Last week, traders seemed focused on two important news stories -- the potential trade war with China and Uber's disappointing IPO. But the stories weren't all that important to the broader market. However, the more I consider the news, the more convinced I am that there could be an explosive rally in the stock market.
Let me explain...
The (Psycological) Trade War
First, let's look at the trade war with China. This seemed to be the primary reason the S&P 500 Index dropped as much as 4.4% below its recent high.
Last week's decline ended when news broke that talks between the United States and China were productive. The news consisted of a single tweet from Treasury Secretary Steve Mnuchin:
"Ambassador Lighthizer and I just concluded productive meetings with China's Vice Premier Liu He. We will continue our talks in Washington, D.C. next week."
That sparked a 2% rally in the S&P 500.
Now, one of the interesting aspects of this story is that many economists believe the proposed tariffs will not have a significant impact on the U.S. economy.
There will be higher prices on some items since the costs are likely to fall on consumers. But the price changes should be relatively small and have little impact on the official inflation data.
We know that because there has been a tariff on washing machines for more than a year. Economists at the Federal Reserve estimate that consumers bore between 125% and 225% of the costs of the washing machine tariffs . In other words, manufacturers used the tariff as an excuse to raise prices.
The price of a washing machine is up an average of $86 because of the policy. But major appliances account for just 0.055% of the consumer price index, so the increase has had a trivial impact on inflation.
The importance of the trade war, for now, appears to be mostly psychological. That's bullish because the negotiations with China will eventually end, and I expect stocks to rally when they do.
The Other Big Story
Now, for last week's other big story: Uber (NYSE: UBER ) . The ride hailing service completed its initial public offering on Friday, and the stock ended the day down. It had opened lower than the IPO price, which is rare, and the IPO had been priced lower than expected.
At the end of the day, Uber was valued at about $70 billion. At the end of last year, analysts expected the IPO to value the company at $120 billion.
I don't believe the disappointing IPO offers insights into the state of the stock market. The IPO tells us that investors have questions about Uber's business model.
Remember, Uber loses money on every ride. Low prices are required to keep customers, and there are questions about whether passengers will use Uber if they have to pay much more.
There are also questions about whether Uber fairly compensates its drivers, and that is an issue that's likely to end up in court, at great expense to the company. If drivers are considered employees, Uber may not be able to survive -- and that is a definite risk to the company.
Local cities are also a threat to Uber. At least some of Uber's passengers would be using public transit systems where they are available. Public transit eases traffic congestion and offers benefits, so cities may take steps to discourage competition at some point.
While I could go on listing the myriad threats Uber is facing, it's not necessary. The point is that Uber faces significant challenges, and the stock price is reflecting that reality.
All we learned from Uber's IPO is that investors are risk averse in the sense that they are not buying just anything that comes to market. Yes, Uber is exciting, but it also has negative cash flow from operations and is unable to finance its business without new investors. That's also the description of a Ponzi scheme. (I'm not saying Uber is a Ponzi scheme, just that it's not a good opportunity for many investors.)
Wrapping up, the reaction to news about China shows that we are in a sentiment-driven market. For now, traders are buying and selling based on emotions. That could fuel significant gains. But the biggest gains will be in individual stocks because not all stocks will participate in this rally.
Investors remember the internet bubble. They don't seem anxious to repeat that pattern. IPOs will attract attention and some buyers, but the underlying business models are more important than the hype.
Zoom Video Communications (NASDAQ: ZM ) is up 30% since its IPO three weeks ago . It's not a coincidence the company is profitable, reporting net income of $7.6 million for the year ended January on revenue of $331 million, compared with a loss of $3.8 million a year earlier on revenue of $151 million.
We should research reports on Zoom, and the other recent IPOs, soon. Analysts generally won't publish reports on companies until 40 days after an IPO. Those reports will be market moving and will give us the next insight into what traders really think of Uber, Lyft, and other money-losing companies. Until then, it seems safe to say that investors want to put money to work in the stock market -- they're just nervous. In this environment, a focus on value should be useful to limit risk. A focus on the short term should also be useful to avoid the steep selloffs that will follow disappointing news.
From a technical perspective, last week, we saw stocks experience a normal pullback within a broad uptrend. The pullback could go a little deeper, but I expect to see a rush of buyers push into the market if the S&P 500 drops to 2,800 (which is almost exactly what we saw during Monday's trading). That limits the downside risks to about 3% and offers significant upside potential.