Data suggests more upside

Coming off a weekend of political disappointment, it’s easy to get caught up in the emotions of it all. As I pointed out, the market was due for a pullback, and it got a reason to. We can “beat a dead horse” and dissect all of the “what-if” scenarios and implications of the failure. But none of this will be fruitful for your investment decisions. We know that pullbacks and corrections are an inevitable part of investing. And once in awhile we get a major decline, usually due to a recession. The key question is does the data suggest a business cycle peak?

The short answer is no.

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Consumer confidence numbers just came out at a high not seen since November 2000.

Small business optimism

Scott Grannis points out that Small Business Optimism has soared post election and is near all time highs.

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Earnings growth is finally back and is projected to be around 9-11% for 2017. This would be the largest annual increase in earnings since 2011. And this doesn’t even factor in the potential for tax reform and repatriation.

And interest rates are still very low. The earnings yield on the S&P 500 is currently 5.59%, while the 10 year treasury bond yield sits at 2.38%. Even the Fed’s overly optimistic projection suggests the real Federal Funds rate won’t even turn positive until another two years or so. So, even though valuations are on the high side and interest rates have risen quite a bit post elections, stocks still present an attractive risk premium.

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An interesting chart to follow going forward is the ten year yield. Post election the 10 year yield has risen on the assumption of pro-growth policies of the new administration. Since then a trading range between 2.3% and 2.62% has been formed. An upside breakout suggests all is clear, while a breakdown suggests that more of the President’s agenda may be in jeopardy.

Time will tell. But for now, things are looking pretty good to me. But I parse this by saying we’re probably closer to the end of the bull market, than we are to the beginning. The stock market and the economy don’t always correlate. We’ve had great performance in stocks over the last 8 years, while the economy largely under-performed. I wouldn’t be surprised if, going forward, we experience a situation where the economy starts to outperform, while stock performance slows down to an eventual crawl.

The great thing about diversification and asset allocation is that we don’t have to be prophetic. We stick to our strategy and re-balance when necessary. It’s that simple, but certainly not easy.

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Do election years affect market performance?

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Heading into another election year, the sentiment appears to be somber as the candidates reflect on the many data points that suggest an economy that is still growing subpar and wage growth that is still stagnant. And seeing that the most recent bear markets of 2000 and 2008 happened to fall on an election year, investors are on edge about the uncertainty and the level of volatility that it may bring.

I decided to take a look at the historical data of S&P 500 returns for election years and the following year, since 1928, to see if maybe we are overweighting the most recent experiences. Click on the spreadsheet picture above to expand the photo.

I have to admit the answers were a little surprising to me. In totality there doesn’t appear to be any discernable pattern. Which goes to show you that markets don’t trade in a vacuum, the situations surrounding each event are almost never the same. And the real components surrounding investment returns have more to do with recession odds, yield curve, corporate profits etc., than they have to do with quantifiable statistics.

However in each case, presidential year and following year, the volatility remained the same (Max to Min return between +50% to -36%). Average returns were similar although presidential elections years showed a better overall return.

The biggest thing that stuck out to me was the overall decrease in volatility during the election years as opposed to the following years. Without doing this study I would have guessed it would have been the other way around, with volatility increased during the election years due to the uncertainty of who would be chosen for the office and what their policies may mean for the economy.

Over 80% of election years ended with a positive S&P 500 return as opposed to the 50/50 coin flip of positive returns for the year following an election.

So we still have no guarantee whether 2016 will be part of the 20% of election years that end negative or part of the 80% of election years that end positive, but the history suggests that the outcome may not be a gloomy as others will lead you to believe.

Source:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

 

Small caps continue to underperform…

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The market opened higher today and then quickly reversed lower into negative territory. This comes after a day of solid gains across the board, so maybe it’s partly profit taking. I think it’s also the continued underperformance of the small cap stocks that ran into resistance today.

The chart above shows the Russell 2000 index opened higher but hit resistance at the August 24th lows and has since lost all of the gains from yesterday. The Russell 2000 is the only major average that is trading below it’s August 24th lows. This will need to change in order to put in a sustainable bottom in equities.

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On a positive note, the other three major averages are still trading above their August lows. On Tuesday of this week, the SP 500 came close to that pivot low at 1867. We’ll have to see if this continues to hold, however as we pointed out there is much support in the 1850-1820 area as well. So even if the August lows get violated, I believe it’s unlikely to expect it to decline much further. I suspect the next move to be a sustained rally back above 2020.

Tomorrow the US non-farm payroll reports numbers are set to be released. This may have market moving implications.

Want to learn how to trade and analyze the markets? Whether your a day/swing trader or investor wanting to learn how to analyze trends in the financial markets, there is something in The Trading Playbook for everyone. 

