Bullish Sentiment Solidifies Even In The Face Of Lofty

The stock market rally from the edge-of-the-cliff reversal on February 12 has continued, and an assault on the all-time highs from almost one year ago (on the S&P 500) now seems plausible. If it can hit new highs, the 7-year bull market is back in business. We are about halfway through earnings season, and after several years of record corporate earnings that were at least partly fueled by Fed policies that helped finance M&A and stock buybacks, some fear that profit margins have peaked. Earnings have contracted for three straight quarters while GDP has weakened, and Apple (AAPL) certainly didn’t help the cause. All of this has pushed up stock valuations to what many feel are as high as they can go without a meaningful improvement in the prospects for corporate earnings -- with the S&P 500 trading near 18x this year's consensus estimate for the S&P 500 of $115. But all is not lost, and investors seem to be comfortable with the prospects for the second half of the year, even as we enter the May-October “summer doldrums.”

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:

Helping the stock market along has been a weaker dollar and a firm bid in oil, with WTI currently trading around $46/bbl. The strength of crude has helped compress credit spreads, which has also helped investor sentiment. Looking ahead, U.S. GDP is expected to expand at a rate of around 2% this year, while earnings weakness should persist until an expected recovery of double-digit growth in the second half. Consensus forecasts show domestic inflation picking up to 1-1.5% later this year, assuming oil prices continue to stabilize, while interest rates remain low around the globe. Europe is expected to pick up some momentum with full-year growth of around 1%, and global GDP overall may rise to perhaps 3%. These conditions would help global investors gain confidence and relieve buying pressure on U.S. Treasuries, allowing a healthy steepening of the yield curve.

Of course, the earnings report from juggernaut Apple (AAPL) was a big disappointment for the market. With flagging iPhone sales, the firm reported its first year-over-year revenue decline since 2003, which sent its shares to test 52-week lows. EPS came in lower than expected and total profit fell by nearly $3 billion (to $10.5 billion) for the quarter. Revenue fell 13% on horrid sales in Asia, with China sales falling by 26%. As of Monday, the stock has fallen for 8 straight days and 11 of the past 12 days.

AAPL makes up a huge proportion of the Tech sector, and the Tech sector has the largest representation in the S&P 500 at 21%, so weakness in AAPL will impact the market’s ability to move higher from here, particularly given the seasonality. Perhaps investors will start looking ahead to the iPhone 7 release later this year. Besides earnings season, other potential market movers are the June vote on a “Brexit” (Britain exiting the EU), the FOMC rate hike decision in June, China’s decision on whether to further devalue the yuan, and of course the crazy goings-on in the US presidential race.

However, I would like to point out that after a long stretch characterized by narrow market breadth (including most of last year), there have been signs of broadening over the past several weeks, which is healthy for the market overall. To illustrate the previous lack of market breadth, let’s compare how large caps have performed versus smalls, and how market-cap-weighted indexes have performed against the equal-weighted indexes, since last summer when the indexes peaked. The large cap S&P 500 Index peaked on 5/21/2015, and then the small cap Russell 2000 Index peaked on 6/23/2015.

In a healthy market, equal weighting typically outperforms as the bias toward value and small caps is more pronounced. However, the cap-weighted S&P 500 Index has greatly outperformed the equal-weighted Russell 2000 Equal Weight Index, which is not desirable. From 6/23/2015 through 4/29/2016, the large cap, market-cap-weighted S&P 500 Index is -2.8% while the small cap Russell 200 Equal Weight Index is -12.7%. So, the performance spread between them is 9.5%. Although this gap is still large, it actually has narrowed considerably from the unsettling 16% performance spread we saw for 6/23/2015 through 2/11/2016 (when the market bottomed). This falling spread indicates a gradual broadening of the market, which is good both for active stock-picking (versus passive indexing) and for equal weighting (versus market-cap weighting). And of course, history tells us that markets eventually rotate back into fundamentally sound stocks (i.e., a flight to quality), which appears to be happening.

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Disclosure: Author has no positions in stocks or ETFs mentioned.


Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice ...

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