'Hated' Rally of 2019 Faces Crucial FOMC Meeting Week
– Probabilities favor an equity rally post FOMC rate cut
– Defensive sectors outperform in first three months after non-recessionary cut
– USD headwind for stocks to fade with cut
As just about anyone who isn’t living under a rock expects, the U.S. Federal Reserve Board is set to cut the Fed funds rate next Wednesday (for more on this see page 6). My anecdotal sense in talking with clients is that they are focusing on the last two rate cycles (2001 and 2007) and therefore see these cuts as both a negative signal and of limited benefit for stocks.
The bears need to refocus on the circumstances surrounding this cut. I’ve previously published multiple studies showing that stocks see positive gains every time the Fed cuts (100% of time, when LEIs positive). Consider the mechanisms.
The strong greenback has been a headwind for Corporate America and its EPS growth since 2018 (taking perhaps 5%-6% off the top-line). Consequently, a Fed cut should let the USD weaken. Moreover, because of either a shortage of USD or an oversupply of short-term Treasures, the Fed Funds rate is now higher than the IOER (interest on excess reserves). The Fed has intended to keep the funds rate below IOER, but in the past three months, the former has moved above this.
Finally, lowering interest rates is a further easing of financial conditions— and hence, positive. Despite the bearish headlines and the record market highs, there are actually multiple reasons for stocks to rise based on a Fed cut next week.
For example, there is also materially less market liquidity and depth in 2019 combined with overall cautious US hedge fund positioning. JPMorgan, in its recent “Flows and Liquidity” report, noted that trading across all markets is down double-digits across most markets (YoY) and 20%-plus for equities.
Note that Comm Services was defensive and basically Telecom stocks until 2018
And hedgies are cautiously positioned despite 20% gains in equities year-to-date, a major contrast to 2017-2018, when hedge fund equity beta (exposure) was elevated. Therefore, if hedge funds decide to increase equity exposure, given the more illiquid trading environment, we could see a large upside move in risky assets —this is bullish.
The S&P 500 index, which has been making new high after new high in July, is blessed with strong market internals. Perhaps the best measure is the advance-decline line. The rally since June is relatively healthy, given that A/D line has also pushed to new highs, which reinforces my view that new index highs are imminent.
And don’t ignore the semiconductor sector, which is hitting new highs as well. This would seem to quash the late-cycle view of the U.S. economy. Semis never rally nor make new highs late in the cycle. For example, semis saw failures in 2001 and 2007, in terms of both absolute price and relative to the S&P 500. If we are in late cycle, semis should be rolling over now. What we see is prices at new highs and strong ‘relative performance’ vs. the S&P 500 index.
Post-cut sector performance isn’t all that consistent but it seems defensives and financials are the best bet in the first three months with win ratios of 83%, respectively (see table below). From there, returns should be based on the contour of the economic trajectory and there’s little consistency. The relative outperformance is likely reflecting stocks sensitive to lower interest rates and stocks that benefit from easing financial conditions. Hence, I think these sectors are the best bets in the next 3 months or so.
What could go wrong? Global central banks are easing and ECB seems to be tilting towards escalating measures. Given the high prevalence of negative yielding debt, this clearly signals investors are just not comfortable with financial conditions and therefore downside risk exists. But we see equity TINA (There is no alternative.)
Bottom line: We are positive on stocks in 2H19 and see upside beyond our 3,125 S&P 500 target. Semis hit new highs and, coupled with new highs S&P 500 and the A/D line, points to a powerful 2H19 rally. The following are 18 stocks to buy on the first Fed cut, based on best 4 sectors + DQM1 ranked: Healthcare, Telecoms, Financials and Staples: AMP, BLK, NTRS, COF, MTB, RE, CL, CLX, PG, MNST, MO, PM, AMGN, BIIB, GILD, HUM, BMY and MRK.
Per FS insight
** Performance is calculated since strategy introduction, 1/10/2019