How low can the S+P go?…

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As I type this the S+P 500 is down about 11.50% from it’s highs. All four major market averages are below their 50 and 200 day moving averages. And the cumulative advance – decline line is also below its 50 and 200 day moving averages. A caution sign if there ever was one, as it has been about four years since we last saw this level of volatility. Let’s take a look at the technical scenarios to look for in the days and months ahead.

The chart above shows trading in the S+P 500 since the 2011 correction. That correction caused a drop in the S+P 500 of 295 points or 21%. After the smoke cleared, the S+P would increase 100% over the next four years.

On the way up there were six minor corrections that were all in the 120-150 point variety, with the exception of the fall 2014 correction that happened to be 199 points. That pattern has broken after the dismal August performance in equities. But there is reason to believe we may be nearing a bottom, at least in the short term.

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We talked about the potential of revisiting the August lows, and it appears that is what the market is attempting to do. However, there looks to be a confluence of support between 1820-1850. As there is a prior swing high at 1850, 1838 would match the size of the 2011 correction (295 points) and the fall 2014 swing low @ 1820.  I have no idea if the final low will come in this vicinity, but I am anticipating some buying reaction here. Given the macro environment, I believe this is the more probable outcome.


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However it’s always good to be prepared for multiple outcomes. So in the case that the market spends much time below 1820, I would have to conclude that a full 20% correction would then be the most likely scenario. This would equate to about 1700 on the S+P 500. We have a swing high in the 1680 area and the 2000 and 2008 bull market tops between 1550 – 1575 could be a likely target if this scenario were to play out.

I would say the majority of the concern is coming from lack of earnings growth. Earnings for the 3rd quarter are estimated to fall 4.5% amidst global growth concerns. If this were to occur, it would be the first time since 2009 that earnings declined in back to back quarters. Couple that with the concern of rising short term rates into a weak earnings cycle, and you have a recipe for volatility and contraction.

Since I also believe there is low risk of recession in the near term. I believe that this recent earnings losing streak will eventually dissipate. At the very least I think it’s unlikely that we see the high level of Earnings contraction that accompanies a recession. And if we are to believe that the Fed will take a very modest and gradual approach to raising rates, it is likely that equities will soon find solid footing once.

Without QE it’s possible we don’t see the level of equity market gains that we have seen in the past. But that doesn’t mean that investors won’t be rewarded either.

Want to learn how to trade and analyze the markets? Whether your a day/swing trader or investor wanting to learn how to analyze trends in the financial markets, there is something in The Trading Playbook for everyone. 

Financial Markets Week in Review: September 21-25

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This week was an overall risk-off environment, as US stocks lost 1.8% and foreign stocks down 2.7%.  Meanwhile Gold, Treasuries and the US Dollar found some demand. September has historically been the worst month for stocks, and Ryan Detrick astutely points out that this last week has historically been one of the worst weeks of the year.

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The weakness was broad based across most sectors. Only Utilities closed positive for the week. Health Care, mainly Bio-tech, has been a drag ever since the May highs. It’s concerning to see one of the leading sectors in a bull market suddenly turn into a laggard. But markets are cyclical in nature. They go against our natural tendencies to want to go with what is working. It’s possible that this under-performance continues into the late cycle stage. But that doesn’t mean there won’t be bargains in individual companies inside the sector.

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As all four major averages are below their 50 and 200 day moving averages, it’s prudent to be cautious in the near term. The St. Louis Fed Financial Stress Index has elevated due to the recent volatility, but is still below normal and well below the levels seen in 2008 and even 2011.

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Even the yield curve has flattened over the last 12 months or so. As short term yields start to pick up steam in response to the nearing Fed Funds rate hike. Though yields remain far from an inversion which has done a good job at predicting impending recessions.

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Most of the weeks economic data came from overseas. However on Friday, final quarter over quarter US GDP came in at 3.9%. Which was slightly better than the 3.7% estimates.

Fed Chair Yellen spoke on Thursday and again reiterated the likelihood of an initial rate increase before year end. She states that the Fed wants to get ahead of the curve before inflation picks, because if they wait too long they may have to tighten more quickly in response and that could disrupt financial markets. The Fed has consistently stated that they will maintain a very gradual pace of rate increases. And this is more important (and beneficial to equities) than the actual timing of the first.

It’s also possible that the market has already priced in the first increase for them. USD has increased over 20% in the last year, credit spreads have widened and the S+P 500 has fell some 12% already.

For next week…

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More important data on tap for next week: Consumer Confidence on Tuesday, China Manufacturing on Wednesday night and US NFP employment report on Friday.

It’s difficult but investors should try to avoid headlines and focus on data. Low recession odds and accommodating monetary policy has generally been beneficial for stocks. 3rd quarter earnings will begin soon and the bar has been set quite low. If earnings can get back on track that may help provide the necessary catalyst for equity markets.

Want to learn how to trade and analyze the markets? Whether your a day/swing trader or investor wanting to learn how to analyze trends in the financial markets, there is something in The Trading Playbook for everyone.