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Why Stocks Rose After Poor Services Data (Hint: Think Interest Rates)

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So what in the world happened in stocks Thursday?

You may think it's counterintuitive that stocks would rise after the ISM non-manufacturing index showed poor results. Think again.

Before we break down how assets moved and what to do going forward, let's trace the movements and drivers first.

What Happened

Thursday morning, the S&P 500 had fallen 0.65% after the ISM non-manufacturing index showed a reading of 52.6. That missed estimates of 55 and was a deceleration from August's reading of 53.1. Anything above 50 represents growth rather than contraction. This sent a minor shock wave through the market since services make up the majority of U.S. GDP.

On Tuesday the ISM Manufacturing Index showed a contraction, with a 47.8 reading, missing estimates of 50.1. On Wednesday ADP reported that the U.S. economy added 135,000 jobs in September, below economists' forecast of 142,000.

Companies have been investing and hiring less, which also threatens to damage the currently "strong consumer," as many put it. The U.S.-China trade war has dented domestic demand, and uncertainty about the White House's next move has made executives hesitant to invest.

"The weaker readings on both the manufacturing and non-manufacturing surveys are signaling that slower economic growth lies ahead, and markets have responded with a knee-jerk reaction over the past few days," Charlie Ripley, senior investment strategist for Allianz Investment Management, told TheStreet by email.

But then stocks rose.

The S&P 500 rose as much as 0.72% by late Thursday. With the emergence of ominous economic indicators, the probability of one more Federal Reserve rate cut in 2019 rose to 90% from below 80% Wednesday. That probability sat at below 50% last week.

The 10-year Treasury yield fell to 1.53% Thursday, in a return to a dynamic seen consistently throughout 2019. Bond prices and stock prices have risen simultaneously at some points, as the markets price in the likelihood of a rate cut.

What This Means for Stocks Going Forward

Most on Wall Street now agree lower interest rates may have boosted the stock market earlier in 2019, but now the Fed has limited ability to support the economy and the stock market.

If a deal between the U.S. and China is not soon reached -- and the two sides will meet Oct. 10 -- lower rates can provide a support level for the market, as seen by Thursday's action. But ultimately a trade-war-induced deceleration in an already peaked economy would outweigh the positive impact of Fed easing.

"All else being equal, [lower rates[ will be supportive," Tony Bedikian, head of global markets at Citizens Bank, told TheStreet over the phone.

"However, it doesn't mean stocks are going to go up. It creates an underpinning of support. If China-U.S. trade relations don't get better, if they get worse, that will outweigh the impact of further Fed eases this year."

While the S&P 500's gain of 15% for the year is below its 2019 gain of 21% as of a week ago, the average forward price-to-earnings multiple on the index remains 17.7, slightly elevated compared with history.

This does not suggest the market is in a bubble, but for the bears who have emerged of late, the environment may be a bit frothy.

Many have recently recommended safer, less volatile dividend stocks in defensive sectors. Some dividend stocks, like oil stocks (not defensive), can yield 5%, far higher than any yields in the Treasury market.

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