Stocks Are Itching For Year-End Breakout Rally, But Who Will Lead It?

The early weeks of September were looking so promising as a brief but impressive surge gave hope of a revival in the long-neglected market segments. This sustained risk-on rotation seemed to be marking a bullish change of market character from the risk-off defensive sentiment that I have been writing about extensively for the past 18 months (ever since the China trade war escalated in June of last year), specifically the massive divergence favoring the low-volatility, growth, and momentum factors, defensive sectors, and large caps over the value and high-beta factors, cyclical sectors, and small-mid caps. But then, for the next few weeks, those risk-on market segments were once again lagging, as fickle investors keep returning to stocks displaying stronger balance sheets, high dividend yields, and/or secular growth stories – in spite of high valuations – rather than the more speculative cyclical growth stocks selling at attractive valuations that typically lead an upside breakout. It appeared that the fledging bullish rotation was caput – or perhaps not. Suddenly, there have been positive developments in the trade negotiations and in the Brexit saga, and the past several days have brought back renewed signs of a pent-up desire to take stocks higher. Signs of a better than expected Q3 earnings season may be the final catalyst.

Of course, although YTD returns in US stocks are impressive, if you look back over the past year to when the major indexes peaked in 3Q2018, stocks really have made very little headway. As of the close on Tuesday, the S&P 500 is +21.3% YTD but only +1.7% since its 2018 high on 9/20/18, while the more speculative Russell 2000 small-cap index is still more than -12% below its all-time high from over a year ago – way back on 8/31/18. The biggest difference this year versus the 9/20/18 high for the S&P 500 is that Treasury yields have fallen (from 3.1% to about 1.8% on the 10-year), which has allowed for P/E multiple expansion (from 16.8x last year to 17.2x today) despite the earnings recession of the past three quarters.

I suppose one can hardly blame investors for their trepidation at this moment in time, given the overabundance of extremely negative news, which only expanded during Q3. We have an intractable trade war with the world’s second-largest economy, intensifying protectionist rhetoric, North Korean missiles, rising tensions with Iran, a brewing war in northern Syria, drone attacks in Saudi Arabia, riots in Hong Kong, China’s feud with the NBA (and the animated TV show South Park!), a slowing global economy, a US corporate earnings recession, flattish yield curve, surging US dollar, low-yield/high-volatility Treasury bonds, falling consumer sentiment, Business Roundtable’s CEO Economic Outlook Index down six consecutive quarters (as hiring is strong but capital investment and sales expectations lag), the steepest contraction in the manufacturing sector since June 2009, UAW strike against General Motors (GM), looming Hard Brexit, top-polling Democratic candidates espousing MMT and business-unfriendly socialist policies, and yet another desperate attempt to impeach the President before the next election. Need I go on?

But somehow the US economy has maintained positive traction while stocks have held their ground given a persistent economic expansion, supported by dovish central banks around the world and a rock-solid US consumer. Indeed, the very fact that stocks have held up amid such a negative macro environment suggests to me that investors are just itching for a reason to rotate cash and pricey bonds into stocks – perhaps in a big way. And from a technical standpoint, such a long sideways consolidation over the past several months suggests that an upside breakout may be imminent – and likely led by those risk-on market segments. Notably, every such bullish rotation has helped Sabrient’s various growth-at-a-reasonable-price (GARP) portfolios gain ground against the SPY benchmark, so a sustained rotation would be quite welcome!

And some good news this week is offering some hope, with strong Q3 earnings reports from JPMorgan Chase (JPM) and UnitedHealth (UNH), a resumption in trade talks, progress in the GM strike, and a possible breakthrough in the Brexit negotiations. Moreover, the highly cyclical semiconductor and homebuilding industries are on fire, with iShares PHLX Semiconductor ETF (SOXX) setting a new high, and Treasury yields continue to fall.

In this periodic update, I provide a detailed market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings now look neutral to me, while the technical picture remains bullish, and our sector rotation model retains a solidly bullish posture.

Market Commentary:

A solid year so far, and optimism about Q4:

Through September, the S&P 500 posted an impressive total return of +20.6%, marking its best first nine months of any year since 1998. But because of the dismal 4Q2018 performance, it has mainly been making up lost ground and remains below its all-time high of 3,026 from 7/26/19. Although all eleven GICS sectors were up during September, the top-performer YTD is Technology at +31.4%, while the worst is Healthcare at +5.6%. During Q3, the leading market segments were the highly defensive Treasury bonds, gold, Utilities, and Consumer Staples, while the laggards were the highly cyclical sectors Metals & Mining, Energy, Basic Materials, and Banking, along with the aforementioned Healthcare – likely due to threatening presidential campaign rhetoric attacking drug pricing (sounds like 2015 redux) and “Medicare for All.” In fact, fund flows into Healthcare funds have been negative on a rolling 3-month basis for the past 6 months, which should be surprising given the solid earnings trends within the sector.

Interestingly, while high-flying Technology is among the worst for EPS growth forecast, laggard Healthcare is among the best. FactSet reported that companies in the Healthcare sector are expected to report the highest YOY revenue growth this quarter, following a Q2 in which 97% of firms beat earnings expectations, and guidance has been relatively strong (with a preponderance of analyst upgrades). So, what gives? Well, given the harsh election rhetoric, it appears that investors are skeptical of the rosy outlook – yet another example of fickle, headline-driven investor behavior that can be so upsetting. The last time Healthcare flows were so negative was during the previous US presidential campaign, when Hillary Clinton was harping on drug price gouging. Nevertheless, intrepid investors may find this sector to be a good contrarian play.

As Q3 corporate earnings season gets underway, investors will be closely watching for clues on margin compression, capital spending, and forward guidance. In addition, the FOMC meets on October 30, and the Brexit deadline is October 31. The pervasive negative news has been starting to chip away at the strong consumer sentiment, as the Consumer Confidence Index came in at 125.1, down from 134.2 the previous month. However, this is still a robust number from a historical perspective (recall that during the last recession the index dropped to a low of 38). Furthermore, individual income tax withholding receipts have been quite strong, the percentage of “job leavers” is at lofty levels (showing confidence in the labor market), and the latest jobs report was solid (with unemployment at 3.5%). Also, the AAII reported last week that bullish sentiment among individual investors dropped to 20%, the lowest since May 2016, which is usually bullish as a contrarian indicator. So, unless we start to see companies cutting jobs in earnest (perhaps due to surging wages and falling margins), there seems to be little reason to worry, and the US consumer appears to be in fine shape.

Another key concern you often see written about is rising debt levels, with the total public debt reaching a record-high $22.5 trillion. But as I often point out, a favorite tactic of the doomsayers is to talk about a given metric in isolation and out of context. In this case, as First Trust has pointed out, the net interest owed on the debt is only about 1.8% of GDP (compared to, for example, an average of 2.7% during the period 1980-2001), as borrowers enjoy ultra-low interest rates. And when you also consider the value of assets held, US household net worth (assets minus liabilities) registers near a record high at 4.3x GDP.

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Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account ...

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