Week ahead: Stock market roller coaster won't stop

4-07-2016

Week ahead: Stock market roller coaster won't stop

The rapid switch in financial markets from absolute fear over the U.K. referendum to cautious acceptance suggests volatility could stay high, as investors await Friday's June employment report. The U.S. economy is expected to have added 180,000 jobs in June, up from the shockingly low 38,000 reported for May. Some economists are treating the May report as an inexplicable anomaly, but traders are watching to make sure it was not signaling that the labor market has weakened. Markets will seriously kick off the third quarter in the coming week, after the three-day Fourth of July weekend. The holiday may serve as a cooling off period after the S&P 500 went on a rapid roller coaster ride in recent sessions. The S&P shed 5.3 percent between last Friday and Monday, after the U.K. stunned the world and voted itself out of the European Union. Uncertainty around that event lingers, but the market rebounded, and the S&P recovered most losses. The S&P 500 ended the week 3.2 percent higher at 2,102, its best weekly gain since November. "Now cooler heads prevail. I was scared to death telling clients to buy last Friday morning, but we had a very high conviction it was the right thing to do, simply because what we saw led us to believe that even with the surprise outcome, investors were completely over-hedged for the situation," said Julian Emanuel, equity and derivatives strategist at UBS. He noted that the over hedging is apparent in the more than 40 percent decline in the VIX, the CBOE Volatility Index, this past week. "Market volatility does not necessarily mean down," he said, adding that "we think the bias is higher into year end." The U.K. referendum led to the resignation of Prime Minister David Cameron, who will step aside when a replacement is named in September. The next prime minister will be the one to trigger the formal proceedings for the U.K. to leave the EU, and at that point, Brexit could return as a key event for markets toward the end of the third quarter. The outcome is likely to be more easing by the Bank of England and possibly the European Central Bank. Futures markets moved to price out expectations of a Fed rate hike this year, or even next, based on the global uncertainty around the U.K. situation. Economists expect a slight impact on U.S. growth, but a recession in the U.K. and slower growth in Europe as a result of the so-called Brexit. That is one reason why buying in the Treasury market accelerated this past week, taking yields on both the 10-year and 30-year bond below their all-time closing lows on Friday. U.S. yields fell in a global flight to quality trade, and as investors found U.S. debt more attractive than negative and low-yielding debt in Europe and Japan. The third quarter is also a time when the U.S. election will come to the forefront for markets, and that could bring its own volatility. "What we saw in the last week, we could envision happening three or four times before the election. This is a year where there's a lot of uncertainty. The international situation is not going to resolve itself any time soon," said UBS' Emanuel. "You still have a political void in the U.K. that's at least a couple months away from getting filled. There's going to be lots of fluctuations. In the U.S., it would probably be improper not to expect volatility leading up to the conventions and coming out of the conventions." The Republican convention starts July 18, and the Democratic convention is a week later. Analysts say the market could be volatile around the conventions, since they often give their respective candidates a bump in the polls. Wall Street widely expects Democrat Hillary Clinton to win the presidential race, so if Republican Donald Trump comes out of the convention stronger, the markets are likely to react. "If that gap narrows, that creates volatility, because I think markets will be more comfortable with a Clinton presidency than a Trump presidency," said John Canally, strategist and economist at LPL Financial. Emanuel expects the market volatility to lead to a higher market, with the S&P at 2,175 by year end. He studied market responses when voters were restless and wanted candidates who represent change, such as when Ronald Reagan was elected. "The voters want change. We're not talking about policy change. We're talking about a businessman with no political experience or the first woman president, so there's going to be change," said Emanuel. "When you look at all those change election years, once the electorate was comfortable with their ultimate selection, the year following the vote was quite positive," he said, noting those years have been positive for technology. Emanuel said that low Treasury yields are also signaling a positive period for stocks, if market behavior since the financial crisis is a guide. In that period, a drop in the 10-year yield to where it is 50 basis points lower than the S&P 500 dividend yield has been positive for stock market returns. The dividend yield is now 2.18 on the S&P 500, and the 10-year was yielding 1.44 percent Friday. "The six-month average return when the S&P 500 dividend yield was greater than 50 basis points over the 10-year yield is 13.8 percent, and 12 month is 28.4," he said. Emanuel said he looked at rolling returns, and notes there were several such periods since the financial crisis. Besides the jobs report Friday, there are a number of key releases next week, including the FOMC minutes from its last meeting and the ADP payrolls report, released Thursday instead of Wednesday because of the Monday holiday.