Positive sentiment in back and the market is on the move.
The chart below is the S&P 500 on a weekly basis. It would appear that we
have broken out of a consolidation phase that has lasted two years and started
on a new trend higher.
RSI (14), P&F percent bullish, percent of stocks above
their 50DMA and 200DMA all have room for additional upside as they are not yet
at extreme over-bought conditions. There was also a recent MACD bullish cross. Given
the rise of “animal spirits” and the seasonally strong time of year for
equities we are fully invested and remain so at least until the end of the
year.
Sentiment indicators are confirming our tactical outlook. University
of Michigan Consumer Sentiment Index rose to 98 last week, the highest it’s
been since January 2015.
The Sabrient Insider Sentiment Index is an equal- dollar
weighted index comprising publicly-traded companies that reflect positive
sentiment among those 'insiders' closest to a company's financials &
business prospects (top management, directors, analysts). This index recently
sprung to a new high but year-over-year is only up 15%. This is far from an
overly euphoric number (30% - 40%) that indicated excessive insider optimism.
The shift in sentiment can be seen in many indices. From IBD,
“The IBD/TIPP Economic Optimism Index
surged to a 10-year high in December, as confidence in the outlook got a jolt
from the presidential election and the subsequent stock-market rally.
Economic Optimism rose
3.4 points to 54.8, the highest since November 2006, remaining above the
neutral 50 level for the third straight month.”
Anything above the 50 level is economic optimism.
From Merrill Lynch (via Calculated
Risk), “Anecdotes and surveys suggest
that business and consumer confidence has improved following the election. The gain in animal spirits could amplify
the boost to the economy from fiscal stimulus, creating upside risk to our
forecast. We will have to wait for the "hard data" from November
and December to have clarity on the timing and magnitude.”
From Wells Fargo (also via Calculated
Risk), “Small business owners are
feeling much more optimistic about the prospects for the economy and their
business in the coming year. The latest Wells Fargo/Gallup Small Business
Index, which was conducted from Nov. 11 to Nov. 17, jumped 12 points to 80 from
the previous quarter and is up 26 points over the past year. Small business
optimism is now at its highest level since January 2008, when the index was
coming down as the economy slid into recession. The latest reading marks the
largest quarterly increase in a little over a year and is one of the largest
quarterly gains in the series’ history.
While political
factors likely influenced the magnitude of the improvement in small business
confidence, business owners’ attitudes about the economy and their business
have been gradually improving for the past few years. All of the improvement in
the most recent quarter, however, came from the expectations series, which
jumped 17 points in the fourth quarter. The present situation index fell 5
points, essentially reversing the prior quarter’s gain.”
Dow Theory Buy Signal
Cam Hui from Humble
Student of the Markets and Jeff Hirsch of Almanac
Trader both pointed out that both the Dow Industrials and Transports are
hitting new highs, thus confirming the current break-out. From Jeff Hirsch, “Well it looks like the Dow Transports just
issued a Dow Theory Buy signal by breaking out to a new high on today’s close.
The Dow Theory Sell Signal we discussed on January 6 of this year was followed
by a further decline of -7.4% on the Dow Jones Industrials.
The current
post-election bullish rally looks like it’s got more legs and that further
confirms our Best Six Months Seasonal MACD Buy Signal from October 24 and our
recent call last week for further gains, based on our bullish scenario for
Trump and his new team of policy makers to deliver stimulus, tax cuts, slow
rising rates and healthy inflation.”
VIX and Complacency
The VIX is back down under $12 indicating a healthy dose of
complacency in the market.
While this is a cautionary sign that the market may be prone
to a pull-back, there are a few reasons why I don’t believe this to be the
case, at least through the end of the year. The first of course is the new wave
of sentiment that is building. This optimism could drive the market higher for
the next few weeks or months at least. Additionally, many asset managers
(including myself) will use this opportunity to boost their annual returns by
trading this rally. That will be fuel for the rally. From Dana
Lyons’ Tumblr, “From jacked-up
surveys to record ETF inflows, it’s probably safer to conclude that folks are
pretty enthusiastic about stocks right now. One specific example comes from the
National Association of Active Investment Managers (NAAIM) survey of active
manager equity exposure. This week, based on the survey, these active managers
have an average of 101.6% exposure to equities. I’d say that’s pretty high.”
“Now, don’t go and
sell all of your stocks just yet based on a contrarian analysis of this data
point. That’s because the previous “all in” bets by these managers didn’t
exactly lead to disastrous results.”
“In fact, on a 3-week,
1-month and 6-month basis, the S&P 500 was higher each time following these
>100% readings. And only this past July’s reading led to a negative 3-month
return, barely.”
