Iran Sparked A Sell-Off

The indices ended the week on a sour note. Iran sparked a sell-off that left the broad market down by -0.60% at the end of the day Friday and down -1.3% for the week. While Friday's move was sparked by Iran's seizing a UK-flagged tanker the move for the week is driven by mounting uncertainty. The only thing to be certain of is the uncertainty and that is a bad bad thing for a market trading at all-time highs.

Hope has driven the S&P to its current levels if reality doesn't meet up to the expectation I fear a deep, deep correction will come. The top of the list this week is the FOMC. The market has built up an expectation for deep FOMC rate cuts and there is absolutely no guarantee one will come. While Jerome Powell's testimony to Congress and John William's off-the-cuff comments suggest the FOMC is going to cut rates aggressively the data just doesn't support it.


This week's data isn't robust but neither is it poor. On balance, the data is still solid and points to a steadily growing U.S. economy. The retail sales figures were strong and confirm consumer expectations arising from the last NFP report; strong job and wage gains = a healthy consumer. Consumer Sentiment data was also good. Consumer Sentiment missed expectations but still posted an increase over the last month.

The NAHB Home Builders index was also solid. There is still some weakness in traffic but the traffic that's there is converting to sales. All three sub-indices gained in the last month, sales and outlook for sales are both above 70 and at what I will call robust levels. Housing starts were also good but offset by weak permits. Permits are an indication of future starts so this is a potential red-flag.

Jobless claims were also good, initial and continuing claims are trending near their 5-decade lows and edged lower over the last week. There is still some volatility in the data but it seems to be quieting down. The total claims data persists in its signal as well, the total claims did not retreat as much as expected this season and suggests an end to market tightening. Because the slack is gone, there is no need for the Fed to do anything about rates because of labor.


The Philly Fed's MBOS was fantastic. The MBOS rebounded 21.5 points from last month's tepid 0.3 to 21.8. The rebound is driven by an increase in new orders, shipments, demand, employment, future expectations, and prices. Employment rose 15 points to 30, its highest level since December 2017. Prices, inflation, rose as well. Current prices received rose 9 points to 9.5 while the Prices diffusion index gained 3 to hit 16.1. Based on this the Fed doesn't need to act aggressively or swiftly to prop up manufacturing, looks pretty good to me.


The only negative in terms of the data and the FOMC outlook was the import/export price indices. Both fell, export prices more than forecast, and that does suggest the FOMC might want to lower rates. Even so, this data is offset by the MBOS and does not suggest the Fed need to act aggressively if it does choose to act.

The Beige Book confirms economic activity continued to expand at a modest pace from mid-May through early July, with little change from the prior period. The outlook is generally positive for the coming months, with expectations of continued modest growth, despite widespread concerns about the possible negative impact of trade-related uncertainty.

The Beige Book also indicates the rate of price inflation was stable to down slightly from the prior reporting period. Districts generally saw some increases in input costs, stemming from higher tariffs and rising labor costs. While the inflation data is weakening it has by no means reached the point where the Fed has to act. A preemptive move might be necessary, it would absolutely play into Trump's hands and I don't think Powell is keen to do that regardless what the FedWatch Tool is indicating.

The FedWatch Tool is still predicting a 100% chance for a 25 BPS cut in July and I think that is too high. The odds for a 50 bps point rate cut are close to 20% but down from near 40% just after William's remarks Thursday. The odds for 75 bps by December is near 70% now and that is way too high. With the data already firming a single cut is likely all the economy will need, if that. We may get a cut this month but I think the outlook for future cuts is going to fall short of expectations.


The next FOMC meeting is in eleven days, the risk for traders in that time is the data. Next week's calendar is not full by any means but there are some potentially market-moving events. On Monday the Chicago National Activity Index will be watched for confirmation of economic rebound over the past month. On Tuesday Existing Home Sales are expected to hold steady or fall slightly. On Wednesday we'll get flash readings on PMI, services, and manufacturing, along with New Home Sales which are expected to rise by 2.2%. Thursday is jobless claims as usual but the big economic news of the week will come Friday.

Friday is the first estimate for the 2nd quarter GDP. The 2nd quarter GDP is expected to fall to 2.1% from 3.1% in the first quarter. It may turn out to be a dud but I think a miss or beat on this figure will have a big impact on the market. A miss will reinforce hopes for aggressive rate cuts and fears of global economic slowing; a beat will reduce hopes for aggressive Fed action and the stability of U.S. Fundamentals despite the trade war.

As if the FOMC isn't enough for the market to worry about there is still the trade war. The way it stands now, the best the market can hope for is Trump and Xi can maintain the status quo. While Mnuchin says the two sides are getting close to holding face to face talks again the sticking points remain and Huawei is at the center of it. And there is still the as-yet unratified USMCA, a slowly escalating trade-situation with the EU, the Brexit, issues between Japan and South Korea, general political instability within the EU, escalating tensions in the Middle East, and their effects on earnings growth to worry about.


Earnings Season Scorecard

The earnings cycle is well underway although it is still early in the season. So far 16% of the S&P 500 have reported and the results are good. The blended rate for growth has risen to -1.9% from last week's -3.0% which is great. At this rate, earnings growth is likely to turn positive by the end of the reporting season. Six of the eleven sectors are beating consensus with an average per-company beat of 7%. If this rate keeps up we should see earnings growth top 3% by the end of the cycle but I'm not holding my breath. There are still a lot of companies to report, next week there are 144 on the list including 1/3 of the Dow Jones Industrial Average.


