Now that’s what I’m talking about. I have been discussing the overbought technical conditions of the S&P 500 for some time and the need for a pullback to test bullish support levels. And as many commentators have suggested, the more time between pullbacks, the more severe is the action when it finally arrives. Bears had become very hungry after a prolonged hibernation. This week offered up a nasty pullback. But fear not, because in my view it was just what the doctor ordered for the bulls to recruit new troops in order to have a chance at breaking through some ominous resistance levels.
In this weekly 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 trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.
Market overview:
Once Fed Chairwoman Yellen mentioned a little something about inflation, bulls got spooked, and of course a little fear at overbought levels can snowball in short order. The stock market is a discounting mechanism in that the theoretical fair value in a discounted cash flow model is the sum of future earnings discounted back to a present value. So, if inflation starts to creep up, there would be pressure on the Federal Reserve to increase the discount rate, which would make it harder to support elevated multiples. Moreover, it would make corporate borrowing for stock buybacks or capital investment less attractive. Thus, the kneejerk reaction. This further underscores the need for economic expansion and rising corporate earnings (as well as rising revenues) to support valuations. So far, earnings season has been pretty good, and of course Q2 GDP smoked all predictions by clocking in at a robust +4%, while the dismal Q1 rate was revised upward.
Wage inflation is the necessary precursor to price inflation, and reports showed that U.S. labor costs in Q2 recorded their biggest gain in more than five years. Argentina defaulting on its sovereign debt and increasingly severe sanctions on Russia didn’t help investor psyche, either. On Friday, unemployment ticked up to 6.2% (even though many observers thought it might drop below 6%), most likely due to an increase in the labor participation rate (i.e., more people trying once again to find a job as the economic conditions improve). Furthermore, the Fed has shifted its focus from simply the unemployment rate to a range of labor market indicators. So, the FOMC is unlikely to start raising rates any time soon. PIMCO founder and bond expert Bill Gross opined that we in the midst of “a global marketplace that is deflating and de-levering to a certain extent. It’s not Lehman Brothers of 2008…It appears the only safe haven is the front end of the U.S. yield curve.â€
After nearly three years without a 10% peak-to-trough correction, hungry bears have been itching to pounce. And although investors have become immune to most of the daily worries about the global economy and potential Black Swan events, the reality is that it has been eight years since the Fed last raised rates, so an increasingly imminent change in policy has become the major focus and source of investor angst. At the moment, the first rate hike isn’t expected until mid-2015, but it could come sooner should inflation rise faster than the Fed anticipates.
Still, the 10-year U.S. Treasury yield didn’t flinch, closing Friday at a still-low 2.49%. Scott Minerd of Guggenheim has pointed out that international demand for U.S. Treasuries should remain strong when compared to alternatives like 10-year Japanese government bonds yielding around 0.50% or German 10-year bunds yielding just over 1%, which is a historic low and the Treasury/bund spread is near all-time highs. A further decline in the 10-year Treasury yield is possible even without Fed buying.
