The Intelligent Investor’s Market Memo Nov 4, 2019 -

November 4th, 2019

Top Investment Trends Affecting Your Portfolio This Week

Markets rallied last week because the Fed cut interest rates, and economic data was better than expected.

Better than expected economic reports and more accommodation from the Fed drove stocks higher last week. The S&P 500 rallied by 1.5% to close at an all-time high, while the tech-heavy Nasdaq 100 and the small-cap Russell 2000 increased by 1.65% and 2.00%, respectively, this week.  International stocks also performed well, the MSCI EAFE Index (international ex-US and Canada) and the MSCI Emerging Markets appreciated by 1.5% and 1.2%, respectively.  

The leading sectors of the S&P 500 were Healthcare (up 3.05%), Technology (up 2.11%), and Industrials (up 2.06%), while the defensive sectors (Reits, Utilities, and Consumer Staples) lagged the S&P 500 last week.

Despite the “risk-on” environment, the safe havens performed well -- the U.S. Treasury long-bond (TLT) jumped by 1.50% this week, and gold rallied by 0.50%.

Also, it is interesting to note that high-yield spreads widened this week, which typically indicates that investors are risk-averse.

The Stock Market Liked the Fed’s “Hawkish Cut.”

On Wednesday, the Fed reduced interest rates by 0.25% for the third time this year. Fed Chairman Powell indicated that he believed that “monetary policy is in a good place” and suggested that future rate cuts are on hold for the foreseeable future. The market expected the rate cut and the pause by the Fed, and importantly, the market performed well despite the indication of no future reductions.

Currently, investors believe that there is only a 6.6% chance of another rate cut at the Fed’s next meeting on December 11th. While Powell indicated that the Fed is likely done cutting interest rates, the Fed Funds market is discounting a 45.1% probability that the Fed cuts rates by their April 29th, 2020 meeting.

As we discussed last week, the Fed raised interest rates four times in 2018, and in December, they stated that they would raise interest rates three more times in 2019 and continue their Quantitative Tightening program that sold $50 billion of bonds each month to reduce their bloated balance sheet.  Unfortunately, the Fed underestimated the negative impact of tightening monetary policy, and the trade war with China had on the economy. 

This year, the Fed followed the markets (i.e., falling long-term interest rates and an inverted yield curve) and shifted from a tightening cycle to an easing cycle to stimulate the slowing economy. Now, after three rate cuts, the Fed has indicated that their easing cycle is on hold.

While the Fed’s aggressive pivot to stimulate the economy, stabilized the bond market, and drove the S&P 500 to an all-time high, it is important to remember that the Fed pivoted because growth was slowing, and recession risks were elevated.  Unfortunately, the Fed has had limited success in engineering soft landings, and since they never normalized interest rates after the last recession, their monetary tools are limited.

According to CNBC, during the past twenty-five years, when the Fed’s third rate cut was its last, the market performed well very over the next 12-months, but if the Fed had to make additional cuts, stocks perform poorly, and the economy went into recession.

The third cut was final

1996
1998

S&P 500's 12 month performance
24.7%
17.4%

More cuts were necessary

2001
2007

S&P 500's 12 month performance
(12.6%)
(42.4%)

Source: CNBC

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The Stock Market Also Liked the Better than Expected Economic Data

Last week, three of the most important economic reports (Q3 GDP, October Employment Report, and ISM Manufacturing Index) were released, and the results were better than expected.

The real economy grew at 1.9% in the third quarter, which was greater than expectations of 1.6%, but down slightly from 2% growth in Q2. The consumer remained strong, while business capex and exports were disappointing. Consumer consumption (PCE) rose at a 2.9% rate, which was down from 4.6% in the previous quarter, and capex fell at a 3.0% annual rate, which was its most significant decline since Q4 2015. While the GDP report was better than expected, the results were consistent with a decelerating economy.

Nonfarm payrolls increased by 128,000, which was significantly above the consensus of 75,000. Importantly, the prior two months were revised higher by 95,000, which brought the three-month average employment gain to a robust 176,000. Average hourly earnings rose by 3.0%, which was in line with expectations and near its cyclical high.

Finally, the ISM Manufacturing Index was 48.3 in October, which was a 0.5 point improvement from September, but below consensus of 49.1. Manufacturing activity contracted for the third consecutive month, and according to the ISM, a reading of 48.3 is consistent with economic growth of 1.6%. While the ISM was below consensus, investors focused on the strong job market and drove the S&P 500 to an all-time high.

While the consumer and the labor market remain robust, the global economic slowdown and the trade war with China have negatively impacted the corporate sector. The manufacturing sector remains in a contraction and corporations have significantly reduced their capex for two consecutive quarters.

In our view, the Fed’s 0.75% reduction in interest rates will not incentivize corporations to increase capital spending or offset the negative impact of the trade war.  CEO’s reduced capital spending because of economic uncertainty and declining profitability. We are concerned that as the trade war continues, their next reduction will be in jobs, which will negatively impact consumer sentiment and spending. We are hopeful that the trade talks continue to progress, and Phase 1 of the trade deal is signed soon.

Charts of the Week

The Unemployment Rate is a Critical Recessionary Indicator

Federal Reserve economist Claudia Sahm created an indicator that could identify recessions in a timely manner. Her research found that when the three-month average unemployment rate rises half a percentage point above the previous year’s low of the past year, the economy is in a recession. Since 1970, the indicator has identified every recession.

Since the last recession, which ended in 2008, the unemployment rate has dropped from its October 2009 high of 10% to 3.5% this September. According to Sahm’s indicator, if the unemployment rate rises to 4.0% for three months, we will be in recession. Thankfully, Friday’s jobs report indicated that the unemployment rate was 3.6%, and Sahm’s 3-month average was equal to the 12 month-low in the unemployment rate (see chart below).

​​Source:FRED

Market Outlook

In the short-term (three months), we expect that stocks will rally into January on the expectation that the Fed’s dramatic policy shift (three rate cuts and purchasing $60 billion of T-bills each month) and the pause in the trade war with China will lead to an acceleration in economic growth next year. Also, we are entering the strongest three-month period of the year (November through January). Currently, the stock market has a poor short-term risk-reward – stocks are very overbought, and investor optimism is extreme. To participate more in the yearend rally, we will increase our risk exposure when the market is oversold, and sentiment returns to normal.

In the long-term (more than four years), we continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and high-profit margins that are poised to return to an average level. While investors believe that easy monetary policy can drive economic growth, we are concerned that since rates are already low, the Fed’s paused easing cycle will have a muted impact on economic growth.

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.