Wednesday, March1, 2019
- The Fed’s “U-turn” since December helped stocks move higher.
- Speculation on a positive outcome to U.S./China trade discussions also helped rally stocks.
- Earnings growth slowed in Q4 and may be heading negative for 1H’19 but stocks looked past that due to the above.
- 10-year yields traded in the narrowest range in a year, stabilizing near 2.65% -2.70%.
U.S. equities continued their powerful rebound off the December lows through the end of February with the Dow Industrials (DJIA), Nasdaq Composite (CCMP), Nasdaq 100 (NDX), and Russell 2000 (RTY) indices each extending their streak of weekly gains to nine. All of the major equity indices closed out February with YTD gains ranging between 11% and 17%, and the January trend of smaller cap stocks outperforming large, and cyclicals outperforming defensives, rolled on in February.
The revival in risk sentiment can be credited to a number of factors. The Fed is now on “pause” after a turbulent Q4 which saw a dramatic decline in inflation measures and overall financial conditions, as well as a 45% drop in oil prices. WTI crude has since rebounded more than 36% off the December lows and ended February at $57.22 (+25.8% YTD). Crude’s rebound has been driven by Saudi Arabia cutting back more than they originally agreed to, strong Chinese purchase volume in January, and optimism over U.S.-China trade talks.
On trade, following “productive talks” between the two sides, Trump agreed to delay the U.S. increase in tariffs that was scheduled for March 1st. The biggest beneficiary was the Shanghai Composite which responded the next day with its best trading session (+5.6%) in ten years (March ’09). Yet while the extension is certainly a positive signal, the abrupt end to the U.S.-North Korea Summit sends a warning that a trade deal could also fail to materialize.
The Russell 2000 and Russell Microcap indices have led the rebound with gains of 24% off their December lows, while the S&P 400 Midcap Index (MID) and CCMP are right behind at +22%. The “laggards” have been the large cap DJIA and S&P 500 (SPX) with gains of +20% and +19% since late December. Perhaps the most impressive of the lot is the NDX which is +20% above its December lows. While this ranks in the middle of the pack, the NDX only declined a modest 1% in 2018 versus declines of 12% and 14% for the small and mid-cap indices.
The flagship SPX index came within 5% of its 52-week highs but in the final days of the month stalled at the 2,813 level. This top is within the widely expected resistance zone of 2,800 – 2,815 representing the bear market rally highs of October, November, and December. Many are now expecting a “healthy” correction to follow, however there is a common trading adage that in the near term the market often does the opposite of what many expect. The “pain trade” of short covering and cash on the sidelines waiting for that elusive pullback could first push stocks higher still.
The rally off the December lows is now entering its third month and has been accompanied by particularly strong breadth, as opposed to a few number of larger cap stocks driving the benchmarks. This is noteworthy as breadth can often lead price.
The Russell 3000 represents 98% of all publicly listed U.S. companies and its advance-decline line (lower panel, blue line) made fresh all-time highs in late February. In similar fashion but earlier, the SPX saw its ADL make new highs in January. Also, currently 87% of the companies in the Russell 3,000 are trading above their 50-day moving average which last occurred in early 2016 and early 2013 (middle panel, green line). Both of those occasions took place in the early stages of a multi-year uptrends.
As further evidence of the bullish market breadth and small cap outperformance, the S&P 500 equal weight index (SPXEWI) has outperformed the cap-weighted SPX by 250 bps YTD. The equal weight index has already surpassed its bear market rally highs from October through December which are holding back the cap-weighted SPX. Seen below the ratio of the equal weight index to the SPX (SPXEWI/SPX), a measure of relative strength, moved back above its 40-week moving average in mid-January and is now in an established trend of higher highs and higher lows.
In line with the strong monthly and YTD index returns, all level 1 GICS sectors finished their second consecutive month in the green. Leading sectors included the trade-leveraged Industrials and Technology sectors which are now up 18.1% and 14% YTD. Energy stocks +13.2% YTD are riding the rebound in crude, while REITs +11.4% are benefitting from the remarkable dovish pivot by the Fed. Seven of the eleven sectors are up double digits YTD, while the defensive healthcare +5.8% and utilities +7% – 2018’s top performers – are bringing up the rear.
Federal Reserve Interest Rate Policy
The Fed minutes released on February 22nd offered few surprises, which meant the market correctly discounted the Fed’s newfound dovishness with respect to rate changes and its balance sheet.
Chances of the Fed not taking any action on rates have spiked sharply since December. A month ago, the chance of a rate hike by December 2019 was about 26% with very little chance of a cut (4%) and a two-in-three change of the Fed standing pat. As of the end of February, the chance of the Fed doing nothing is up to 92%, with the chances of a cut (6%) greater than the chances of a rate increase (2%).
*Data from CME Fedwatch, which uses Fed Funds Futures to calculate probabilities for future target rates.
Buybacks in Focus
While stock market is off to its best start since 1987, institutional and individual investors have been selling based on fund flow data. Making up the difference is company buybacks. This is not a new trend but an important factor to consider in market performance since companies have become the single biggest source of demand for U.S. stocks especially given criticism by some who prefer greater capital spending or payroll increases in lieu of buybacks. According to the NY Times, companies have announced plans to repurchase more than $190B of their own shares so far this year, only slightly behind last year’s record pace. Net stock purchases are expected to total $700B for all of 2019, rivaling last year.
