Stocks Resume Technical Breakout Despite Political Turmoil At Home And Abroad

In late May, the major US stock indexes finally eclipsed those pesky psychological levels and hit new highs, and this week they have managed to maintain the breakout even in the face of James Comey’s Congressional testimony and the British election, not to mention more saber-rattling from North Korea. The S&P 500 has held above 2,400, and the Dow has maintained the 21,000 level. The ultra-strong and Tech-heavy Nasdaq regained 6,300 and the Russell 2000 small caps moved back above 1,400 after both briefly pulling back below to test support early in the week. They both showed notable strength on Thursday after the James Comey testimony. Such backing-and-filling and technical consolidation was inevitable given that the proverbial “rubber band” was stretched so tight, with price rising well above the moving averages.

With the strength in Nasdaq, it should come as no surprise that the Technology sector has been by far the top performing sector, up about +22% year to date, while Energy has struggled, falling about -15% YTD. Notably, on Wednesday, oil prices fell more than 4% due to an unexpected rise in U.S. crude inventories.

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. In summary, our sector rankings still look bullish, while the sector rotation model maintains its bullish bias. Volatility remains historically low, economic conditions continue to improve, and overall, the climate seems quite favorable for risk assets like equities – particularly dividend payers, small caps, and GARP stocks (i.e., growth companies among all caps selling at attractive forward PEG ratios). Read on....

Market overview:

Given our government’s singular reliance for the past several years on monetary policy without any complementary fiscal stimulus, I see it as likely that our economy is still in the early expansion phase of the business cycle, just plodding along on the back of asset inflation while awaiting the next stage of earnings-driven growth, which finally seems to be underway. Thus, the peak phase of the business cycle (which would generally foreshadow a recession) may still to be years away. Moreover, although Sabrient does not have its own macroeconomic model, I like to read the tea leaves of our quant models to infer the implicit assumptions of the analyst community and the trends suggested by the aggregate projections of their earnings models, which leads me to this market outlook:

1.Low yield environment persists; modest inflation; rising GDP; continued share buybacks; resurgence in corporate capex

2.Oil prices remain in Goldilocks range ($40-60); cheap commodity prices persist

3.US fiscal stimulus begins to some extent (particularly tax and regulatory reform), which complements still-accommodative Fed monetary policy

If these expectations indeed play out, I would expect to see a continued improvement in market breadth, low sector correlations, and widening performance dispersion among individual stocks, which would mean that investors are discerning as to which companies they want to own, thus creating both winners and losers, as opposed to all boats rising or falling together with the tide. Overall, I expect investor focus on the solid global fundamentals and improving corporate earnings, rather than simply reacting to the daily news.

Unemployment fell to 4.3%, which is the lowest level in 16 years, while labor force participation declined to 62.7%, primarily due to increasing numbers of workers hitting retirement age. There are now over 6 million job openings according to the BLM’s JOLTS report. As of April, the number of unemployed workers per job opening in the U.S. hit a record low of 1.2 (compared to more than 6.0 after the Financial Crisis). As a result, the Q2 GDPNow estimate is 3.4% as of June, with a new update due out mid-day on Friday.

For several years, the Fed’s essentially free money encouraged companies to take the quick-and-easy path of borrowing to fuel share buybacks. This has supported EPS in the short term but has done little to enhance long-term prospects, as would be gleaned from capital expenditures. I have written often about the undesirable impacts of our sole reliance on Fed monetary policies like ZIRP and QE to stimulate the economy, including a recession in both capex and profits and the widening wealth gap, so it seems that a combination of fiscal stimulus and executive compensation tied to longer-term goals (rather than short-term stock price performance) would better support long-term growth in corporate revenues and earnings as well as sustainable stock price appreciation.

As for equity valuations, there are many dynamics supporting the elevated valuation multiples. For one, our services oriented economy is not so vulnerable to a low-cost competitor like it often is in a manufacturing economy, so higher margins are attainable. Furthermore, a P/E of 20 suggests an earnings yield (or real return) of 5%, or 7% nominal return (including inflation), which is well above the benchmark 10-year Treasury yield (under 2.2%). Also, when you combine the S&P 500 dividend yield of 1.9% with share buybacks, the total “returned capital yield” exceeds 4.0%, which is relatively attractive compared to the 10-year Treasury. Moreover, comparisons with historical P/E or the oft-cited cyclically-adjusted price-earnings ratio (CAPE) can be misleading when you consider that GAAP accounting standards have stiffened through the years, thus artificially shrinking the denominator of the equation.

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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 ...

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