Barron’s pointed out this weekend, “While stocks look overbought in the short term, with three of four
stocks already stretching above their 50-day averages, the bullish throng won’t
thin now – not when selling after Jan. 1 lets you put off paying capital gains
until April 2018, when tax rates just might be lower.”
Thus, the complacency in the VIX number doesn’t mean we
should immediately start taking profits. From Dana
Lyons’ Tumblr, “what do stocks do
after very subdued VIX readings in early December? Specifically, we looked at
occasions when the VIX made a 3-month low, as it did today, during the first 18
days of December. While December has generally been a strong month, it has also
not been immune to some adversity during the middle part of the month.
Therefore, our expectation was that stocks had perhaps struggled following
historical occurrences – if not through year-end, at least intra-month. That has
not been the case.”
“Since the inception
of the VIX in 1986, today marked the 30th time that it hit a 3-month low during
the first part of December. Of the prior 29, 27 showed a positive return in the
S&P 500 from that date into year-end, with a median return of +0.95%. Even
the median drawdown until year-end was very contained, at -0.23%, with just one
date seeing a drawdown before year-end of more than -2%.”
The shift in sentiment can absolutely be a powerful yet
frustrating event that has the ability to defy even the soundest of analyses.
We came across this article that
highlights the power and frustration of market sentiment.
From Business
Insider speaking about Albert Edwards of Societe Generale, “Historically, according to Edwards, there
has been a close relationship between the Economic Policy Uncertainty
Index — which hit an all-time high after Sunday's Italian referendum — and
credit spreads (using a mix of US, UK, and euro corporate bonds against their
benchmarks): In times of higher uncertainty, global credit spreads have gone
up.
Edwards noted that
that this relationship, however had been much weaker recently than in the past.
Put simply, the debt market hasn't seen a lot of selling or instability even
though the outlook for global policy is murkier than it has been in over a
decade.
Edwards included
commentary from Guy Stear, SocGen's head of emerging markets and credit
research. From the note:
"In 2008 and
2011, the correlation between economic policy uncertainty and credit spreads
was very close. As uncertainty rose, so did spreads, but something different is
happening now. The EPU index is up at all-time highs, but spreads are at the median
levels of the period going back to 2008. The
chart implies that given the current level of economic policy uncertainty,
global spreads should be twice as wide. This ought to worry the bulls."”
“In Edwards' opinion,
the credit market is too Pollyannaish. There's the possibility the European
Union could break up after the Brexit vote and the Italian referendum, and the
election of Trump as US president could bring about either a trade war or a
corporate boon. Instead of discounting this risk, Edwards said, the market
seems to be simply ignoring it. From Edwards' commentary (emphasis ours):
"Markets shrugged
off the Brexit vote in a couple of days. They shrugged off Donald Trump's
election in a single day. They shrugged off the Italian Referendum result in a
couple of hours. Heck, in this mood they
would shrug off an alien invasion of planet Earth. But global political
risk is now at such elevated levels that investors must surely be on another
planet."
The strategist noted
that he had long been worried about the sheer amount of corporate debt floating
around. He said, in fact, that the relationship between junk-bond spreads and
the amount of debt showed how the credit market had lost touch with reality.
"It is not just
the levels of political uncertainty that suggest corporate yields should be
considerably above current levels," Edwards wrote. "Normally at this
level of corporate debt accumulation, investors have begun throwing their toys
out of the pram."”
Long Term Chart
Last year we had gone on alert for the next bear market. The
chart below shows how we look at the S&P 500 in a technical way to develop
our strategic positioning. On the monthly chart we look for a bearish MACD
cross that triggers our warning. From there we look for RSI (14) to break below
50 with the stock falling through the 20-month moving average. Once the
20-month moving average starts sloping negative and the index tests the moving
average as resistance and fails…we get out of the market and/or start trading
from the short side.
Additionally, we look for the slope in 12-month forward
S&P 500 earnings forecasts to start sloping negative. We got that signal in
early 2015, coinciding with our technical warning. Earnings did improve
somewhat over the next year but took a turn for the worse at the start of 2016
(similar to the 2000 bear market).
Lastly we watch the yield curve for a flattening or
inverting of the two and ten year treasury yield. While we didn’t get an
inverted yield curve we did experience substantial flattening over the last few
years. Given the extreme monetary policies in place we were willing to relax
the rule of the inverted yield curve as recessions and bear markets have
occurred without an inverted yield curve.
