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President Trump indicated that he would be willing to let the March 1 deadline for more tariffs on Chinese imports slide a little if the progress continues on trade talks. Also, according to reporting by Bloomberg, the president will grudgingly sign the budget/border deal being hammered out in congress. While neither issue is a “done deal,” traders will probably be willing to bid the major indexes higher on the news.
The reaction to President Trump’s comments on trade had a stronger effect on stocks in mainland China than in the U.S. I have recently pointed to the relative strength in the Hang Seng Hong Kong index, but the Shanghai Composite Index also broke out of a bullish double bottom pattern today.
In the following chart, I have used a Fibonacci retracement based on the second low of the double bottom pattern to create an upside price target for the Shanghai Composite. However, from a best-practices perspective, it makes sense to treat that price level as tentative because the last two major signals on the index failed.
Even though they weren’t official announcements from the White House, the news about trade and a budget deal would have normally sent prices much higher. The open on the S&P 500 was initially very strong, but traders got the rug pulled out from beneath them following a report that Florida senator Marco Rubio is proposing a plan to tax share buybacks like dividends.
Whether buybacks are good or bad for stock performance and shareholders is debated. On the one hand, there are the outliers like Microsoft Corporation (MSFT) that have done very well during their buyback campaigns – however, are buybacks the source of the gains, or is it the growth in enterprise value? A classic example of buybacks becoming a distraction and a poor substitute for good management has been the results experienced by International Business Machines Corporation (IBM) and General Electric Company (GE) over the past few years.
Regardless of the debate about whether buybacks increase shareholder value or not, new taxes are usually seen as a short-term negative for stocks. In my opinion, the fact that the proposal is coming from a Republican senator has made investors take it much more seriously as something that may eventually come to fruition. As you can see in the following chart, although the S&P 500 passed trendline resistance yesterday, momentum evaporated following the announcement. I would be surprised if the major indexes didn’t use the changes today as an excuse to “sell the news” and retest support.
Risk Indicators – Yield Curve
I believe the net impact of the news today will be supportive for higher stock prices in the short term. If Washington can create less uncertainty, I would expect earnings estimates for the first quarter to start to improve from where they are now.
Besides meddling from the official sector, there are still two other areas where improvement could make a material difference for investor expectations. First, as I have mentioned several times in previous Chart Advisor issues, the dollar’s recent strength will drag on corporate returns and worsen the trade deficit. Second, the yield curve is still flat as a board – this yield curve behavior is correlated with a recession.
A flat yield curve is a problem for the financial sector and capital investment because the returns on long-term loans and capital projects aren’t high enough relative to the cost of short-term capital. One example of this problem is that, if banks are borrowing at short-term rates and lending at long-term rates, there isn’t enough profit to justify taking risks on long-term loans.
As you can see in the following chart, after flirting with turning negative in December, the difference between the interest rate on 10-year Treasury yields and 2-year Treasury yields is still a fraction of what it was in 2014 and almost as low as it has been since the last recession. A positive yield curve not only is a sign of growth: it creates the opportunity for better performance by making it easier to profit from long-term loans and capital projects.
Bottom Line: Outlook Still Positive for Retail
The retail sales report from the Census Bureau is due tomorrow and should help provide some guidance for the retail reports coming next week from firms like Walmart Inc. (WMT). The flat inflation report released today doesn’t suggest that consumption will be a huge surprise, but anything positive is still likely to help keep volatility low. Assuming we continue to see positive news about the budget and trade, I expect any dips in the major indexes to be brief.
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