be shortly forthcoming, taking all restraints off the economy, and 2) FedMed will fly in to save the economy because of the trade-war threat. (Two mutually exclusive hopes.)
It is not because investors are pessimistic about the economy that the stock market has priced these self-contradicting beliefs fully in. Rather, investors deny the truth that a) earnings went down last quarter a lot (beating only much lowered expectations) as did forward expectations, and no companies today are breathing any hope that they are about to go up; b) the main thing floating earnings along has been stock buybacks, which are likely to start diminishing as the benefits of the tax cuts subside a little; c) investors have believed that a China trade deal is imminent now for an entire year, and they have been wrong an entire year; yet d) they are still believing it, which is irrationally euphoric as there is not one more shred of reason to believe it now than a year ago. If anything, there are more reasons not to believe.
Goldman has created a “barometer” index tracking the probability of a trade resolution. It now stands at just 20%, or a one in five chance that the two superpowers will find an amicable resolution, and while this is up from 7% one month ago, it is down from 80% back in March.
So, the stock market is in the most irrationally euphoric state I have ever seen, betting everything on a solution to a Chinese puzzle that is a best-case scenario that has evaded the market and Trump for a year and that has little chance of transpiring. Thus, an article like the one just quoted that says the market has finally reached peaked pessimism is truly as irrationally and insanely euphoric as you will ever see.
This market’s mania is best seen in the way it is hoping for two essentially mutually exclusive things at the same time — hoping for a China trade deal that will take away the earnings problems that are starting to build while also hoping the lack of China trade deal will press the Fed to preemptively lower interest rates. It is even irrationally refusing to recognize the historic fact that lowering interest rates when the economy is supposedly in recovery only happens when the Fed believes its recovery is about to fail, and no stock market has ever done well as we are plunging into recession, though occasionally the market has managed to sputter along for a little while.
News that causes the Fed to lower rates in bad times when stocks have already crashed creates rate changes that can boost stocks back up; BUT, when stocks are already priced to perfection and hanging upon a star, a sudden move to lowering rates after a year or more of raising them means without fail recession is coming. That is an historic fact! The Fed does not lower rates unless it believes major trouble is imminent, and the Fed is almost always late to see trouble coming. In fact, two Fed chairs in recent memory boldly told congress no recession was in site when they were already standing in the middle of the biggest recession in almost a hundred years!
Peak irrationality can be witnessed in the contradictory position that a China trade deal is imminent, and the Fed will soon lower rates because the ever-evasive Chinese trade deal will scare them into pre-emptive action. That is all wrapped up with a bow called denial that maintains the economy is fundamentally sound even though the Fed will be raising rates soon. And to think stock investors believe bond bulls are the fools right now! (Never mind that, in a contest between bond bulls and stock bulls, bond bulls have almost always proved to be most prescient about the economy.)
Something even more bizarre may this way come
There is one caveat to all of this, which would be even crazier and I think never before seen. It could happen that the Fed will drop interest rates and keep dropping them through the floor andreturn to quantitative easing in the months ahead at even greater levels than it did before because its recovery fails. In fact, I think it is certain that the Fed will do that eventually. Once that is actually happening, all that free money will have to go somewhere, meaning it will likely go into stocks and bonds, driving prices of both even higher while the economy fails because none of that is going to cause the failing middle class to buy more stuff or cause the Trump Tariff War to go away.
In fact, Trump so hangs his hat on the stock market, that he is a likely to be emboldened by the present market high to continue with tariffs in his misguided belief that China pays for them, not the middle class. So, we could see the most bizarre situation where the stock market and bond market soar relentlessly even as the economy is crashing into recession.
In that case, the banksters may be able to repossess a lot of houses while they simultaneously get richer on stocks and bonds because rising stocks and bond prices (meaning falling bond yields) aren’t going to help most people pay their mortgages unless they are retired and accessing their retirement accounts because, for most people, their retirement accounts are their only stock and bond holdings. That is kind of a bizarre worst-case scenario, so I’m not advancing it as being most likely, but I can see how it could happen.
That would be the most insanely nauseating economy with the most disproportionate doling out of benefits we have ever lived under. Last time, banksters participated in the crash first, then got richer when they were bailed out. In this kind of situation, banksters would get richer at the start of the economic crash as the stock market soared and all the way through it, due to Fed pre-emptive action, as the middle class erodes further away. In the end, however corporations would end up with no one left to sell to because they’ve destroyed the great US middle class; but maybe that won’t matter any longer so long as the Fed keeps giving all corporations free money to buy their own stocks, regardless of what is happening to their markets! Halelujah! Isn’t America great?