Scott Martindale

About the Author Scott Martindale

Scott is the Senior Vice President for Sabrient Systems, a quantitative equity research firm in Santa Barbara, CA, and Gradient Analytics, an equity research firm in Scottsdale, AZ focusing on forensic accounting and earnings quality analysis. He is an institutional sales, marketing, and business development professional. He also supports clients in their portfolio management and marketing efforts. Scott is an experienced trader of stocks, options, and ETFs. He holds both an MBA and an MS in civil engineering. Sabrient Systems offers fundamentals-based quantitative equity research, tools, and strategies, and publishes indexes for ETFs. The firm builds multi-factor quant models that work well for long portfolios, hedging, long/short, market neutral, indexing, and portfolio weighting. And the bottom-up Sector/Industry/ETF evaluation and ranking model is valuable for asset allocation, sector rotation, enhanced sector, and sector pairs strategies. Gradient Analytics offers deep-dive fundamental research into the earnings quality, forensic accounting, executive incentives, and anomalous executive behavior of individual stocks -- both U.S. and International. Grades tend toward the negative side, focusing on red flags.

S&P 500: Fundamentals Still Look Solid Despite Brexit-Induced Volatility

After a nice little rally from mid-February until early June, investors started taking chips off the table, ostensibly in anticipation of Thursday’s Brexit vote. But Monday brought a fresh hint of optimism that Britain will vote to remain in the union, and the market responded with a healthy, broad-based rally. On balance, there appear to be good tailwinds for U.S. equities over the near term. I still see improving global stability (even with the impending Brexit vote), stable oil prices (in the range of $40-60, and currently near $50), and modest inflationary pressures on wages and prices.

I still think the S&P 500 will finish the year with a low double-digit return (currently up about +2.4% YTD as of Monday close). However, we likely will see continued sideways price action until a catalyst emerges — perhaps improving forward guidance during 2Q earnings reports, which start next month, or perhaps when 3Q reports commence in October.

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.

Market overview:

From approximately June through February, stocks traded more based on news rather than fundamentals, which is not a healthy long-term approach to investing. But then in mid-February, the market reversed, starting with the usual short-covering and speculative rally that launches every bullish reversal. However, unlike the last big rally attempt last fall, this one began to rotate into more sustainable characteristics, such as improving breadth, lower sector correlations to the major index, and a flight to quality, which is a positive environment for anyone picking stocks based on fundamentals and forward valuation (including Sabrient).

Then on June 8, investors started taking chips off the table (in a return to their cautious, news-driven, risk-on/risk-off M.O.) in anticipation of any fallout from Thursday’s Brexit vote. But Monday’s broad-based relief rally helped breathe renewed life into those aforementioned positive market trends.

ConvergEx recently noted that monthly industry correlations to the index fell to around 70% for the past few months from the mid 90% range where they had lingered for much of the previous several months. In addition, by early June, broad indexes like the NASDAQ, Russell 2000, and the transports had all recaptured their 50-day and 200-day simple moving averages, and the equal weighted versions of the major indexes had been greatly outperforming the cap-weighted versions, with small caps greatly outperforming large caps. These are all positive signals for equities in general and fundamentals-based stock picking in particular.

Of course, the bogeyman of the moment is the Brexit vote in which U.K. voters decide whether to remain a part of the European Union (EU), which essentially was formed as a treaty among 28 European countries to create a more efficient economic zone through common trade policies and open borders for the unrestricted movement of people, goods, services, and capital among them. Britain has the fifth largest economy in the world, thus the anxiety of global investors as to what might come next. Indeed, the bond market has been signaling a flight to safety as the 10-year yield fell last week to around 1.60% and the 30-year to about 2.40%, while German 10-year bunds crossed into negative territory for the first time ever. So, for a little more than a week, it was risk-off. Oil fell and gold rallied. The average mutual fund’s cash holding reached nearly 6% (more than in 2008 or 2011).

However, I don’t think an exit decision will have a huge long-term impact on global trade or the equity markets. For one thing, the referendum is only advisory and not mandatory, so a vote to exit does not necessitate an exit. Secondly, Britain will still trade with its neighbors, whether as part of the EU or not, although it would need to set up alternative trade agreements. In fact, a definitive decision to exit the EU would trigger a lengthy 2-year exit process during which Britain would renegotiate everything with each of the other 27 countries.

Not to be overlooked, on Friday (the day after the Brexit vote) the widely-followed Russell Indices will implement their annual rebalance, so volatility is likely to reign later this week. After that, no matter what the result, I expect markets to eventually return to rational behavior, including broadening and low sector correlations in a general flight to quality and fundamentals-based investing.

