Optimism About Tax Reform Gooses Bullish Sentiment

Another day, another new high in stocks. Some observers understandably think this is a sign of excessive complacency and a bad omen of an imminent major correction, as valuations continue to escalate without the normal pullbacks that keep the momentum traders under control and “shake out the weak holders,” as they say. But markets don’t necessarily need to sell off to correct such inefficiencies. Often, leadership just needs to rotate into other neglected segments, and that is precisely what has been happening since the mid-August pullback. Witness the recent leadership in small caps, transports, retailers, airlines, homebuilders, and value stocks, as opposed to the mega-cap technology-sector growth stocks that have been driving the market most of the year.

Yes, the cap-weighted Dow Industrials and S&P 500 have both notched their eighth straight positive quarter, and the Nasdaq achieved its fifth straight, and all of them are dominated by mega-cap stocks. And the new highs have just kept coming during the first week of October. But it’s the stunning strength in small caps that is most encouraging, as this indicates a healthy broadening of the market, in which investors “pick their spots” rather than just blindly ride the mega caps. Rising global GDP, strong economic reports, solid corporate earnings reports, and the real possibility of tax reform have all helped goose bullish sentiment.

Those of you who have read my articles or attended my live presentations on the road know that I have been positive on small caps and that the momentum trade so far this year and high valuations among the mega cap Tech stocks likely would become self-limiting, leading to a passing of the baton to other market segments that still display attractive multiples, particularly those that would benefit the most from any sort of new fiscal stimulus (including tax and regulatory reform), like small caps. Moreover, I believe that with a still-accommodative Federal Reserve moving cautiously on interest rates, and with strong global demand for US Treasuries and corporate bonds, the low-yield environment is likely to persist for the foreseeable future.

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 latest fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model also maintains its bullish bias, and the overall climate continues to look favorable for risk assets like equities. Although October historically has been a month that can bring a shock to the market, it also is on average one of the strongest months for stocks, and of course Q4 is seasonally a bullish period. Read on...

Market overview:

September proved to be another solid month despite its reputation as the weakest month of the year. The S&P 500 rose almost +4% during the month, while the Dow Industrials rose almost +5%, and NASDAQ rose 5.8%. Most major indexes have achieved a new all-time high. As of Friday’s close, the SPDR S&P 500 Trust (SPY) is +13.8% YTD, while the suddenly-strong Russell 2000 small cap index is +11.3%, essentially all of which has occurred just since the market turned and began to broaden on August 21. Meanwhile, after lagging for most of the year, S&P 500 Value greatly outperformed S&P 500 Growth during September, further demonstrating an expectation that solid economic fundamentals will persist. Among sectors, using the 10 US sector iShares, the top-performer YTD through Friday is Technology, up +26.6%, followed by Healthcare at +21.1%, boosted by a sudden resurgence over the past couple of weeks in the biotech segment, while Energy is the worst at -10.6%, followed by Telecom at -9.0%. The small-cap-dominated SPDR S&P Biotech ETF (XBI) was up +13% during Q3 alone and is now up nearly +50% YTD.

From a factor standpoint, S&P Dow Jones Indices has reported that during 3Q, High Beta, Growth, and Momentum factors all performed well, while Equal Weight underperformed. However, the last several weeks of the quarter saw the trend shift more toward Value and Equal Weight.

The CBOE Market Volatility Index (VIX), aka fear gauge, closed Friday at 9.65 and actually hit an all-time record closing low of 9.19 on Thursday. As a reminder, there hasn’t been a significant stock market correction since February 2016. Even during August’s brief bout of heightened volatility, VIX spiked above the 15 fear level but only peaked at 17.28, and never came close to the 20 panic level. I will continue to warn that although complacency can persist for a long time, the VIX is an oscillator, so it will eventually spike again – although some are now saying that once a metric becomes a trading vehicle (as VIX has), it uses its usefulness as a metric. I suspect that given the growing use of VIX futures, options, and ETFs, along with other active volatility strategies employed by big-money institutions, the VIX sees a lot of manipulation these days.

Moreover, the S&P 500 has not yet shocked investors this year with a 2% single-day move (in either direction), which is highly unusual. In fact, the last time a full year went by without having a 2% single-day move was 2005. Instead of selling off, the market has simply rotated into other segments.

Just when talking heads had pretty much written off any sort of tax reform any time soon, September saw a surprise Republican proposal that resurrected the so-called “Trump Trade,” including value oriented sectors and industries like industrials and banks, as well as small-cap domestic-oriented companies that could benefit most from tax reform. Energy stocks have rallied, partly on higher oil prices, but also because they stand to benefit from typically high effective tax rates, as do financials, utilities, and consumer staples companies. And from a cash repatriation standpoint, consider that as of its Q2 filing, Apple (AAPL) was holding a whopping $246 billion in cash with foreign subsidiaries, which represents the equivalent of 29% of its total market capitalization. Small caps, without typically having overseas tax havens, tend to pay higher effective tax rates, so they also should enjoy extra benefit from tax cuts. Although a tax bill still has a long ways to go and plenty of hurdles to cross, the mood on the street has been celebratory – so Congress had better not disappoint (yet again).

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Disclosure: The 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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