Are stocks ready for a rally?

Wall Street is split on whether good news on the Fed and easing of trade tensions were enough to overcome weakening economic fundamentals

Dec 3, 2018 @ 5:53 pm

By Bloomberg News

The easing of U.S.-China trade tensions might not be as unabashedly bullish as investors had expected.

When the Dow Jones Industrial Average on Monday was unable to sustain a 400-plus gain on news of the weekend agreement to delay a planned increase in tariffs on Chinese goods, it was a warning to bulls sounding the all-clear for a year-end rally.

While the combination of a less aggressive Federal Reserve and ebbing trade tensions are encouraging, Wall Street remains split on whether that's enough to overcome the weakening global economic fundamentals that sent the S&P 500 Index into a correction last month.

For Peter Tchir, head of macro strategy at Academy Securities, the truce opens the path to a more lasting trade deal, clearing the way for a rally in risk assets.

"I'm staying the risk-on course for now," he wrote in a note to clients Monday. "Still nervously, but the number of people who have expressed interest in fading this risk-on move gives me the conviction it has more room to run. Within the next 24 hours, equities will likely trade lower, U.S. Treasury yields will come back in, but within the next 48 hours stocks will be higher, Treasury yields higher and credit spreads tighter."

Consumer discretionary and energy shares paced gains in American equities, closely followed by technology stocks that bore the brunt of selling during the correction. For the trade-truce rally to persist, it may need leaders other than the stocks that carried U.S. indexes to all-time highs in September, according to Evercore ISI.

"A return to multiple months of growth and momentum leadership remains unlikely given the persistent headwinds of slowing economic and earnings growth," Dennis Debusschere, head of portfolio strategy at Evercore ISI, wrote in a note to investors.

Short-term positives

Investors rattled by the correction positioned for possible progress ahead of the talks by owning option bets that pay off if equities rise — an unusual approach because bullish bets usually come in the form of buying stocks themselves, according to Pravit Chintawongvanich, equity derivatives strategist at Wells Fargo Securities.

This dynamic provides a narrow window in which the S&P 500 could be squeezed up to 2,800 to 2,825 over the next few sessions, he said in a Friday note.

"In the near term, risk is rallying because 1) vol (uncertainty risk) was priced too high going into the event, and 2) the buildup in upside calls means dealers are 'short gamma' and buying stock to hedge, exacerbating the move higher," he said on Monday. "The 'upside hedging' means the pain trade is to the upside."

Stocks fell from their highs on Monday in part because traders were monetizing gains on call options that expire Dec. 7 to lock in profits, the strategist added.

Quants are confident the advance has more room to run compared to the 2.1% relief rally in the S&P 500 that followed the U.S. midterm elections — but warn it might not persist.

"We expect speculative fast-money investors such as CTAs and global macros to increase their pace of buying from here on," wrote Masanari Takada, quantitative strategist at Nomura.

Emerging strength

A temporary trade detente may be all that embattled emerging-market assets need to make up ground on their American counterparts. Indeed, U.S. stocks pared a substantial part of Monday's gains, but emerging-market equities are maintaining most of theirs.

"Following what we expect will be a significant Fed-induced relief this week, the mini-positive trend in EM may keep the asset class in a good spot between now and the beginning of January," writes Luis Costa, head of CEEMEA strategy at Citigroup.

"The truce will be enough to keep the EM rally going through the end of 2018," said Per Hammarlund, chief emerging-markets strategist at SEB in Stockholm. "In addition, EM risk appetite will get another boost from reduced inflationary pressure in both DM and EM since October."

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