Stocks rise as U.S. and China reach phase one trade agreement

I think that stocks have been this tremendous, tremendous equalizer for people in this country. Guys who can’t make a lot of money at their jobs have been able to make a lot of money in the stock market. – Jim Cramer

There was no shortage of good news last week and, as a result, all of the major stock averages closed higher with the technology-laden Nasdaq Composite Index turning in the best performance with a gain of nearly 1%. The first piece of favorable news came on Tuesday when the House of Representatives agreed to support the U.S.-Mexico-Canada trade agreement (USMCA) intended as a replacement for the North American Free Trade Agreement or NAFTA. Despite speculation that additional tariffs would be imposed on China on December 15^th, the suspense ended on Friday when the U.S. and China finally came to terms on a phase one trade deal. As part of the agreement, the U.S. agreed to roll back some of the tariffs on China and agreed not to impose any new ones on December 15^th. In return, China agreed to purchase $40 billion in U.S. agricultural products and will abide by structural reforms in the areas of intellectual property, technology transfer, financial services and currency and foreign exchange. The U.S. will also continue to maintain a 25% tariff on $250 billion in Chinese goods already in place. The agreement will likely be formally signed in January with discussions for phase two of the deal scheduled to begin immediately. In addition to the positive trade news, the Federal Open Market Committee (FOMC) met last week and, as expected, decided to leave the federal funds rate unchanged in a range of between 1.5% and 1.75%. In a statement, officials said that current monetary policy is appropriate to sustain the current economic expansion, a strong labor market and inflation near the 2% level. As a result, the Fed expects no change in interest rates next year, either, as inflation remains low and is unlikely to rise appreciably enough to warrant hiking rates. There was even good news overseas as uncertainty over Brexit ended in the United Kingdom with Boris Johnson’s Conservative Party winning a landslide victory, thereby almost certainly guaranteeing that Britain will finally exit the European Union (EU). It was a week that could be characterized as the opposite of Murphy’s Law as everything that could go right did go right.

Last Week

Inflation continues to be benign as the producer price index (PPI) was unchanged in November and has risen only 1.1% over the last 12 months while the consumer price index (CPI) rose modestly and has risen just 2.1% during the same time period. November U.S. retail sales rose slightly and were less than expected but small-business owner’s confidence surged and recorded its largest month-over-month gain since May 2018. Weekly jobless claims rose 49,000 to 252,000, a 2-year high, and were much higher than expected, although claims tend to be volatile in the period after the Thanksgiving Day holiday.

For the week, the Dow Jones Industrial Average rose 0.4% to close at 28,135 while the S&P 500 Index added 0.7% to close at 3,168. The Nasdaq Composite Index gained 0.9% to close at 8,734.

This Week

November leading economic indicators are expected to edge up slightly and the final reading for third quarter gross domestic product (GDP) is expected to remain at 2.1%. Both November housing starts and existing home sales should be on a par with the previous month and consistent with continued strength in the housing market.

Both the Bank of England and the Bank of Japan announce their monetary policy decisions this week with the former expected to keep its interest rates unchanged at 0.75% and the latter given a 50% chance of lowering its benchmark rate to negative 0.2%.

The most prominent companies scheduled to report quarterly earnings this week include FedEx, Cintas, Micron Technology, CarMax, RiteAid, General Mills, Conagra Brands, Darden Restaurants and Nike.

Portfolio Strategy

After trailing large cap indexes in recent years, the Russell 2000 index of small cap stocks has begun to perform better and has closed the gap with large cap stocks. An obvious difference between the two asset classes is their size as small cap stocks generally have a market capitalization of $3 billion or less while large cap stocks are $10 billion or more. Another difference is that small companies typically generate most of their revenue in the U.S. with only about 21% of revenue from overseas compared to 33% for large companies. One small cap exchange-traded fund (ETF) that has seen improved performance is the iShares Morningstar Small-Cap ETF (JKJ), which has posted a year-to-date total return of 26.3% through November 30^th, only slightly below the S&P 500 return of 27.6%. This ETF currently owns about 260 stocks and has as its benchmark the Morningstar Small-Cap Core Index. Small cap stocks are currently inexpensive relative to large caps as the price earnings ratio for JKJ is 19.7 compared to 22 for the S&P 500 Index based on trailing earnings. The two indexes are also different when it comes to their sector weightings. In the S&P 500 Index, the largest sector weighting is technology at 23%, followed by health care (14%), financials (13%), communication services (10%) and consumer discretionary (10%). In JKJ, the most heavily weighted sectors include industrial (18%), financials (17%), real estate (13%) and consumer discretionary (13%). The technology sector only comprises 11% of this fund. While the valuation of the overall stock market certainly is not cheap, small cap stocks are historically very inexpensive compared to large cap stocks.