foxex: ECB Raises the Stakes for the Fed Tomorrow

Chart Advisor | Focus on the Price

Tuesday, June 18, 2019

1. ECB Promises to be Ready with More Easing

2. S&P 500 Pops on Another Trade Tweet

3. Risk Takers are Still Active in the Market

Major Moves

In yesterday's Chart Advisor I mentioned that without some kind of "external shock" the market was likely to remain range bound heading into the FOMC announcement on Wednesday. This morning's cascade of news may not quite qualify as a "shock," but it certainly pushed the S&P 500 out of its range.

Mario Draghi, the European Central Bank's (ECB) chairman, told reporters and analysts today that the ECB is ready with stimulus (e.g. free loans to banks, quantitative easing, etc.) if the economy needs it. The ECB is joining the Fed and central banks in Australia, UK, Russia, India, and Canada that have already either eased policy or are threatening to do so in the short term.

Draghi's statement has already had a discernable impact on the euro to US dollar exchange rate (EUR/USD) which has been dropping in favor of the dollar since February 2018. The promise of loose monetary policy in Europe had a predictably positive impact on the market, but this won't be a positive for all US stocks.

The problem with a declining euro is that it will cost more in US dollar terms to buy exports from the US. For example, Harley Davidson's (HOG) sales in developed markets were down -6.2% in the first quarter as confidence in the UK and Europe dropped while costs rose. Added to rising loan defaults, the issues in the currency markets puts companies like HOG at a further disadvantage.

As you can see in the following chart, there is a relatively strong relationship between a falling EUR/USD and a weaker HOG share price. While a rising dollar isn't the only thing affecting manufacturers like HOG, it is a material risk that could make Wednesday's FOMC announcement all the more important.

Now that the ECB has raised the stakes by promising their own easing, a disappointment by the Fed's FOMC tomorrow could send the dollar much higher very suddenly. Based on the future's prices, the market doesn't believe the Fed will cut the target rate tomorrow, but traders are definitely expecting very dovish forward-looking statements for cuts starting in July. If the Fed's statement leaves any room for doubt, the market could take a big hit.

S&P 500

S&P 500 was helped along today by an early morning tweet from President Trump to his followers that he and Chinese Premier Xi Jinping will be meeting during next week's G-20 meeting. Semiconductor, manufacturing and tech stocks received the news with a bullish move higher.

At the risk of being too skeptical, I don't think bullish trade sentiment is likely to last very long. Over the last few months we have seen good news about a trade "deal" be contradicted or fade a day or two later. I don't see any reason to believe that this time will be different.

The S&P 500 burst out of its range but stopped well short of the prior highs near 2,950 as investors cooled off a little later in the trading session. At this point, I still expect the index to remain below the prior highs in the short-term while we wait for more concrete economic data during next month's earnings season.

The Basics Of Currency Trading

Who Is Mario Draghi?

What Is Currency Risk?

Risk Indicators - Risk Seekers are Still Active

I will confess that my bullish outlook has been weakening over the last few weeks, however, the risk of a major disruption does not seem to be rising yet. Risk indicators like the VIX and SKEW are at low levels and the rally today was mirrored by high yield bonds, transportation, and small cap stocks.

Although the market indexes have been flat, this has been a good year for stock pickers focused on value and/or growth characteristics. Stocks with the highest expected growth rates have continued to attract buyers and outperform.

For example, the 50 stocks in the S&P 500 with the highest P/E ratios at the beginning of the year have appreciated an average of 27% while the S&P 500 is only up 16%. I know that statement may sound confusing to many of you who have been led to believe that high PE ratios are "bad" but statistically, stocks with the highest PE ratios tend to perform the best in flat or bullish markets because that kind of valuation metric reflects growth expectations.

In other words, a high PE ratio means investors believe there is a lot of growth potential for the stock. Those growth expectations lead to a higher share price, even if current earnings are relatively low. For those of you raised on the investing wisdom of the 1980's this probably all sounds like heresy but statistically, this is the way the market works until overall economic growth begins to contract and then those high PE stocks get hit.

For example, the Invesco DWA NASDAQ Momentum ETF (DWAQ) has one of the highest average PE ratios among non-sector based ETFs and yet has doubled the return of the S&P 500 over the last 6-months as you can see in the following chart.

My point is not to advocate a strategy of seeking out the stocks with the highest valuation ratios, but to show that this is a market where risk-seekers are still very active even if it isn't obvious on the major indexes. If stocks with the most extended valuations started to underperform, then we should be much more concerned about the potential for a larger correction.

What is the PE Ratio?

REIT Funds Testing Multi-Year Resistance

Bottom Line - Expectations for the Fed are Sky-High

The biggest outstanding questions for the market should be resolved tomorrow afternoon when the Fed makes their interest rate announcement and releases their economic projections. Investors have been pricing in a very dovish statement with 2 or more rate cuts this year. This has increased the risk that the Fed will disappoint investors in order to assert its independence from political or market influence; I think that will reinforce resistance at the prior highs on the S&P 500 in the short-term.

Perfect Storm Threatens Bull Market After Rallies on Fed, Trade Talks

Learn the basics of investing

How can we improve the new Chart Advisor? Tell us at chartadvisor@investopedia.com