Two big uncertainties are fading from market-memory. Why that bodes well for how we’ll close out 2019

When you’re watching a scary movie and the monster suddenly jumps out from behind the door, what do you?

Most likely, you startle in your seat. The reason why is simple — you weren’t expecting it.

But when you’ve seen the same scary movie 20 times and the monster jumps out from behind the door, what then? Nothing. That’s because you knew what was coming. Expectations met reality. Ho hum.

This dynamic plays out similarly in the investment markets, pointing toward an interesting takeaway …

The thing or event that actually happens in the market — whether good or bad — isn’t what drives price-action. Instead, the real driver is the difference between what actually happened and what was expected to have happened.

Take a company’s earnings report …

If analysts are calling for $10/share of earnings, but that number comes in at $8/share, that underperformance is going to take the market by surprise. Expect a sell-off.

However, let’s say analysts were actually expecting a loss of $3/share, but that number came in at a loss of just $2/share. This time, the surprise was positive. The stock will probably surge.

But notice the nature of these “events” themselves — the first company profited $8/share yet its stock suffered. Meanwhile, the second company burned through $1/share, yet its stock rose.

In a vacuum, does that make any sense?

No, but it illustrates our point — market events themselves aren’t the driver of short-term prices — it’s surprises to our expectations.

Last Friday, and continuing Monday morning as I write, the Dow is at a new all-time high. Why? Well, in large part, it’s because in recent weeks, three of the most significant issues on investors’ minds — interest rates, earnings, and China — have either met expectations or been mildly surprising in a good way.

Sprinkle in some smaller positive surprises, such as last Friday’s unexpectedly strong October jobs report and you have the makings for a bullish market environment.

So, in today’s Digest, let’s do a brief recap of where we are with these three market influencers, and then take a look at why things are looking good for a strong finish to 2019.

 

***Whether or not the Fed “got it right,” at least it met expectations

One of the most significant movers of the market is the Fed. Specifically, what it does with interest rates, including its language about what it might do with those rates in the future.

If the market doesn’t like the Fed’s decision — watch out.

Take last December, when the Fed signaled that it planned to keep raising interest rates. The market — not expecting this — had been up 300 points before the announcement, only to abruptly reverse, and drop 650 points, ending that day down 350 points.

Last week, we had another Fed meeting, resulting in a quarter-point cut, lowering the target rate to 1.50% to 1.75%. Now, whether or not this was the right move for the economy is beside the point. The bottom line is it met the market’s expectation.

John Jagerson from Strategic Trader noted this in his recent update to subscribers:

We expected some more volatility because the FOMC’s statement indicates it is ready to pause the rate cuts for now. The sanguine reaction to the announcement probably means the Federal Reserve met expectations, which is usually a good thing for the market in the short term.

Fed Chair Jerome Powell also took steps to be clear about what markets should expect going forward. In other words, he told us exactly which doors will have monsters behind them, and which won’t.

He did this by signaling that the Fed was stopping rate cuts for now. On more than one occasion, he said the Fed would keep its policy steady as long as there are no threats to its outlook for a moderately growing economy.

Given this, as we stand today, there’s far less room for the Fed to surprise the markets in some way as 2019 rolls forward. In other words, “green light” from the Fed.

***Earnings haven’t been the overwhelming disappointment many had been fearing

As I write, more than 350 S&P companies have reported earnings. Of them, 76% have topped estimates, according to I/B/E/S data from Refinitiv. That said, earnings are down about 0.8% for the quarter, based on companies that have reported already and estimates.

Here’s John for more color on this:

According to Zacks Research, the first 205 reports show earnings from the S&P 500 have declined since this quarter last year, but revenue has grown by 4%. In both cases, that is mostly in line with recent estimates.

However, it is worth noting that regardless of whether the reports are meeting expectations, investors are paying more for each dollar of revenue and earnings than they were at the same time last year.

Now, the fact that earnings are down isn’t good — nor is it good that multiples are increasing.

But remember, what moves prices? It’s not what actually happens, it’s whether or not what happens surprises market expectations. And in this case, the majority of earnings have either met expectations or even topped them.

Though we’re past the halfway mark of Q3 earnings season at this point, we still have a good amount of companies left to report. That said, what we’ve seen so far is a tentative “green light” from earnings. Assuming we don’t get too many nasty disappointments as we wrap up this earnings season, that’ll cross a very big “room for dangerous surprises” item off our list for the remainder of 2019.

***Finally, what about disappointments with the trade war with China?

Well, first, let’s put some shape around this China-trade-war boogeyman. After all, there’s a very real fear about the negative impact the trade war is having on the global economy and specific U.S. companies. But it’s a bit vague and shadowy. What are some real numbers related to this fear?

Let’s go back to John for that information:

According to Factset, the companies in the S&P 500 that generate more than 50% of sales from outside the U.S. have experienced a decline of 9.1% in earnings. A trade deal with China won’t completely reverse that damage, but it could improve the outlook considerably.

There are companies in all of the major sectors that fall into this category, but information technology, basic materials and consumer staples have the most exposure to international trade. All three groups have recently rallied back to likely resistance levels which gives us a good benchmark for whether the broader rally will continue.

For example, as you can see in the following chart, the SPDR Basic Materials ETF (XLB) has rallied back to $59 per share where it has run into resistance twice earlier this year. It could be that investors are pricing in a short-term improvement in international trade, and we would consider a breakout beyond resistance to be a trigger for more aggressive bullish positions.

 

 

So, the trade war is definitely having an impact on some companies’ earnings. That said, it’s encouraging to see the three sectors with the most China-exposure rallying back to resistance levels. That’s a bullish sign.

Looking forward, what can we say about a trade war resolution and market expectations?

This past Friday, Trump said that negotiations about a “phase one” agreement were going well, and suggested he could sign a trade agreement with China in Iowa (the state has been hard hit by tariffs). By the way, “phase one” allegedly represents 60% of a long-term agreement, so this is significant.

The fact that Trump is now referencing specific signing locations is clearly good news — of course, we’ve been near trade agreements before, only to see them fall apart. So, this is the real wild card, and it presents the biggest risk of market expectations being far different than eventual realities.

But the flip side is that we’ve experienced — and gotten through — many trade war disappointments up to this point. In the process, the markets have become increasingly resilient to these letdowns.

So, while a trade-war-related disappointment between now and the end of the year is certainly a possibility, things would really have to go off the rails in order for a sustained market meltdown to be the result.

Putting it altogether — the Fed, earnings, and the trade war — and it appears there’s reduced risk of negative surprises between now and 2020. And that supports the likelihood we’ll finish the year at or near record highs.

***On that last note, congrats to Matt McCall’s Early Stage Investor subscribers for some massive gains this past Friday

As we’ve noted here in the Digest, Matt McCall is wildly bullish on Chinese biotech stocks. In fact, he’s even called them “an investment that may have the biggest upside potential I have ever seen.”

This past Friday, we got a glimpse why …

U.S. biotech giant, Amgen, reported it is taking a 30% stake in one of Matt’s China biotech picks — BeiGene. The Chinese stock exploded 30% higher on the day, bringing its overall gains to Early Stage Investor subscribers to over 50%.

From Matt:

The deal also illustrates the huge potential as China pushes its biotechnology industry to grow more than 100X. We’ve talked about how that country’s approval process is now up to the standards of other countries, which opens the door to more partnerships and big money flowing into these companies.

In other words, it’s another step forward — a big step — on the path to massive profits.

To learn more from Matt about his Early Stage Investor China biotech picks, click here.

Have a good evening,

Jeff Remsburg