Frothy Market Awaits Consolidation And New Catalysts

Last week, in the wake of the President’s address to Congress, stocks rallied hard but ran into a brick wall at Dow 21,000, Nasdaq 5,900, and S&P 500 2,400. For the moment, optimism is high due to solid economic and corporate earnings reports along with the expectation that economic skids will soon be greased by business-friendly fiscal policies. But the proof is in the pudding, as the saying goes, and the constant distractions from a laser focus on the Trump agenda are becoming worrisome – not to mention the many uncertainties in Europe, North Korea’s missile launches, and China’s lowered growth projection as it tries to address its high debt build-up. Nevertheless, capital continues to flow into risk assets.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review Sabrient’s weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas. Overall, our sector rankings still look bullish, and the sector rotation model continues to suggest a bullish stance. Read on....

Market overview:

It took me longer than usual to put together this market commentary. There’s just so much going on and so much to say. But first of all, let me mention that Sabrient’s ninth annual Baker’s Dozen top stocks list for 2017 just completed another successful launch and asset raise for the unit investment trust offered by First Trust Portfolios. During my (and my colleagues’) travels around the country in support of the sales effort, it was evident that there is a renewed optimism among the financial advisor community about the economy and the stock market. If you are a regular reader of my Sector Detector articles, you know that my outlook has ranged from cautiously optimistic to solidly bullish for quite some time, based on both fundamentals and technicals. Indeed, investors appear to be rewarding fundamentals once again and are generally back in alignment with the expectations of the analyst community, which is “typical” behavior.

As a result, sector correlations have fallen, dispersion has increased, and small-mid caps have been strong, meaning that investors are picking their spots rather than engaging in narrow, risk-on/risk-off, fear-based trading. According to ConvergEx, there has been a notable reduction in sector and asset class correlation as compared to the 2009-2016 timeframe, putting them back to historically “normal” levels. Correlation among the 11 sectors of the S&P 500 has fallen from the 75-80% range before the election to 57-62% shortly thereafter, and then more recently it fell even further to the mid-50s. This implies lower volatility for the broad indexes as winning and losing market segments offset each other, and it highlights the importance of good stock picking.

Over both the past three months and the past 12 months, the top performing sectors have been Financials, Industrials, Materials, and Technology. Although Healthcare is the worst performer in the S&P 500 over the past 12 months, it has perked up more recently. In fact, the biotech segment, which had been languishing under election campaign rhetoric, now appears to be breaking out. On the other hand, retailers as a whole have been struggling.

But it goes without saying that a continued upward path for US stocks will not be a straight line. On the contrary, I fully expect a significant (and perhaps scary!) selloff at some point this year, and the longer the market goes without such a pullback the worse it will be when it eventually comes. Nevertheless, unless it comes in response to a game-changing “Black Swan” event that sends the global economy into turmoil or hinders implementation of the new administration’s widely-anticipated fiscal policies, I would expect such an occurrence to be a welcome buying opportunity.

President Trump gave an impressive and potentially unifying speech last Tuesday night. At least the stock market liked it, as the next day the Dow gained more than 300 points to surge above 21,000, and an incredible $8.2 billion flowed into the S&P 500 SPDR Trust ETF (SPY). However, most of this post-election market advance has come courtesy of multiple expansion, which is not sustainable. For example, the trailing P/E on the S&P 500 is now 22x and the forward P/E hit 18.5x when the S&P peaked at 2400 last Wednesday. But I expect a gradual contraction in multiples over time, which means that stocks will need to rely on earnings growth – preferably with plenty of upside surprises – and this will require a corporate focus on capital investment and top-line growth – not just stock buybacks, cost-cutting, and productivity gains. The bad news on this subject is that the street has become a bit more cautious, slightly reducing consensus 2017 earnings, even as investors have become more optimistic. Corporate tax reform alone may boost earnings, encourage overseas cash repatriation, boost dividends, increase stock buybacks, and provide the fuel for capex (the driver of real growth). Add in regulatory reform and perhaps some significant infrastructure and defense spending, and a surge in capital expenditures can provide demand for new equipment, new business formations – which particularly bodes well for the small cap space.

Although the new Administration’s business-friendly proposals have contributed to the enthusiasm, stock performance ultimately comes down to corporate earnings. And overall, Q4 earnings reports have shown numerous positive earnings surprises and raised guidance. It appears earnings growth for the quarter reflects about 7.5% quarter-over-quarter improvement (on revenue growth of about 5%). More than 2/3 of S&P 500 companies beat on earnings and more than half beat on revenues. It is evident that many multinationals were able to offset the impact of the strong dollar by issuing corporate debt in offshore markets at ultra-low interest rates and buying back shares to bolster reported EPS.

Although S&P 500 earnings have been flat for the past three years in the range of $117-$119/share, Q4 2016 was the strongest since Q4 2014. Looking ahead, EPS for 2017 is expected to be $130, and dividing this by the recent all-time high on the price index of nearly 2400 produces an earnings yield of 5.4%, whereas the 10-year Treasury is only yielding around 2.5%. That’s quite a risk premium, assuming rates aren’t on the verge of spiking. So, on this comparison, there is more room for upside in equities.

Looking ahead, I see a continued improvement in economic fundamentals (both in the US and abroad) that should encourage investors to hold higher levels of risk assets, including equities. GDP growth has been improving, the corporate “profit recession” has come to an end, capital expenditures are expected to rise with new incentives, and leading economic indicators are strong (and rising). Wages, employment, and personal and corporate spending continue to improve, fueling positive trends in equity correlations (lower) and dispersion (higher). Investors are more discerning in picking their spots, and good stock-picking and savvy active managers should have a better opportunity to outperform – notably, this is happening just when the financial media has all but counted them out, pronouncing pure-beta passive investing as the “new normal.”

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Disclosure: The author has no positions ...

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