Now that stocks are at record highs, the Fed is a risk that could stop the rally

The S&P 500 broke through its previous highs Monday, just as the historically best time of year for stocks got underway.

That should give the market fuel for a positive market move into the end of the year, with November and December the top two months for the S&P since 1950. But analysts warn of potential pitfalls that investors should watch out for along the way, and any of them could sap the market’s gains.

The S&P 500 on Monday roared past its July high of 3,028, amid improving views of the economy and optimism that the U.S. and China will sort out some trade differences in the near future.

In fact, J.P. Morgan strategists said stocks could reach next year’s target of 3,200 for the S&P 500 sooner than expected. “Looking ahead, given improving trade rhetoric, the market could reach our 2020 midyear price target of 3,200 sooner (by late 2019 or early 2020),” Dubravko Lakos-Bujas, the firm’s chief U.S. equity strategist, said in a note to clients on Monday.

Three big factors have combined to lift stocks prices, and any of them could also derail the rally.

For one, the easing of tensions in the trade war has been an important factor for the stock market, since trade has also been a negative factor for the market this year. The S&P 500 has gained about 2.5% in October, as talks between the U.S. and China appeared to make progress.

Earnings news has also been positive and is helping to lift stocks. Analysts are encouraged the corporate earnings reports, on a whole, have not raised concerns about a recession.

The easy hand of the Fed has also been a factor, and stocks have been moving higher ahead of Wednesday’s anticipated quarter-point rate cut, its third since July.

The Fed, however, is the first hurdle for the market, and it could cause volatility.

In addition to the cut, the Fed on Wednesday is expected to signal its intentions about future rate cuts. The market is pricing in a rate cut for this week, then a pause, followed by a rate cut for next year.

But many economists do not expect the Fed to keep on cutting, as some market pros expect it to. There is no new economic or interest rate forecast from the Fed, so its communications will be limited to the post-meeting statement and comments from Fed Chairman Jerome Powell at his press briefing.

“From our point of view, you’re likely to get a sell-off based on a Fed disappointment,” said Julian Emanuel, chief equity and derivatives strategist at BTIG. He said fed funds futures are signaling a 50% chance for a rate cut by March, but many economists, like those at Goldman Sachs, expect this Fed cut to be the final one and it could signal it’s finished.

Emanuel said he expects the Fed to cut a quarter point, but then back off promising any more cuts, though it may keep the door open just slightly. “We think the market has discounted a lot of positive news, and it’s likely to be shocked by this now,” he said.

Emanuel said a sell-off could take the S&P back down to the 2,875 level. The benchmark traded as high as 3044.12 on Monday.

“There’s the potential for the market to pull into the 200-day moving average in the next couple of weeks, if the market is sufficiently spooked by the Fed,” he said. The 200-day moving average was at 2,877 Monday.

Emanuel said that the downside will be limited because of the Fed’s commitment to keep liquidity in the markets. Following the spike in repo rates, the Fed has taken action to keep the money markets swimming in cash, by expanding the size of its open market operations and also to increase its balance sheet by adding Treasury bills to its holdings.

The repo market is literally the basic plumbing of the financial markets. It’s where banks go to fund themselves short term, and the concern is any stress in that market could filter through to other corners of the credit market. Analysts say the recent problems in the market were most likely a cash crunch, not a deeper problem, and the Fed has helped by expanding the size of its overnight repo operations and created long-term facilities.

Even so, disappointment about Fed commentary this week could spark a short term sell-off. Emanuel has a target of 3,000 on the S&P for year-end, but he says his number could be too low. He expects the S&P 500 to head to 3,250 next year.

“There are still plenty of people who think there’s going to be a recession next year. They may all be underweight stocks, but the fact is if the Fed is going to talk down the likelihood of a rate cuts, those people are not going to be buyers of stocks. They’re going to be sellers,” he said.

Corporate earnings season is about half way over, and S&P 500 companies so far are beating third-quarter earnings estimates at a rate of about 4 to 1. So far, earnings are down about 2%, based on actual reports and expectations for those that have not yet reported, according to IBES data from Refinitiv.

Analysts have been concerned this quarter about an erosion in margins, which have more or less been flat. If they were to dip significantly, some see it as a recession warning.

Nick Colas, co-founder of DataTrek Research, described the quarter so far as “there is no there there.”

“Yes, more companies are beating, but by less than usual and with diminished margin structures. Markets sit near all time highs not because of this lackluster trend, but rather over hopes for a US-China trade war resolution and lower interest rates,” he wrote.

He said the pressure on margins is causing analysts to cut fourth-quarter estimates. “A week ago Wall Street had 1.5% earnings growth in their Q4 2019 models on 3.2% revenue growth,” he noted. “Now, they show 0.7% earnings growth — less than half last week’s estimate — even as revenue growth expectations are essentially the same at 3.0%.”

Bank of America Merrill Lynch analysts said companies are downbeat in their comments on the quarter, but they still show some optimism.

“With half of earnings reported, commentary on earnings calls suggests companies are still seeing the weakest trend since the financial crisis: mentions of ‘better’ or ‘stronger’ vs. ‘worse’ or ‘weaker’ are tracking the lowest since 2009,” they noted. “However, companies have continued to express a much more optimistic tone than in recent quarters, with 48% of companies mentioning ‘optimistic’ or ‘optimism’ during earnings calls vs. just 37% last two quarters and the historical average of 43%.”

Jim Paulsen, chief investment strategist at Leuthold Group, said the earnings are OK, and the market can muddle through them. “It hasn’t exactly been a game changer, but it’s certainly better than feared again, and it sort of supports a little better data in general, and sort of supports what the bond market is doing in lifting yields. You just get a sense that confidence is building after dying in August,” he said.

One of the reasons for a turnaround in sentiment has been signs that the trade tensions between the U.S. and China are easing, as the two sides work toward a preliminary deal.

Market analysts now expect some sort of agreement in the next couple of weeks, and the U.S. should hold off on the next round of tariffs, scheduled for December.

President Donald Trump told reporters Monday that his administration “may be a lot ahead of schedule” on signing a China trade deal.

The risks of a further escalation have faded for now, but if they reappear, stocks could take a hit.

J.P. Morgan’s Lakos-Bujas said his more bullish call for the S&P is the result of positive signs for the trade talks.

According to the Stock Traders Almanac, November is the second best month of the year for the S&P 500, gaining an average 1.5% since 1950. December is the best month, with a gain of 1.7%.

The other major indexes, the Dow and Nasdaq, have still not regained their highs. The Dow is 1.2% from its high, while the Nasdaq is 0.2% away.