08.25.19

The S&P 500 finished the week just a hair below the all-time high put in back in August. Earnings reports continue to roll in better than expected, the trade environment sits momentarily on more stable ground, and economic data hasn’t been too strong to thwart the hopes of another rate cut. A cut at next week’s FOMC meeting is priced in with near certainty, but the language about additional cuts will be most important. From a strong technical and what looks to be a stronger than expected fundamental position, the market is primed to continue rising. If the Fed can find the right words next week, we could be headed for a breakout.

The Fed has cut rates 2 times this year. Historically, there have been 8 instances since 1982 where interest rates have been cut at least 3 times without hiking in between. As noted, the language around the 3rd cut has been the most critical to market returns. When the 3rd cut was followed by less than 2 more cuts, the S&P was higher by an average of 14% over the next 6 months. When rates were cut 2 or more additional times, the S&P was flat over the 6-month time frame. In other words, if the economy responds favorably to cuts, the market will appreciate it. If the economy continues to slide and cuts pile up, the market will be disappointed and start to fear a recession. The good news is that we are getting hints of the former.

While manufacturing data continues to languish, it doesn’t appear to be translating to company earnings in a big way. With just over 40% of the S&P 500 reporting, earnings have beaten analyst estimates by over 4% on average. Against tough 2018 comps, earnings have only fallen by .5% year-over-year. This is impressive and the sector level data is even more encouraging. Technology and Materials are two of the most cyclical sectors yet they have surprised to the upside by the most. Given their broad Chinese exposure, semiconductor earnings are perhaps the most pleasant surprise and hopefully an early sign the trade war has not been as damaging as previously thought. Beyond earnings, there are additional signs of increasing cyclicality. For example, global bond yields continue to trend higher, industrial metals are picking up, and global banks are improving.

With this backdrop, it makes sense that stocks are on the door of an all-time high. An additional cut or two can shore up the environment further and give the bull market some running room. Twice in history has the Fed cut rates for a third time with the market at an all-time high. Following the 3rd cut in 1985, the S&P rallied another 88% before eventually topping out two years later. After the 3rd cut in 1996, the market climbed 157% before topping out over 4 years later. This is obviously a small sample size, but encouraging nonetheless.

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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.