Euphoria Fades From The Market, But Marko Kolanovic Doesn't Fade From His Forecast

So we had a pretty strong rally in the major indices on Monday. By now, everyone is aware that a “trade truce” between China and the U.S. has resulted in the latest market uptick. The media has taken to task the trade truce, describing it as lacking substance and less likely to prove an actual deal and/or outcome within the 90-day period outlined by the 2 participating parties. Seems rather timely that the media throws cold water on the trade truce given the subdued market sentiment since October and with the S&P 500 still in correction territory. With regards to the trade truce and to be clear, that 90-day period will commence on January 1, 2019. The key investor takeaway from the trade truce is quite simple: NO ADDITIONAL TARIFFS, INCLUDING THOSE PREVIOUSLY THREATENED BY THE WHITE HOUSE, WILL BE IMPLEMENTED DURING THE 90-DAY NEGOTIATING PERIOD! Finom Group (for who I am employed) believes that regardless of how the media portrays the trade truce, it is a net positive for sentiment, at least until something materially changes in the negotiations.

But the rally in global equities and domestically on Monday is already fading; as I expected it do so, but only to a degree. In my weekly research report (subscription needed) titled Does the Trade Truce Produce a Change in Analysts’ Earnings Estimates?, I offered subscribers the following expectation regarding the potential for markets to rally initially, but find resistance and sellers rather quickly.

“More importantly with respect to where the S&P 500 rests, if that is a positive move come Monday that does achieve the expected move for the day, it takes the SPX above 2,800. Pretty key level folks, pretty key level. But even if the S&P 500 breaks above 2,800, Finom Group isn’t of the belief that sellers would not step in and lighten up positions at that point/level. It’s always important to plan ahead and that’s why we’re referencing the Monday expected move and the possibility of what institutional traders could already have in mind.”

 

As one can clearly see from the chart of the S&P 500 above, the benchmark index gapped higher at the opening bell, achieving 2,800 and before sellers stepped in. Nearly half of the daily gains on Monday were removed by the afternoon trading hours, but the S&P 500 still managed a healthy 1% gain on the day, led by tech stocks.

While the percentage gain of the market yesterday was strong, the rally didn’t’ seem as spectacular as what the pre-market activity suggested it would be. The “sell the rip” sentiment is still in place, but I think that will prove advantageous for the bull market and investors who maintain a healthy discipline. Two of the major headwinds and dark clouds hanging over the market have been either removed or put on the back burner with a more dovish Fed and a trade truce between the world’s 2 biggest economies. Crude oil prices rose sharply yesterday and are proving to further its rally on Tuesday and ahead of Friday’s OPEC meeting, which is largely expected to bring about production cuts. And with all these headwinds being removed or finding some semblance of resolution, corporate earnings haven’t changed, haven’t worsened and have only found the possibility of improved sentiment for 2019. Citigroup’s Tobias Levkovich’s recent notes take the earnings outlook into consideration when forecasting the potential for equity markets in 2019.

"Back in September, we were deeply concerned that investors were too optimistic," Levkovich, the bank's chief U.S. equity strategist, wrote in a note to clients. "But sentiment has shifted following the rout of the past two months. Low-end neutral readings argue for a 90% probability of gains in the next 12 months versus September's 70% chance of a down market – a very marked change. 

Our normalized earnings yield gap work, which incorporates both cyclically adjusted P/E ratios and the five-year forward swap contract's 10-year Treasury yield levels ... it implies a 90% chance of an up market in 12 months." 

Despite how quickly market sentiment shifts, seemingly from one week to the next, it remains keenly important that investors focus on the fundamentals. The fundamentals still promote earnings growth out into 2019 and for the whole of 2019, thus far. While it is true that trade skirmishes can still pop up in 2019 and global economies are slowing, domestic corporate earnings are not expected to decline in 2019 and equity markets follow earnings over time.

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