The Tug-o-War Continues

stock market

It’s fair to say the market really doesn’t know what to make of all this tariff war business. When stocks fall, it’s down to ‘concerns over a trade war’. When stocks rise, it’s because those concerns have ceased for the time being.

That’s because no one knows how this will play out. And more importantly, the economic consequences of a trade war will only emerge after some time. In the meantime, the market will struggle to maintain focus on trade as an issue. The news cycle wants to move on.

And with another US quarterly earnings season upon us, the focus is changing. That’s why the Dow jumped overnight, as the Wall Street Journal (WSJ) reports:

The Dow Jones Industrial Average had its best day in a month Monday as investors focused on a strong jobs report from late last week and the coming earnings season, despite heightened trade tensions.

Recent tariffs have kept investors on edge, with the U.S. and China slapping levies on $34 billion of each other’s exports on Friday. Some fear the protectionist trade policies will slow corporate activity and crimp global growth, hurting a range of assets from stocks to commodities.

The stock markets response to the numbers is important

For now, at least, the market is looking ahead to second quarter earnings results, and putting the prospect of a US-China trade war to one side.

And given the US economy is still motoring along, those earnings results should continue to come in nice and strong.

According to the WSJ, Thomson Reuters’ compiled earnings estimates expect S&P500 companies to post a 21% year-on-year earnings increase in the June quarter. If achieved, it would be the second best quarterly gain in seven years, only behind the first quarter of this year, which racked up a year-on-year gain of 26.6%.

Given that earnings nearly always come in ‘better than expected’, thanks to the age old practice of companies ‘beating’ estimates when the actual results come out, this quarter will indeed be a good one for corporate profits.

But it’s not the numbers you should focus on, it’s the market’s response to the numbers. As mentioned, first quarter profits surged 26.6% year-on-year, yet US stocks peaked at the start of the quarter, and fell when the numbers came out. That tells you the market had already priced in the good news.

What about this quarter? The market has more or less gone nowhere over the past five months, as you can see in the chart below. Will this ‘breather’ provide the necessary energy to propel stocks to new highs? What’s priced in at these levels?

MoneyMorning 10-07-18

Source: Bigcharts
[Click to open new window]

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How did the market respond to the trade war?

From a charting perspective, the good news is that the medium term trend is still positive: The 50-day moving average (yellow line) remains above the 100-day moving average (blue line).

In addition, the recent trade war induced correction didn’t do much damage to the chart and now stocks look set to rally.

The question is (as always) what’s in the price already? Based on 12-month ahead earnings forecasts, the S&P500 trades on a price-to-earnings ratio of just over 17 times. That’s only slightly above the long-term average. So on the surface, US stocks aren’t particularly expensive here.

But this is where things become tricky. There is a lot of uncertainty about where we are in the earnings cycle. If we have peaked, and earnings growth starts to slow, then above average earnings multiples look a little too optimistic.

The uncertainty is reflected in the volatile sideways movement in stocks you’ve seen for most of this year. You can see that in the chart of the Dow, above. After trending relentlessly higher for two years, US stocks are now much less certain about the future.

There’s a tug of war going on between those who believe earnings growth will continue and that stocks are good value, and those who believe the end of the earnings cycle is nigh, and the stock market will sell-off.

Forward earnings multiples above the long-term average suggest the bulls have the upper hand. That means any disappointments on the earnings front will not go down well.

For what it’s worth, in my view a tightening Fed and increased tariffs will put an end to this earnings cycle. I just don’t know when that will be.

But what I think doesn’t matter. Dead and useless opinions litter the stock market floor on a daily basis. The equation is simple: If US markets make new highs, the global bull is alive and well. If the lows of February, April and May give way (see chart above), we’ll be welcoming a new bear market.

Until either of those events plays out, the volatile sideways movement tells you uncertainty is the predominant theme.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

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Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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