Yield Sign: After Heavy Losses, Stocks Face Fresh Earnings, Renewed Budget Debate

Wall Street remained lower as of mid-morning Monday, but the market began clawing back a bit after another big plunge that took the Dow Jones Industrial Average ($DJI) down an additional 355 points. That came after European and Asian stocks caught the U.S. market’s flu overnight.

The early drop had the $DJI off roughly 1,000 points from where it had settled Thursday, and off about 5% from recent highs. The broader S&P 500 Index (SPX) fell about 4.7% from its highs by early Monday. The 5% mark is sometimes viewed as a “correction,” and it’s something that typically happens a few times a year but hadn’t occurred even once in 2017. Profit taking after January’s rally, worries about climbing bond yields, and concerns about possible inflation remain the big stories.

A lot of people are also worried that the solid jump in wages seen in last Friday’s jobs report could lead to a more hawkish Fed. Dallas Fed President Robert Kaplan might have played into those worries when Bloomberg News reported he said three rate hikes remain the base case this year, but added, “It could be more than that; we’ll have to see.”

However, San Francisco Fed President John Williams said, “I don’t see an economy that’s fundamentally shifted gear” and “we should stick to that plan” for gradual rate hikes, Bloomberg reported.

By mid-morning Monday, a handful of sectors emerged into the green, with consumer discretionary, materials, and info tech all posting modest gains. The White House also weighed in, saying it’s “concerned” about the stock market sell-off.

To put things in context, stocks are still up for the year, and up around 20% over the last year. Many investors had apparently been looking for an excuse to sell at recent high levels, and the rise in bond yields might have provided some of them a reason. However, even at the current 2.85% yield in 10-year Treasuries, borrowing costs remain low, and earnings season has been really solid, with positive outlooks from many companies. Tax reform could continue to inject more optimism on the corporate front, and data keep looking strong. It’s hard to argue that big jobs and wage growth are bad news, because they aren’t.

That said, it’s not time to pretend there’s no reason for concern. Markets remain highly valued, and commodity prices have risen a lot lately. Inflation is arguably a risk.  Naturally, investors should consider exercising caution going into the new week, and hopefully many people had already re-allocated their holdings back around the new year to help insulate themselves in case their stock holdings had grown too much due to the long rally.

Looking at the week ahead, investors face another major earnings onslaught, with less info tech but more consumer discretionary companies stepping onto stage. Additionally, the government’s deadline for a new budget approaches this coming Thursday, so the week begins under the shadow of another possible shutdown in Washington, D.C. The other question is whether the bond market will keep stamping its boot on stocks. That remains to be seen.

The Fed, of course, has power to step in and try to splash a bit of cold water on the economy by hiking rates. At this point, odds of a March hike seem pretty baked in, with the futures market indicating a nearly 78% chance. The Fed has projected three hikes this year, but the market is pricing in higher chances for a fourth, and that could be worrying some investors. Right now, futures prices project about a 25% chance of four hikes this year instead of three.

All that said, whatever happens with bonds, there’s still a new week ahead with a fresh batch of earnings reports to watch. This, along with rising yields and possible noise from Washington, could potentially bring more volatility, and the VIX climbed above 19 by early Monday before falling back slightly. Investors should consider a prudent approach to trading this coming week considering the high volatility, continued concerns about interest rates, and possible fireworks coming out of the capitol.

From an earnings standpoint, the big ones to watch include General Motors Company GM before the open Tuesday, followed by Chipotle Mexican Grill, Inc. CMG and Walt Disney Co DIS after Tuesday’s closing bell. Tesla Inc TSLA is due out after Wednesday’s close, followed by Twitter inc TWTR before the open Thursday. Generally, it’s a little quieter on earnings going forward, and this coming week is the last really crowded one of the season. Research firm CFRA estimates a 12.3% year-over-year earnings increase for S&P 500 companies in Q4, with 10 of the 11 sectors expected to report positive overall comparisons.

Taking a technical view, the S&P 500 index (SPX) fell through a couple layers of key support, first at 2825 and then at 2798, as the old week advanced. Support below that is at around 2736, CFRA said. The late-week slide hit nearly every stock sector, with consumer discretionary the only one making any advance as of midday Friday. Small-caps were also lower, and European stocks floundered as well. European stocks are now slightly down year-to-date.

This coming week is a bit light on data, with the standout report probably being Tuesday’s Job Openings and Labor Turnover Survey (JOLTS) for December. Wholesale inventories for December are due Friday.

FIGURE 1: YELLOW LIGHT. This one-month chart probably says it all. The S&P 500 (SPX, signified by the candlestick), rose to record highs in late January, only to drop sharply over the last week as 10-year bond yields (purple line) marched inexorably up toward four-year highs. Data sources: Standard & Poor’s, CME Group. Chart source: The thinkorswim^® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Silver Lining?

If there’s something good to say about the selling on Wall Street late last week, maybe it’s that at least oil prices took part in the losses. While that’s not welcome if you’re in the energy sector, it could take some pressure off the rest of the economy. Gas prices recently climbed above $3 a gallon across much of the West Coast, and typically gas costs rise further once spring and summer come along and more people take driving trips. The Dow Jones Transportation Average — sometimes seen as a key derivative of broader economic and stock market trends — has fallen more than 400 points since mid-January, about a 4% drop, likely due in part to major airlines, trucking firms, and railways facing higher fuel costs. At this point, many airlines have hedged some of their fuel costs, but eventually higher prices could catch up, perhaps forcing them to raise fares, analysts said. Crude oil fell below $65 a barrel early Monday.  That’s still a long way from about $53 at this time last year.

Mind the Gap

Late last year, some investors grew worried about a narrowing gap in the yield curve, which can sometimes signal pending economic weakness. For a while, the gap between 2-year U.S. Treasury yields and 10-year yields fell below 60 basis points, and some people even started talking about the possibility of an inverted yield curve at some point, which is when shorter-dated bond yields climb above longer-dated ones. Maybe they jumped the gun a little, because the curve has steadied and even grown a bit over the last month. As of Friday, the gap between “2’s” and “10’s” had climbed all the way back to nearly 70 basis points. Mind the gap, as they say in the London Underground, because the yield curve can sometimes be an underlying factor affecting the broader market.

Good News Behind Higher Yields

When borrowing costs steadily rise like they have lately, it often reflects deep-rooted economic factors. Most of the data coming in late last week seemed to reinforce ideas of a robust U.S. economy, with the jobs report just one marker. Factory orders, which climbed 1.7% in December, were another. Additionally, final University of Michigan consumer sentiment for January at 95.7 was above the preliminary number and above Wall Street analysts’ consensus. Earlier in the week, we saw a solid Chicago PMI report. The confidence data could be particularly revealing, as it gives a direct insight into what might be motivating consumers, whose spending makes up about 70% of the economy. “The key takeaway from the report is that it revealed consumers are being motivated more to make purchase decisions by feelings of job security and growth in wages and financial assets, as opposed to discounted prices and interest rates,” Briefing.com said Friday.

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