Fed Meeting Starts With Market Off To Worst December Start in 38 Years

(Tuesday Market Open) Powell and company are back in town, and face a critical decision tomorrow: Should they raise interest rates a fourth time this year or hold off for a bit as overseas economies show signs of struggle and the stock market keeps plunging?

While there’s a lot resting on the Fed move and whatever Fed Chair Jerome Powell says afterward at his press conference, at the end of the day, no matter what he does, the ping pong of tariffs doesn’t go away. The overlying theme is still tariffs. Companies are still trying to figure out what the rules of the game might be, and that’s affecting their desire and ability to spend.

With December off to the month’s worst start in 38 years, there seems to be more hanging on this gathering than any other recently. Some economists have urged the Fed to delay another hike, but arguably that might make things even worse for the markets. People could interpret that as a sign of the Fed being increasingly worried about the economy. 

Futures trading puts chances of a hike at 71% as of early Tuesday, which might indicate a likely raise perhaps accompanied by dovish “wait and see” language about 2019. One school of thought is that with all the pressure on the Fed, this might be the last hike for a while. 

Until the Fed decision, investors could see slow trading. That’s often the case when a Fed decision looms. There’s a more positive tone early Tuesday after Monday’s sell-off, but it’s hard to feel too much optimism with the Dow Jones Industrial Average ($DJI) down around 1,000 points over the last two sessions alone and the S&P 500 Index (SPX) sitting just above its low for the year (set yesterday). We’ve seen this movie before. Every recent rally attempt has fizzled out, bringing major indices back down to flat or even lower by the end of the session. It might be a moral victory to see this early buying simply hold up.

As the Fed meeting loomed, some positive data came out early Tuesday from the housing market. November housing starts and building permits both hit it out of the park, easily exceeding Wall Street analysts’ expectations. The market, however, didn’t seem to get any immediate boost from the numbers.

A Monday to Forget

A sell-off that rolled into the weekend picked up pace Monday, taking all the major U.S. indices to 2% losses for the second-straight session and setting a new 2018 closing low for the S&P 500 Index (SPX). The storyline didn’t change much from Friday, with investors still apparently squeamish about slowing overseas economic prospects and chances of a rate hike from the Fed later this week.

Though the SPX remains a long way from entering an official bear market (down 20% from the high), it is down 13% from the year’s closing peak, and all of the FAANG stocks that helped drive momentum earlier this year are in bear territory. Also, the small-cap Russell 2000 Index (RUT) is now officially in a bear market. Barron’s observed over the weekend that many small companies are burdened with issues like high valuations, slowing revenues, margin pressure, or excess leverage.

If you like slasher movies, this might be the market for you, with bleeding in every sector. Even so-called “defensive” neighborhoods like utilities took a dive on Monday. There’s also a mess in the commodity pits, where crude crumbled to close below $50 a barrel for the first time in over a year. Another industrial commodity, copper, fell too. By early Tuesday, U.S. crude prices were well under $49, burdened by heavy supplies and booming production pretty much anywhere you look around the world.

Meanwhile, volatility spiked close to 15% as measured by the VIX, which rose back toward levels near 25 seen during the October sell-off. 

Dollar Strength Hurting Multinationals

Recent dollar strength hasn’t been a very welcome Christmas gift for some of the major U.S. multinationals, including those bellwethers of trade with China, namely Boeing Co. BA and Caterpillar Inc. CAT. Both have been hit pretty hard over the last month or so, but then again, who hasn’t? Anyway, some positive news from BA came out late Monday when the company said it planned to raise its dividend 20% and increase stock buybacks. It cited strength in its business and confidence in its outlook, and shares rose in post-market trading. Johnson & Johnson JNJ also announced a $5 billion buyback. It might be worth watching to see if some other deep-pocketed companies try similar strategies here in the depths of this sell-off, perhaps trying to pull investors back in even as their stocks come under pressure.

Another positive for any company would be solid earnings, and that’s what Oracle Corporation ORCL appeared to deliver after the close Monday, beating Wall Street analysts’ top- and bottom-line expectations. Shares rose around 4% in post-market trading, but ORCL remains down for the year. The company continues to transition into the cloud business, seeing year-over-year revenue fall slightly during the quarter, so it’s not necessarily out of the woods.

Orderly March Downward

As ugly as things have gotten, the selling still seems orderly. What does that mean? It means there’s no sign of a real panic, which would be the case if we saw aggressive selling of stocks and buying of risk-off products like bonds, gold, and the VIX. This hasn’t been a true “dump” of stocks, and there hasn’t been a major spike in volatility.

What might be happening is that many investors who bought the dip the first time the market went down back in October didn’t benefit, and now they’re apparently not so willing to buy the next dip. It looks like many investors are willing to own stocks for now, but the question is whether at some point they start to throw up their hands and panic. So to sum up, it’s not like everyone is rushing for the exits, but there’s just not a lot of desire to buy, partly because of the tariff overhang. Think about how orderly this downturn has been. It probably reflects a lack of buyers, not panic selling.

Also, there’s some technical stuff to consider keeping in mind. The SPX managed to close just a touch under the psychological 2600 mark last week, but then fell through technical support below that at 2570 by late Monday. That set up a test of 2530, just under the intraday low for the year of 2532 posted back in February. 