Japan has had five recessions without an inverted yield
curve and the US has had six recessions without an inverted yield curve. A
common theme among these non-inverted yield curve recessions is that they
occurred when underlying rates were low. Central banks have greater power to
prevent an inverted curve. We can see today in newly formulated monetary policy
agendas in Japan and Europe in which the BOJ and the ECB are attempting to
control the steepness of the yield curve.
We hit most of these conditions starting in 2015 and we have
certainly been trading with a defensive posture. In early 2016, we received
almost all of our signals for the next correction. We started anticipating a
weaker market and we turned out to be wrong. Our returns in March and April of
this year underperformed the market as a result.
Our view of the future market activity is still cautious but
we are no longer under full bear market alert. On the technical side, RSI (14)
is back above 50, the slope of the 20-month moving average is positive again
and the index is trading above that level. Probably most importantly we
received a bullish MACD cross. Given the new break out from the two-year
consolidation we have removed the alert and are now searching for clues of a
further “melt up” technically.
The slope of the 12-month EPS consensus has turned positive
once again as the earnings recession appears to have ended. Indeed the cut in
corporate tax rates proposed by the incoming Trump administration will help
earnings per share in our view. In a recent analysis by S&P Global Market
Intelligence, they estimated that for every 1% reduction in the corporate tax
rate will equate to roughly a 1% increase in corporate earnings. Thus if the
Trump administration cuts the tax rate from 35% down to 15%, the current
12-month forward EPS figure for the S&P 500, currently around $131 per
share could conceivably jump to $157 per share.
Additionally lowering the repatriation tax to allow US companies to
bring in their cash from international holdings would spur additional rounds of
share repurchases. This could have a profound impact on equity prices.
The yield curve has steepened since the election as investor
deem a business friendly, lower taxes, less regulation, stronger fiscal policy
administration to be economically beneficial. Richard Bernstein recently wrote, “The slope of the yield curve is one of the
most reliable indicators of future nominal growth. Steeper curves forecast
faster nominal growth, flatter yield curves forecast slower growth, and
inverted yield curves forecast recession.
Global yield curves
are steepening, which supports the forecasts of global leading indicators.
Chart 7 shows the percentage of global yield curves that are inverted (i.e.,
forecasting a recession). In 2008, 41% of global yield curves were inverted.
Currently, it is only 2%. The US yield
curve, for example, has been steepening for 5 months.
Steepening global
yield curves imply that most investors’ asset allocations are inappropriate,
and are too defensively positioned.”
As market technicals improve, corporate earnings accelerate
and the yield curve steepens while monetary policy becomes more normalized, the
economic policies of the Trump administration could propel the economy and
stock prices.
Richard Berstein points out that the global economies are
already moving in the right direction. “The
global economy might still be in secular stagnation (although we are
increasingly doubtful), but cyclical acceleration is clearly underway. Leading
economic indicators (LEIs) around the world are strengthening in a unified
manner that hasn’t existed since the credit bubble.
Chart 6 shows the
relationship between the current global LEIs to those of three months ago. If a
country lies above the diagonal line in the chart, then the rate of change in
that country’s LEI is stronger than it was three months ago. If a country is
below the line, then the rate of change is deteriorating. Most LEIs are
improving in unison, which indicates broad improvement in the global economy
and an increasing chance of rising interest rates over the next year or so.”
This trend could possibly accelerate as perception becomes
reality. Michelle Meyer, chief US economist at Bank of America Merrill Lynch
(via Business
Insider) states, “"The data
clearly show that consumers, investors, and business CEOs have all become more
optimistic since the election," Meyer wrote in a note to clients on
Thursday.
Things such as
regional manufacturing indexes, consumer confidence surveys, and investor
sentiment have ticked up since November 8. The only survey that has slid is the
ISM-adjusted Empire Manufacturing Survey, which measures the confidence of
manufacturers in New York state.
"Bottom line:
Most business activity surveys point to greater confidence following the
election," Meyer wrote.”
“This sort of upswing
in confidence usually starts to show up outside of surveys and in real data in
a short amount of time, according to Meyer's analysis. The increases in
business indexes usually point to an increase in capital expenditures, while
the consumer confidence indicators can predict consumer spending.”
“Some of the
correlations are weaker than others, Meyer said, but directionally they point
to higher output for the US economy.
"Overall, we see
a significant relationship between surveys and actual output, but we would be
careful given lags and historical episodes with misleading signals," Meyer
wrote.”
We will be watching the data closely.
Bottom Line: In the
short-term we are fully deployed and believe this “Trump rally” can last through
January. Longer-term, we have exited our cautionary stance on the market and
are reconfiguring the portfolio to tilt more towards GARP (growth at a
reasonable price) strategy, away from an overly defensive posture.
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
Web Site: http://www.squaredconcept.net/
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