Despite the strength in this quarter's earnings the outlook for future earnings continues to decline. The outlook for all four of the following quarters fell an average -0.75% which is a big blow to expectations. The way things are going I expect the outlook earnings will sour over the course of the season. At the current rates of decline, the outlook for EPS growth in the 3rd quarter will be mid-single digits and the 4th's will be low single digits. The good news is that growth is still in the forecast. Although those estimates are falling as well, growth should re-accelerate next year.


Microsoft reported last week and beat on the top and bottom lines. The company says revenue grew 12% YOY driven by a 64% increase in Azure revenue growth. Cloud computing has been driving Microsoft's strength in recent years so analyst were sure to point out Azure growth decelerated from last quarter's 73%. Regardless, the company posted solid gains in all segments and spent less on CAPEX than expected. Microsoft guided earnings outlook higher after the report and that helped shared rise by more than 2.0%. The bad news is the analysts were expecting more and the highs weren't sustained. Company guidance is a range with consensus in the middle which is OK but not great. The analysts at BMO, Raymond James, and Canaccord Genuity raised their price targets to an average $159.30 in response to the news, an 11.70% to Friday's close. The caveat is the candle, Friday's candle is not pretty and may lead to a better buying opportunity.


American Express also reported better than expected earnings and failed to impress investors with guidance. The company says weakness in consumer was offset by strength in commercial segments for a net increase in merchant services income. The company only reaffirmed its guidance despite the strength, no increases, and the stock fell on the news. Investors were hoping for a better indication of the future and they didn't get it. The $124 level may be a good entry point, but it may also be a good selling point. The indicators are bearish and suggest support is going to be retested; if the $124 level breaks down a move to $120 could come forthwith.


Schlumberger reported revenue is slightly above expectation with EPS inline with consensus. The company says North American weakness is offset by International strength and that is expected to continue in the foreseeable future. Spending in the International segment is expected to increase 7-8% while that in the U.S. is expected to fall -10.0%. The news sparked some volatility in the stock, shares fell hard on the news but found support at $38. At these levels, the 5.20% dividend rate is attractive although there is some risk of a distribution cut.


Sketchers jumped more than 9.0% after it reported strong numbers and raised its guidance. The global shoe company says sales are up 10.9% with high single-digit comps at its U.S. stores. International wholesale is the strongest performing sector surprisingly enough and up 18%. Direct to consumer is up strongly at 14.4% but U.S. wholesale saw a small decline. Regardless of the breakdown, the brand's organic strength and expansion plans are driving revenue and EPS gains and that is what counts.


Results were mixed among the transportation companies that reported last week. Union Pacific and CSX both missed on the revenue side and CSX at least provided weak guidance. Trucking/Intermodal operator JBHT reported revenue in line with consensus and a small EPS miss. Comments from JBHT and UNP during the conference calls settled some market fears, those stocks were able to hold steady or rally, CSX tanked on its results and closed the week with a loss near -12.5%.


Netflix reported revenue in line with consensus and EPS was slightly ahead of expectations. Then it shocked the market saying subscriber growth was only 2.7 million, about half the expected and last year's gain. The news was not taken well and sent shares down more than -10% despite a net annual subscriber gain of 21.9%. One reason for the decline is content, Netflix lost some key content over the last year and that is dragging on subscriptions. Looking forward, NFLX is expecting Q3 gains to make up the loss as new shows come online. The rest of FAANG will report over the next ten days.



The Indices

The indices do not look good. All three majors hit new all-time highs last week and all three saw those highs rejected. The Dow Jones Transportation is not at an all-time and yet it too saw its price move rejected. The transports formed a fairly large doji candle and it is showing resistance and uncertainty at what could be a crucial level for the index. If the index moves higher great, if not it will be forming a Head & Shoulders and confirming previously strong resistance. Resistance is just above 10,750 and the near the December 2018 highs. The fact the Transports are not at new highs while the Industrials are is one red flag, the fact the transports are showing resistance at such a critical level is a second.


The Dow Jones Industrials posted the smallest loss last week but the candle is no less bearish. The index is hanging at a new all-time high showing a bearish candle pattern, not quite a Piercing Pattern, with overbought conditions and divergent MACD. The MACD isn't just a little bit divergent either, it is highly divergent and highlighting weakness in the market. The blue chips may not fall from this level but it certainly doesn't look like a time to buy.


The tech-heavy NASDAQ Composite posted a weekly loss of 1.18%. The candle is forming a Bearish Piercing Pattern and suggest a small correction at least is on the way. The indicators are set up in such a way to make me think the correction could be large when it does come. The MACD is already divergent from the new all-time high and shows a definite weakness in the market. the stochastic is still moving higher so may not diverge but, if the index falls, will confirm divergence.Once the selling starts the initials declines could be big and those big enough to trigger follow-on selling.


The S&P 500 shed -1.20% last week. The candle formed is a Dark Cloud Cover. The indicators are consistent with a peak in prices and set up for a strong downdraft once the selling starts. The MACD here is also divergent and showing a serious lack of substance in the recent rally. Stochastic is still moving higher but set up to show a major divergence if the index were to fall from this level. The 2940 level is the first and most obvious level of potential support, the previous all-time high, and may be strong enough to hold the market up. If it fails a move to 2,750 is possible.


The indices may not correct but that is not something I can trade on. There is too much uncertainty in the market and that uncertainty is shining through in the charts. The indices have been drifting higher on hopes and allowed to hit new highs because of a "wait and see" mentality, now it's time to face reality. Earnings are being reported, new data is coming in, and the FOMC is about to meet so there is a lot of reality to face.

The earnings, at least, are better than expected and that is good, fingers crossed the season continues on that way. What I'm worried about is the FOMC. The market has a lot of expectation baked into that cake and I think it is going to be deeply disappointed in how it turns out. The next FOMC meeting is in 10 days.

Until then, remember the trend!

Thomas Hughes