By late Monday, the SPX had fallen below 2532 to set a new low for the year before swinging up slightly to end the day. Some analysts say there might be a gap in support below 2530 that extends down to near the 2400 level, which is a long way to fall. Such a drop would put the SPX within a couple of percentage points of falling into bear territory for the first time since the 2008-09 economic crisis. That means 2530 could remain the level to watch when trading starts Tuesday.

Aiming Low?

With the SPX down more than 5% for the year and facing a possible annual loss for the first time since 2015, the question might be whether the market is baking in too negative a forward outlook. Here’s why. In 2015, as the SPX fell just under 1% for the full year, earnings were also on the decline. 

In what analysts then called an “earnings recession,” quarterly S&P 500 earnings fell the final three quarters of 2015, with a worse than 3% year-over-year performance in Q4. Things are a lot different now. The market is falling, but earnings have been impressive all year. They’ve risen more than 20% the last two quarters, and many analysts still expect mid-teens growth for Q4. Looking into 2019, the picture weakens, but it’s still not an earnings “recession” if current estimates of mid-to-high single-digit earnings growth don’t fall. 

However, as an analyst on CNBC noted Monday, the SPX is behaving now as if there’s not going to be any earnings growth at all next year. The forward 12-month price-to-earnings ratio now stands at about 15, according to Factset, barely above the 10-year average (which includes the depths of the 2008-09 economic crisis), and down from 18 or higher earlier this year. So either the market is right and earnings next year have farther to fall, or the market is aiming too low, meaning you could argue the SPX is underpriced at current levels. This is a debate that’s not going to be decided anytime soon, but could make for interesting viewing as the new year rolls in.

Data Watch

From a U.S. data perspective, things continue to look pretty good, though Monday’s Empire Manufacturing number for December came in well under expectations. Some of the interest rate-sensitive sectors like cars and housing continue to come under pressure, but wages and job growth still look strong even while inflation remains manageable. The only thing is, jobs and wages are sometimes seen by economists as trailing indicators, meaning they can be the last statistics to go up in a rising economy. 

There are a couple of things particularly relevant to this week that investors might want to keep in mind. First, there’s earnings from a bunch of companies, including Oracle Corporation ORCL, FedEx Corporation FDX, and Nike Inc. NKE. There’s also quadruple witching on Friday, marking the simultaneous expiry of stock index futures, stock index options, stock options & single stock futures. This can result in volatility as traders unwind positions. 

Also, many hedge funds and traders are measured this week in terms of bonuses, so they may be unloading any positions they have that are still up for the year.

Figure 1:  Technical Points to Ponder. The breakout to the downside has many chart watchers eyeing possible levels of technical support. Today's low in the S&P 500 Index (SPX) of 2530 eclipsed the February low of 2532, but a bit of end-of-day support kept the SPX from a settlement at a new low. Looking beyond that level to the downside, some point to the night of the 2016 election, when a head-fake break down to 2083 turned to breakout rally that seemed to be a one-way train until it derailed in February 2018. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Thank Goodness It’s (Not) Friday? Lately, Fridays just haven’t been kind to bullish investors. The S&P 500 Index (SPX) fell on three of the last four Friday sessions, with steep losses on the last two, especially. One school of thought suggests investors are nervous about what sorts of developments might happen over the weekend, so they could be taking profit ahead of time. This is sometimes the kind of thing you see in volatile markets like this where geopolitical issues are swirling and headlines frequently drive price movements. People are afraid of the next shoe to possibly drop.

GAAP Gap? Speaking of earnings and P/E ratios, one thing to consider keeping an eye out for in Q4 earnings is any widening of GAAP and adjusted results in company reports. As a reminder, GAAP stands for “Generally Accepted Accounting Principles,” but tends to get overlooked in media and sell-side analyst reports, where adjusted earnings pull in most of the headlines. Adjusted earnings are simply that—”adjusted” to leave out any issue the company considers relevant to only the quarter in question. Those factors get covered by the GAAP earnings, meaning adjusted is sometimes considered the best way to track a company’s long-term performance unencumbered by one-time costs like an expense associated with closing a factory or paying for a product recall.

Still, when times get tough, companies have been known to stretch the definition of “one time,” so they can ensure that adjusted earnings meet or exceed Wall Street analysts’ projections. This doesn’t mean they’re breaking any laws, only that adjusted earnings might tell a brighter story than GAAP earnings do. When the “gap” between GAAP and adjusted widens, then it might be time for investors to wonder if companies are starting to use fancy accounting to make up for any problems and still meet their own or Wall Street’s projections on the adjusted line. If that seems like the case, it might be worth taking a closer look at the individual company’s performance to see if issues deeper down in its Securities and Exchange Commission (SEC) filings reflect any issues for concern. Though it may seem daunting, if you really have a large position in a company’s stock, it’s probably a good idea to read through the key parts of its most recent 10-K filing and be aware of the company’s major challenges (outlined in that filing). Then you can think of how that might eventually spill over into the bottom line and potentially affect the company’s P/E.

Pressure on Fed Mounts: As the Fed gathers today, it’s coming under increased pressure to adopt a more dovish strategy. An op-ed Monday in The Wall Street Journal co-written by Kevin Warsh, a former member of the Fed’s Board of Governors, warned the Fed to take note of slowing overseas economic growth, softening credit markets, and falling commodity prices. It was titled, “Fed Tightening? Not Now.”