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A shot across the Dow

The Days Ahead: Fed meeting.

One-Minute Summary A steady drip of lower but not catastrophic economic numbers helped push the S&P 500 up every day this week. Yes, it’s one of those “bad news is good” things because the Fed is on hold and lower rates make stocks look better. The S&P 500 seems reluctant to broach its September highs but we’re only 4% off the record and up 14% from December.

To us it looks like an asset and technical trade. The asset side is just the relative attraction of equities. To oversimplify, lower rates allow equity discount models to throw off higher valuations. The technicals are just resistance lines for moving averages. We'll leave both to those who know what they’re talking about.

But what we don't see is bullish, confident, “great quarter guys” talk coming from the corporate sector. It’s all a bit wait-and-see if the cycle can keep going. We think it can and see this as the pause that refreshes.

And in an update on the tenth anniversary of the market low, we’d remind investors that the S&P 500 rolling 10-Year return is 16.5%. It hasn't been above 15% since 2001 so the 10-Year numbers are about as good as they get. What can we expect? Somewhere between the rolling 20-year number of 6% and 5-year of 11%.

 1.     How low can rates go? Don’t know. They’re already way below what we thought they would hit in 2019. This week we had a run of weak data, starting with retail sales, lower new home sales and Friday’s industrial production. The 10-Year Treasury tracked lower every day and hit 2.58% on Friday morning.

The yield curve is fully inverted in the belly of the curve with 10-Year Treasuries yielding only 7bp more than 1-Year Treasuries and 15bp more than a Treasury FRN. The latter has no duration risk. The 10-Year Treasury has a duration of around 8. The curve isn't yet the alarming shape it was back in 2007 but here, in the blue line, you can see the kinks in the curve.

We think the following dynamics are at play:

  1. Fed is on hold and there’s talk of only one rise this year. A few weeks ago it was a pause until June and then two.

  2. The ECB talked a grim book last week and announced a new LTRO (a sort of bank lending subsidy). No chance of rate changes there either.

  3. The German and Japanese 3-month bills are at -0.5% and -0.1. The U.S. is at 2.43%. On a relative basis with global money movements, the U.S. trade is a no-brainer.

  4. Brexit and Venezuela creates a fear trade. The U.S. retains haven status

For what it’s worth, rates have declined steadily since the December FOMC meeting. There is much discussion about the level of the  R* rate (the neutral rate where the economy neither expands or contracts). What is clear is that it’s lower than thought a few months ago. And we’ll probably see confirmation of that at next week’s FOMC meeting.

2.     Is there any sign of inflation?  No. The Fed talks about inflation all the time. It’s one of their two mandates: promote maximum employment and stable prices. They do not provide more specifics. Maximum employment could be unemployment of 2% (it’s never 0%) or 4% depending on the cycle and circumstances. The inflation target is usually held to be 2%. It’s relatively easy for the Fed to kill inflation but very hard for them to increase it. But, my, how they have tried. Years of QE, forward guidance and low rates should have stoked the inflation fires. But they haven’t. Not in the U.S. or in any other leading economy. Here’s the long-term trend in U.S. inflation.  

Inflation tends to rise going into a recession. No surprise there as the Fed chokes off any inflation uptick very quickly. But you can see that inflation has barely stayed above 2% since the recession or indeed going back to the 1990s.

The latest inflation measure looks like this:

That’s shows housing at 3.2%, core inflation at 2.1% and, because of soft gas prices, headline inflation at 1.5%. There are still deflationary forces at work…the bottom graph shows things like TVs and cell phone prices falling.

What’s next for inflation? Banks and investments houses pushed TIPS earlier this year on the basis that the Fed would allow higher inflation. That hasn't worked out. Expected inflation was as high as 2.1% in October but slipped to 1.9%. We think there is some risk of wage inflation coming though in the back end of the year. But there’s also the force of a strong dollar and lower import prices if a trade deal comes through. On balance, we don't see much inflationary pressure. Neither does the bond market.

3.     We're not alone in rubbishing the Dow as a lousy indicator of market sentiment, direction or performance. It's price weighted which means that the higher the stock price, the more that stock moves the Dow.

The five most valuable stocks (MSFT, AAPL, JPM, JNJ, XOM) in the Dow are 38% of the index. But the five highest prices are Boeing, United Health, 3M, Goldman Sachs and Home Depot. They’re 12% of the value but 32% of the prices. So, when Boeing tumbled on Tuesday from $450 to $358, it had an oversized influence on the Dow and greatly overstated stock market weakness.

So what does the Dow have going for it? Longevity and the sound bite value of “the Dow fell 400 points” rather than “the S&P 500 rose 0.8%”. But as a market measure? Nothing.

Bottom Line: Expect the news and macro events to keep stocks going. We think one of the big catalysts will be for news out of Europe to stop worsening. Expectations are beaten down. A small respite could help European stocks a lot.

Please check out our 119 Years of the Dow chart  

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All charts from Factset unless otherwise noted.