Why a Trade War With China Is Bad News and Thoughts on U.S. Financials and Oil

We're in the home stretch of 2010. The favorite, Weak Recovery, is ahead by a nose. QE2 and Falling Dollar are right behind. Toxic Asset and Solid Earnings have been unable to mount a charge.

But two horses -- Man 'o Trade War and Europe's Problem -- are moving on the outside and could decide the race.

There are so many conflicting catalysts, sometimes it seems as though you have to pick your horse, place your bet and see what happens.

I'm sure plenty of Congress-persons are pretty proud of themselves for moving a bill that would label China currency manipulators through the House.

But let's not kid ourselves: this particular strategy for standing up to China is both reckless and hypocritical.

It's reckless because it demands action from China on the yuan.

It's hypocritical because we don't act when the ECB intervened in the currency market to weaken the euro. And we don't cry when Bernanke buys Treasuries to lower interest rates and the U.S. dollar.

(OK, so maybe some investors aren't happy with the Fed, but stocks have certainly responded to the Fed.)

I'm no apologist for China. There are serious trade issues with China - Like intellectual property and patent piracy. Then there's the playing field in China that overtly favors state-run enterprises. And the recent move by China to restrict exports of rare earth elements is a WTO violation.

These are the angles from which we should be attacking the China fair trade issue. Congress is pandering to its constituents when it plays the currency manipulator card.

Does anyone really believe a stronger yuan is the cure-all for the U.S. manufacturing sector? And does anyone think a trade war with China is anything other than the single fastest way to return to recession and push the unemployment rate to 15%?

The real fix is for Americans to take care of business at home. And it would probably be wise to make it more difficult for companies to move operations to China.

Ultimately, a trade war would hurt China worse than the U.S. anyway. China does not have the mature consumer market that the U.S. does. If its export economy dried up, it would be absolutely devastating for China.

Alright, I've spoken my mind on China for today. Let's get back to the stock market...

I said Thursday that we should be expecting a pretty sharp move lower for stocks on either the last day of the third quarter (Thursday) or the first day of Q4 (Friday).

I'm sure we could consider the 200-point swing from highs to lows on Thursday a pretty sharp drop. (Though I will say I was pretty impressed with the rebound.)

And the reason for the declines has nothing to do with the economic data that came out. It had everything to do with the institutional investors.

Mutual funds, hedge funds, pension funds and the rest of the institutional crowd have not been making a lot of money this year. Massive investor redemptions aside, volatility has made profits difficult. So after a nice rally to end the quarter, it should be no surprise that funds wanted to lock in some gains. They pretty much had to.

And I don't think they're done. I expect we'll see a strong rally in the next day or two. The Fed is giving the green light to buy stocks and most institutions will not fight the Fed.

Interesting note from the financials: they led the rally in early September, then lagged the rest of the month. But Thursday, the financials showed relative strength.

It would be fitting for financial stocks to resume a leadership position, especially if this rally is to continue.

Keep an eye on Citigroup (NYSE:C). The Treasury just finished selling around 1.5 billion shares. It will take a break until Citigroup reports earnings on October 18. That could give the stock some upside.

I suggested a position in Citi ahead of last quarter's earnings. The stock ran from $3.80 to as high as $4.50 on July 13, three days before it reported. A similar 18% run would push it to $4.60 over the next two weeks.

Bank of America (NYSE:BAC) also made a nice run ahead of earnings.

Speaking of earnings, just a reminder that 3Q reports start a week from today with Alcoa (NYSE: AA). My Wyatt Investment Research colleague Jason Cimpl, thinks yesterday's surprisingly strong Chicago PMI regional manufacturing survey bodes well for a good earnings report from Alcoa.

Finally, I'd be remiss if I didn't note the huge jump for oil prices Thursday. Oil closed just below $80 a barrel, but spent most of the day above that level. Oil is now at a 7-week high.

Oil is an excellent gauge of economic growth expectations. Despite a seemingly conflicting message from stocks, oil's message is pretty clear cut.

About the author: Ian Wyatt

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