-- This Week In The Money --

Analysis, Perspective, Trading Strategy

Hope the Fed gets it Right. Watch the Bond Market. Stick with what’s working.

By Joe Duarte on July 28, 2019

Investors are playing a wait and see game revolving around the Federal Reserve and its interaction with the bond market even though stocks have soared to new highs on better than expected earnings for many large cap stocks.

Last week, in this space, I noted my concern about the sudden lack of buyers seen in the stock market on July 19. And although the short term meltdown in stocks that I thought was possible failed to materialize, the confusion caused by conflicting statements from the Federal Reserve which led to the buyers walking away on 7/19 provided a valuable glimpse into the importance of what the Fed does and how the bond and stock markets perceive whatever the Fed does on July 31.

Of course, the odds for a Fed rate cut are high. But it’s not certain whether a quarter point cut in the Fed Funds rate, the most likely development, will be viewed as a positive or a negative by the biggest influence on the markets, the algos, when the news hits. Meanwhile, the global economy is clearly slowing; perhaps rapidly which is usually a reason for central banks to lower interest rates as South Korea recently did and as the European Central Bank forecast it would do in September.

In contrast the U.S. economy seems to be slowing less rapidly, if at all, which means that the Federal Reserve’s likely rate cut on July 31, could be seen by the markets as a “preventive” move or worse as a sign that the Fed knows something that the market has yet to factor in, such as worse news than the data has shown so far based on some double secret crystal ball in Mr. Powell’s office.

I know that sounds silly but that’s how traders and algos seem to think. What’s even potentially worse is that Mr. Powell will have a press conference to follow the meeting and the news release which will increase the odds of volatile trading as the algos move the market with every word he utters and every breath he takes.

Still, the bulls can’t complain since as a result of the Fed’s expected rate cut, we’ve had a nice rally in the month of July, despite the choppy trading we’ve seen at times. Moreover a look inside the stock market suggests that it’s really the bond market that is ruling the roost, based on the action of the U.S. Ten Year Note yield (TNX) which has failed to fall below 2% since it dipped below this key chart point a few weeks ago.

 

 

But that may be changing as we could be at that point in the cycle in which bonds sell off but stocks don’t as money moves out of bonds and into stocks. If that’s what’s happening, it certainly could explain the most recent rally to new highs in stocks and the relative calm in bonds as being fueled by traders who missed the July rally in stocks while sitting in bonds and are now trying to catch up.

In addition much may depend on the interactions between the Markets, the Economy, and Life -the MEL continuum – and how it reacts to whatever the Fed does in short order. Already we are seeing that nearly record low mortgage rates are not leading to rising home sales, which means that consumers are very in tune to interest rate fluctuations, especially when making decisions about long term, big ticket items.

Thus, if the Fed fails to satisfy the markets, I would expect a rapid and negative response in both bonds and stocks which would then translate into an equally rapid shutting down of consumer wallets and a significant slowing of the U.S. economy in which the data will begin to reflect the slowing within weeks.

On the other hand, if the bond market tanks but the stock market rallies, it is plausible that the U.S. economy does not tank as consumer spending remains stable, or perhaps increases and thus corporate earnings remain good enough to keep stock prices higher.

A third scenario, which is what happened on July 26, would be that the bond market shrugs off whatever the Fed does and moves very little, leaving the stock market to think for itself, which it did when it responded to the Fed. Especially important will be how everything responds if and when TNX breaks above or below the 2-2.25% yield range.

Chip Stocks Ignore Bond Market and deliver Blowout Earnings

The markets may turn very scary next week, but for now things remain very bullish. For example, two semiconductor stocks, Texas Instruments (TXN), and Teradyne (TER) blew away their earnings expectations while delivering positive guidance for the future, which is why despite all the uncertainty it pays to be patient and to stick with what’s working.

 

 

Certainly both companies noted that the current slowing in the semiconductor cycle will be around for perhaps another quarter or two. But more important is the fact that both companies are using the current climate to make long term management decisions about their business for the future, as they prepare for the return of growth while focusing on their strengths. As a result, they were able to beat reasonable expectations and the stocks popped.

 

 

TXN continues to benefit from its economies of scale in their manufacturing processes, especially their 300 mm analog chip design which allows for the placement of more circuits per chip and which has led to increasing levels of free cash flow even during a down cycle. For its own, TER beat its expectations on higher than expected orders for 5G, wireless, handset and memory chip testing equipment.

Thus the rally in TXN and TER is proof that well managed companies in well chosen niches of the tech sector can still deliver positive surprises and that algos will usually respond to headlines in extraordinary fashion.

NYAD Made a New High Last Week

The New York Stock Exchange Advance Decline Line (NYAD) has been the most accurate indicator of the market’s trend since the 2016 presidential election. Moreover, in the last two weeks it has mapped out a trading pattern of midweek new highs followed by less enthusiastic trading into the weekend. On July 26, NYAD closed the week just below a new high after making a new high on July 24. But given the fact that it made a new high midweek, the trend remains bullish as there is no overt major negative divergence at this point.

 

 

This, of course, could rapidly change. But mostly, this choppy trading pattern confirms the insecurity of traders, which as I pointed out above, is being highly influenced by the bond market and its effect on stock traders.

 

 

Both the S & P 500 (SPX) and the Nasdaq 100 (NDX) indices made new highs on July 26, which coupled with the positive action in NYAD again suggests that money continues to move into the stock market and that the path of least resistance is up, for now.

 

 

Certainly this very bullish picture could change on July 31, which is why what’s happening now isn’t a reason to over invest on the long side until we actually know what the Fed is going to do.

It’s better to be safe than sorry

Since there is no way to know what the Fed will say or do and how the markets will respond, the best trading posture at the moment is one of being well prepared. What that means is that the focus of any portfolio should be on sticking with what’s working while laggards should be sold via 5% or less sell stops. It’s also a good idea to consider tightening sell stops on winners. Finally, it makes sense to hedge into the Fed’s decision and to act accordingly once the deed is done.

Those who wish to trade options can consider straddles – buying both a call and a put - for the S & P 500, the Nasdaq 100 and the 30 year T-bond via ETFs – SPY, QQQ, and TLT. I discuss straddles and other option trading techniques in “Trading Options for Dummies.” See below for full details on how to get your copy.

I own TXN and TER as of this writing.

Joe Duarte has been an active trader and widely recognized stock market analyst since 1987. He is author of Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com - now in its third edition, The Everything Investing in your 20s and 30s and six other trading books.

Preorder the second edition now of The Everything Investing in your 20s & 30s at Amazon and The Everything Investing in your 20s & 30s at Barnes and Noble.

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