According to NYU professor Aswath Samodaran buybacks climbed dramatically through the lows of 1980s and 1990s, both in dollar value terms and as a percentage of overall cash return. The trend has only accelerated in the 2000’s. In 2018, more than 60% of the cash returned by S&P 500 companies was in the form of buybacks, amounting to almost $700 billion.
According to FactSet, 89% of the companies in the S&P 500 have reported earnings to date for the fourth quarter. Of these, 69% have surprised on the upside, (9% in-line and 22% below). This is below the 1-year average (77%) and the 5-year average (71%). Tech and Industrial companies have been the leaders in earnings beats with 86% and 81% respectively. For revenues, 61% of companies have reported actual sales above estimated sales, below the 1-year average (72%) but slightly above the 5-year average (60%).
For Q4, with about 90% of S&P companies having reported, the aggregate estimate is for roughly 13% earnings growth (up from about 10.9% at the beginning of the quarter) on revenue growth of 6.6%. If trends hold, this will be the fifth consecutive quarter of double-digit earnings growth (Q1-Q3 saw about 25% growth each).
Still, earnings estimates have been sharply revised downward. For Q1, analysts have been cutting expectations and now expect a 2.7% declinein earnings. This estimate turned negative in January after starting the year at +3.0% and has been moving deeper into the red each week. For Q2, the expectation is for a 0.7% gain in earnings but given the recent trajectory of estimates the positive growth seems to be hanging on a thread. This estimate was at +3.7% at the start of 2019. Still, stocks have been moving higher on Fed dovishness and the aforementioned hopes for a breakthrough on trade.
For the first quarter, the S&P 500 is projected to report a year-over-year decline in earnings of 2.7%, but year-over year growth in revenues of 5.2%. Given the dichotomy in growth between earnings and revenues, there are concerns in the market about net profit margins for S&P 500 companies in the first quarter. FactSet’s Earnings Insight report says the estimated net profit margin for the S&P 500 for Q1 2019 is 10.8%. This would be the first year-over-year decline in the net profit margin since Q4’16 and the lowest since Q4’17. Ten of the eleven sectors are projected to report a year-over-year decline in their net profit margins in Q1 2019, led by Information Technology (20.1% vs. 22.3%), Communication Services (11.3% vs. 13.2%), and Materials (9.1% vs. 10.6%) sectors. Only Utilities are expected to see an increase in profit margin (by 0.1% to 12.9%). It seems we are on the other side of the tax cut benefits.
The slowing earnings estimates are largely priced in by the market despite the potential earnings recession (two consecutive quarters of negative growth) in the first half of 2019. Balancing out slowing profits has been the dovishness of the Fed and the hope of a breakthrough in China trade. This means that if there is not too much daily news from the Fed and China, stocks tread water. The VIX continued to drop in February, falling below 15 just after Valentine’s Day and ending the month at 14.78.
Another way to look at the new-found serenity in equities is to measure the number of 1% moves in the S&P 500. The chart below shows daily moves of 1% or more have been in decline since the market bottomed in late December, with only 2 such days (both rallies) this month versus ten in December.
While markets appear to have priced in the global growth slowdown, there remains a fair amount of geopolitical risk that could dampen the V-shape rally. U.S.-China trade talks are still up in the air. And while there is a high amount of optimism a deal will eventually get done, the abrupt end of the U.S.-North Korea Summit is not only a warning that things can quickly sour, but we could see stronger U.S. enforcement of NK sanctions to the dismay of China. The Brexit agreement remains unpopular and far from completion. The U.S. could also impose auto tariffs on the basis of national security which would warrant reciprocal action from its trading partners, opening up a new “trade war” front in Europe. Locally in the U.S., the political atmosphere is not improving. Though some argue that gridlock is good for stocks, the inability of the main political parties to work together could hurt sentiment or hamper the government’s ability to respond to a crisis.
The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided “as is” without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
Nasdaq's Market Intelligence Desk (MID) Team includes:
Charles Brown is Associate Vice President on The Market Intelligence Desk with over 20 years of equity capital markets experience. Charlie has extensive knowledge of equity trading on both floor and screen based marketplaces. Charlie assists with the management of The Market Intelligence Desk and works with Nasdaq listed companies providing them with insightful objective trading analysis.
Steven Brown is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over twenty years of experience in equities. With a focus on client retention he currently covers the Financial, Energy and Media sectors.
Christopher Dearborn is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Chris has over two decades of equity market experience including floor and screen based trading, corporate access, IPOs and asset allocation. Chris is responsible for providing timely, accurate and objective market and trading-related information to Nasdaq-listed companies.
Brian Joyce, CMT is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Before joining Nasdaq Brian spent 16 years as an institutional trader executing equity and options orders for both the buy side and sell side. He also provided trading ideas and wrote technical analysis commentary for an institutional research offering. Brian focuses on helping Nasdaq’s Financial, Healthcare and Transportation companies, among others, understand the trading in their stock. Brian is a Chartered Market Technician (CMT).
Michael Sokoll, CFA is Associate Vice President on the Market Intelligence Desk (MID) at Nasdaq with over 25 years of equity market experience. In this role, he manages a team of professionals responsible for providing NASDAQ-listed companies with real-time trading analysis and objective market information.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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