March Madness is in its full glory with some of the most epic displays of competition, controversy, surprises, and visuals we have ever seen. Oh, and the NCAA basketball tournament is pretty incredible, too, but that’s not what I’m talking about. I’m talking about the U.S. presidential election. And it has produced some crazy headlines, news clips, and sound bites. We have hugely popular candidates ranting about topics ranging from massive walls, to repealing laws, to the size of one’s private parts, to riots if there is a brokered convention, to targeting corporations that seem to be “predatory,” to Denmark as the appropriate model for American political policies.
But in the midst of all this misdirection, corporate America seems to be finding a path to climb out of its rut. So, although earnings might remain weak for the short term, the prognosis is good for the back half of the year, and stocks seem to be reflecting an expectation of improving fundamentals rather than the latest attention-grabbing headline. I told advisors during my travels earlier this year (during the market meltdown) that I believe we will see a flight back to quality this year, a return to valuation-driven investing, including value, GARP, and dividend strategies, along with a stabilization and slight recovery in oil and commodity prices. I also said that we could see new highs in the S&P 500 later this year, and perhaps a double-digit total return for the year. I still think these are in the cards.
In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas.
Yes, the headlines are often borderline crazy, but the good news is that investors seem to be ready to move on from their short-term focus and look toward longer-term fundamentals. From an investor’s standpoint, at least three of the four main headline grabbers (China, oil, Fed, election) of the recent past may have finally moved themselves to page two of the newspaper. China appears to be on a workable path to stabilizing the yuan, although global currency wars continue. Oil prices have rallied substantially, which has not only bolstered some Energy sector balance sheets but also helped lessened the doom-and-gloom in the high yield market. And the Federal Reserve has calmed nerves by demonstrating a willingness to adjust its rate hike intentions.
As for the election, however, it is pretty evident this year just how polarized our society has become, with candidates ranging from Tea Party conservatives to democratic socialists, and populist messages of all sorts gaining plenty of traction. Donald Trump might not like it, but the GOP’s system of electing delegates to a convention where a party representative is then chosen for the general election, has been in place for 160 years. During that time there have been ten instances (roughly 25% of the time) in which no GOP candidate earned a majority of delegates, and in seven of those instances a candidate was chosen who didn’t have a plurality of the delegates (the most recent being 1952 with General Eisenhower) but instead was deemed most likely to win the election.
Meanwhile, improving economic data has been a boon to risk assets over the past several weeks, but the February retail sales report and the January revised number were quite disappointing. However, if we focus solely on core retail sales (i.e., ex-auto and gasoline), the numbers were solid — setting a record in February and gaining more than 4% year-over-year.
Stocks have indeed responded. Surprise! The S&P 500 total return turned positive YTD on Monday, albeit ever so slightly (less than 1%). ETF money flows have pushed over $5 billion into domestic equity ETFs over the past week. Moreover, the S&P 500 is now providing a 2.17% dividend yield, while interest rates remain at historical lows with the 10-year Treasury yield closing Monday at 1.92% and the 2-year yield closed at 0.87%, with the spread between them rising slightly from 99 bps two weeks ago to 105 bps today.
As widely expected, the March FOMC meeting concluded with no change in the fed funds rate and the announcement that it will likely raise rates only twice this year instead of the previously indicated four times. Thus, the Fed has been able to create the illusion that it is easing — at least relative to the prior timetable. Fed funds futures are now pricing the probability of at least one quarter-point hike in April at 7%, June 38%, September 60%, and by December there is a 74% probability of at least one hike and a 34% chance that we will see two rate hikes.
Yes, the Fed is your friend, and “Don’t fight the Fed” is still the operative adage as it is committed to supporting the U.S. economy even while trying to normalize rates. Note that the December rate hike was the first one in history in which bank reserves did not contract, with $2 trillion in excess reserves still in place. Monetary policy is actually loosening as M2 money supply has accelerated to 8% annualized growth. Nevertheless, I will say yet again that monetary policy is not a long-term structural answer to slow growth. Rather, a coherent fiscal policy (e.g., taxes, spending, and regulation) is essential, as implored by the G-20 consensus.
As for corporate earnings, Q1 2016 is likely to reveal the biggest contraction in earnings since the Great Recession, thus marking the fourth consecutive quarter of YOY declines, and Q2 might not be much better. But Wall Street’s consensus is that the second half of 2016 looks much stronger than the first half, and investors appear to be looking ahead.
Moreover, much has been made of the lack of inflation, slow GDP growth, and sluggish corporate revenue growth despite the open spigot of liquidity around the world, but smart investors realize that most of the incredible technological advances that entrepreneurs continually create are inherently deflationary in that they create higher productivity or lower cost solutions. For example, when I left the oil industry in 2000, the prevailing expectation was for peak oil in which global demand would overwhelm supply, driving prices above $200/bbl until shale oil and other tight formations would become economic to produce, and the U.S. would be 100% dependent on oil imports and at the mercy of hostile regimes overseas. But intrepid capitalists and entrepreneurs have made such tight oil economic at more like $40/bbl, and North America is now essentially energy independent, with Congress recently lifting its 40-year ban on oil exports.
And then there are entrepreneurial icons like Jeff Bezos and Elon Musk, motivated by dreams more than riches, and launching private enterprise into areas once controlled totally by inefficient government agencies. Thus, the Fed’s 2% inflation target seems arbitrary and outdated as entrepreneurial activity in new technologies accelerates innovation and its inevitable byproducts of productivity and yes, deflation — but most importantly, prosperity.
As stocks have begun reflecting a prognosis for improving fundamentals and earnings, it bodes well for the fundamentals-based, quality-oriented, GARP (growth at a reasonable price) strategies preferred by firms like Sabrient as well as many famous valuation-driven investors and large activist hedge funds. Last year, news headlines, competing global central banks’ monetary policies, currency wars, Fed watch, falling oil and commodity prices, widening credit spreads, China’s economic and currency manipulations, ISIS-inspired terrorism, and election cycle rhetoric all buffeted stocks and created a narrow trader’s market — making almost irrelevant a disciplined quantitative numbers-driven approach that had worked so well for us for so long. Indeed, much equity investment has shifted from active management and stock-picking products into passive index funds. But we might be seeing signs that stock picking is coming back in vogue.
The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 14.02 and Monday at 13.79, which is the lowest reading since August 18. It is back below 15 and solidly in the zone of complacency.
SPY chart review:
The SPDR S&P 500 Trust (SPY) closed Monday at 204.67 and is back above all its major moving averages. In mid-February it formed a double-bottom and bounced strongly from the long-standing support line of “last resort” near 182. In the process it also formed a bullish W-pattern, which needed confirmation via a solid break above the mid-line of the W at the 195 level, which also happened to be the 50-day simple moving average. After consolidating around that level for several days, SPY finally broke out, but with a succession of resistance lines offering up stiff challenges. Next up was a test of strong round-number resistance at 200, which also happened to be the 100-day SMA. After consolidating around that level for several days, the magnetic pull of the bearish gap down from 204 on the first trading day of the year kicked in, but first it took a few days to test bullish conviction at the downtrend line from early November, which also happened to converge with the 200-day SMA. After breaking above that line last week, the gap up to 204 was filled, and SPY is now consolidating at this level. However, bulls may be getting a bit gassed at this point and may need to let price pull back to test resistance-turned-support at 200. Oscillators RSI, MACD, and Slow Stochastic are all overbought. Notably, the iShares MSCI Emerging Markets (EEM) is challenging its 200-day SMA, as well, while the important iShares Transportation Average (IYT) is up 7.7% YTD and well above its 200-day.