One of the Most Crucial Factors for the Stock Market
The stock market is always moving under hundreds of factors. However, there is one factor that happens to be the most sensitive for an equity investor. It is the interest rate. Fluctuation in the interest rate has an immediate impact on the market for three main reasons.
- It changes valuation of a company. The intrinsic value of a company depends on all future cash flows discounted to the present value. Without exploring the details of the mathematics, we would just like to point out that the interest rate appears in the denominator. Lower interest rate, therefore, yields higher value.
- Lower interest rate is good for corporate profits, since the corporations can borrow money for less.
- Lower interest rate makes bonds less attractive compared to stocks.
These are the reasons why financial analysts are always so focused on the interest rate. Financial news talk ad nauseum about how dovish or hawkish the Fed is. They seldom mention the fact that the interest rate goes into the denominator of the fractions they use to calculate the intrinsic value of a company.
Current Market Environment
The stock market had a horrendous sell-off in October and December last year. While many analysts attributed the sell-off to the market anticipation of lower growth in 2019, we believe that it was primarily because of the hawkish statements made by the Fed Chair Jerome Powell. As Mr. Powell changed his stance in early 2019, the market managed to display solid gains in the riskier sectors. Going back over several decades we should notice that often a multi-month market rise started either in the middle of a recession or a very low-growth period. It worked out that way not because the economic visibility suddenly became clearer, but because the interest rate came down to such a level that the equity market became very attractive.
What About the Trade War?
The full impact of the trade war is yet to be evaluated. However, given the strength of the US economy, buoyant consumer sentiment and low inflation, we believe, the tariffs will not make much of a dent in the national output/income. The consumers should be able to change their consumption bundle, and corporations can pass the higher costs to the buyers. Tariff is just like a tax that consumers pay. This is part of the fiscal policy which can be counterbalanced by the monetary policy. This is where the Fed comes into the picture. Jerome Powell, the current Fed Chair, has already mentioned that they are watching the fallout of the trade war, and will be ready to act as necessary.
One Big Fly in the Ointment
“On a sector level, 16 of Huawei’s 31 listed U.S. suppliers are in the Semiconductors sector. Looking at the constituents of the Nasdaq PHLX Semiconductor Index, 14 of the 30 companies are suppliers for Huawei, representing nearly 61% of the total index weight (as of May 31). More than one third of the revenue for this index comes from China. Therefore, it’s no surprise that the index has recently been hammered, recording a 16% negative return in May.” (Source: Factset, June 10, 2019)
Our QuanTimer systems are based on Nasdaq-100 and S&P500 indices. We, therefore, expect to weather the storm, as far as the weakness in the semiconductor sector is concerned. A study shows that the overall effect on these two indices should be minimal.
“Using the Barra U.S. Equity Short Term risk model, a -30% return shock to the U.S. Semiconductor model factor will have -0.18% return impact on the overall S&P 500 as of May 31. However, the effects are not uniform across sectors. While the Technology sector sees a -1.72% impact on returns, the Health Care sector gains 0.71%, making it a potential candidate for a sector hedge.” (Source: Factset, June 10, 2019)
There is no doubt that the global economy is slowing and the net earnings of all public companies are levelling off. But as mentioned earlier, the equity market can start expanding on the upside in the middle of a slow-growth period. At QuanTimer we have our own quantitative model that we use to track the primary market trend. It turned negative in the second week of May. However, at the end of last week it turned positive. While we remain bullish in the current market, we don’t expect a huge rally as we had in Q1 of 2019. The market will most likely consolidate and move sideways with a slight upward bias. Whatever be the case, we will continue to follow the signals from our systems, as they provide perfect downside protection as well as profit-taking opportunities with stop loss and trailing stop loss orders.
We are not interested in starting a debate here in this forum. If you disagree with our market assessment, please submit your post with your own analyses. Thank you.
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