Is a Year-End Stock Market Rally in the Cards?

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

For the past few weeks, an assortment of market columnists and I have been carefully dissecting if and when the market will have effectively priced in the many negative scenarios that prompted what is a now a two-month correction.

The S&P has shed 11.6% and the Nasdaq has declined 14.6%. If it weren’t for the health care, utilities, consumer staples and specialty real estate investment trust (REIT) sectors, the declines would be considerably worse. For growth stock investors, the losses have been particularly painful.

Taking into account the market’s full-blown retest of the October lows, some of the headwinds that investors cited in late September have certainly abated. Rising inflation has tapered with the softening prices for homes and many commodities, as well as a drop in global crude prices. WTI crude closed last week at $50.42/bbl. — a 13-month low that kicked the stool out from under the oil sector, despite the bullish trend in natural gas that has emerged in the past six weeks.

It seems logical that investors and the Fed can put the threat of meaningful inflation risk aside for now. But that is not quite how the bond market sees it. As of Nov. 24, according to the CME FedWatch Tool, rate hike expectations have declined as U.S. equities face selling pressure but are not nearly at a level that would suggest the Fed won’t go ahead and raise the fed funds rate a quarter point to 2.25%-2.50% on Dec. 19.

The fed funds futures market still sees a strong chance (74.1%) that the Federal Open Market Committee (FOMC) will boost the fed funds target range in December, but the implied probability of another hike in March decreased to 37.7% from last week’s 51.9%. So, unless economic data deteriorate further in the next two weeks, it appears as if the Fed will indeed raise rates and offer a wait-and-see dovish statement in its policy statement. That’s what the bond market is telegraphing. If the Fed elects not to raise rates, stocks will react in a bullish manner that could help to repair a lot of damage.

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We just don’t know if Fed Chairman Jerome Powell and the rest of the voting members of the Fed are as concerned with the market’s recent drop as the majority of those invested in it. Recent statements from Powell and other Fed officials haven’t given any clear indications that they may skip a rate hike in December to explain the high probability reading by the CME FedWatch Tool. Regardless, hopes are rising the Fed will eye the recent rally in bond prices and the steep fall in stock prices, as well as take a “wait and see” path next month instead of next year.

 

If recent economic data showing slower gross domestic product (GDP) growth is on the horizon but still isn’t enough hard evidence for the Fed to stand down, then a quick view of what’s occurring in the corporate bond market could surely provoke some thought. The spread on the Merrill Lynch Corporate “A” Rated Minus 10-year Treasury has widened by 20 basis points in the past three months while the spread on the Merrill Lynch High Yield Minus 10-year Treasury has ballooned by 60 basis points to its widest level in a year.

I wrote in early October about how well these spreads were holding in light of external events outside the U.S. markets that were wreaking havoc on foreign currencies and emerging market debt held by the likes of Italy’s largest banks. Well, the situation has changed, and not for the better. Both the U.S. investment grade and high-yield debt markets are sending a clear message that future higher interest rates will undermine the level of creditworthiness and strength of America’s corporate balance sheets.

Corporate Debt Spreads Widening Out

According to S&P Global, the debt load for America’s corporations is at a record $6.3 trillion. And while that number may sound alarming, corporations are sitting on over $2.1 trillion in cash to service that debt, not including future free cash flow. However, the majority of that $2.1 trillion is held by a few giant companies while the riskiest borrowers are more leveraged than they were even during the financial crisis, according to S&P’s analysis, which looked at 2017 year-end balance sheets for non-financial corporations. This could lead to trouble for the economy as interest rates rise. Here, too, the Fed should be on “spread watch” so as to not exacerbate or put further stress on what is a flexed corporate bond market.

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As to the issue of trade with China, I will refer readers of this column to my musings from last week when I addressed this topic in depth. My gut call on this highly fluid issue is that President Trump and President Xi will come away from the G-20 meeting with a “new and promising framework” that will pave the way for a long-term relationship of mutually beneficial trade terms. Basically, China will continue to refuse to concede to U.S. demands on intellectual property (IP) theft, forced transfer of technology, foreign investment in Chinese companies, respecting international rights of way in the South China Sea and cracking down on state-sponsored cyber warfare.

There simply isn’t enough time to do a high-level deal and the next round of 25% tariffs on another $250 billion of Chinese goods will very likely take effect on Jan. 1. I believe this realization contributed greatly to last week’s sell-off into Black Friday. It seems that after the Republicans lost the House, Beijing has only stiffened its resolve to see if Trump is only a one-term President.

And then there is the nagging problem of many hot spots within the emerging debt markets with Italy holding a bad hand. Italian bonds have taken another turn lower as investors respond with deepening concern to the latest political developments. Although investors are demanding ever higher yields on Italian bonds relative to German bonds, which are considered a reliable financial measure of Italy’s perceived political risk, they are well below the levels reached during the worst of the euro-zone sovereign debt crisis in 2011. However, the recent trend higher is disconcerting.

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The good news is that the stock market and its participants aren’t aware of these risks and neither is the Fed, I presume. Right now, the rule of “less is more” (i.e. rate hikes) makes considerably more sense as far as the Fed is concerned. Well before the next FOMC meeting, the future of trade with China will be well defined and many S&P 500 companies will have reported third-quarter earnings and provided forward guidance.

The five-year chart above of the S&P 500 SPDR (SPY) shows that as of last Friday, the market is sitting at a key technical support level. The stock market traded well above its long-term trading range in early January this year and then again in September. The ensuing correction has taken a toll across most sectors, but hasn’t broken the primary long-term uptrend, at least for now. And if the Fed is correct in its 2019 GDP forecast calling for 2.5% growth, then we should see a resumption of upside momentum before Christmas that will bring the kind of relief that few gifts under the tree could satisfy.

Assuming the bulls get the upper hand, income investors will benefit greatly from a sharp rebound in high-yield assets. My Cash Machine advisory service is the flagship income-generating service that I’ve overseen for over a decade and is currently invested in 23 separate holdings paying a blended yield of 9.0%. The assets within the model portfolio are sensitive to inflation and higher interest rates, unlike conventional fixed income asset classes like corporate bonds, preferred stocks and Treasuries. Take a tour of Cash Machine by clicking here to see whether generating a 9% stream of income makes for a great year-end strategy. For thousands of investors, it already is.

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