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
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
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
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
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