Unfortunately, the Brexit vote is symptomatic of the broader move both globally and here at home towards populism, nationalism, and protectionism, as frustrations build about a lack of economic growth (pretty much everywhere). Globalization is a form of economic inclusion and integration that allows the greatest efficiencies, productivity, and entrepreneurial activity to flourish, wherever it is found. So, in my view, any attempt to break up the EU or other free trade treaties is more reflective of a failure to execute rather than a problem with the concept itself.

Most central banks seem to have lost their mojo. For example, in parts of the world where interest rates are negative there has been a decline in both economic activity and stock markets. The BOJ has failed for over 20 years to stimulate Japan’s moribund economy. They and the BOE both opted last week to keep rates steady. And here in the U.S., the Fed also held rates despite having previously telegraphed another rate hike to the market, and its cautiousness may be creating more fear and uncertainty than a more convicted tightening approach would.

CME fed funds futures are now indicating only a 12% probability of a rate hike in July (down from 60% just a couple of weeks ago). The probability rises to nearly 33% by September, and then 54% for at least one hike by December (and only 13% chance of two rate hikes by then), but all of these probabilities are significantly lower than two weeks ago. Unfortunately, this reflects perceived vulnerabilities in the economy, so equities are likely to display some elevated volatility.

Nevertheless, the 10-year Treasury yield remains as low as it has ever been, and of course low rates make stocks all the more attractive, whether an investor is seeking income or growth. A couple of Goldilocksconditions appear to be at work. One is economic growth sufficient enough to hold off a recession while not strong enough to prompt the Fed to raise rates (even though it is itching to do so). Another is oil between $40 and $60, which keeps energy firms in business (which is good for workers, suppliers, and the high-yield market) while not overburdening consumers.

After spiking to near 23 last Thursday, the CBOE Market Volatility Index (VIX), aka fear gauge, fell through Friday even though stocks were in the red, and then closed even lower on Monday at 18.37 as stock rallied. This is a positive signal. Also, there was a lot of insider buying last week as insiders evidently felt their companies were oversold and undervalued after some pre-Brexit vote profit-taking in fundamentally strong companies. Another positive. In addition, leadership of the market last week could be seen in Energy, Basic Materials, and Industrial sectors, which all depend upon economic growth. Even high yield bonds held up well last week.

I read somewhere that the average spread between the 10-year Treasury yield and the S&P 500 earnings yield going back to 1970 is essentially zero. But today, the earnings yield is about 4.2% while the 10-year yield hovers around 1.6%, i.e., a 2.6% spread. This further validates equity prices — at least until either bond yields increase or earnings fall. But with low inflation and an accommodative Fed, coupled with Wall Street’s earnings expectations that 3Q 2016 will be the first positive year-over-year comp in seven quarters, the climate seems good for equities.

On the other hand, with the S&P 500 trading at a forward PEG (P/E to growth rate ratio) of at least 2.0, it may appear that stocks are fully valued for the modest growth expectations — unless companies start guiding revenues higher to grow EPS from the top-line, rather from further cost-cutting, productivity gains, and stock buybacks. Nevertheless, as we were putting together our summer Forward Looking Value Portfolio of attractive GARP stocks (which launches on Thursday through First Trust Portfolios), we were able to find 35 companies with solid earnings forecasts for the next 12 months that, as a diversified portfolio, are selling at an average forward PEG of around 0.30. So unless the analyst community is way too optimistic, there are still some compelling investment opportunities to be found.

As a reminder, I will be attending the 21st annual IMN Global Indexing and ETFs Conference at the St. Regis Monarch Beach Hotel in scenic Dana Point, CA next week, June 26-28. has provided me with a discount code to share with any of my readers who might want to attend: SD10.

SPY chart review:

The SPY closed Monday at 207.85, making a nice recovery from a nasty bear attack, and is back above its 50-day, 100-day, and 200-day simple moving averages. It remains stuck in a sideways channel, or trading range, between 205 (where the early April breakout occurred) and 210 (roughly corresponding with S&P 500 index at 2100). Its June false-breakout high is 212.54, and its all-time high from May 2015 at 213.78. Last week, several bullish gaps were filled, and price approached the bottom of the channel at 205, where bulls mustered conviction and ultimately put together Monday’s bounce. I still believe that we are most likely in store for more sideways action during the summer, and Monday’s gap up will likely be filled. But I also believe we will see a new all-time high before year-end, and perhaps double-digit returns on the SPY (which, after considering dividends, would put it at or above 220). Oscillators RSI, MACD, and Slow Stochastic are all pointing up bullishly.




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