Breakout Failure As Resistance Holds

Last week, I discussed the “Seemingly Bulletproof Market” and how, despite the carnage in Technology and Discretionary sectors, the overall market was mostly unaffected.

“Stepping back from the sector-specific action, if you only looked at the S&P 500 to judge what was happening in the markets, you wouldn’t suspect anything was wrong.”

“The market breakout remains intact currently with support at 2400 holding firm. The bullish trend line, which also intersects at 2400 remains critically important as the secondary buy/sell signal remains in positive territory. The only negative currently, despite improvement, is the ‘weekly sell signal-1’ remains triggered which keeps us on ‘alert.’ (It is also worth noting both signals remain at VERY high levels which suggest current upside remains somewhat limited.)

You can understand why more and more commentary is beginning to succumb to the ‘siren’s song’ of why ‘this time is different.’ Whether it is terrorist attacks, poor economic data, geopolitical tensions, or plunging oil prices, the market has continued its advance. It certainly seems to be ‘bulletproof.’” 

That was SOOOO last week.

Last Monday, the markets shot out of the gate and rose 20 points for the day which confirmed the breakout above previous resistance. Unfortunately, that bout of “exuberance” was short-lived and the rally faded for the rest of week closing back below resistance as shown below.

Importantly, note the short-term “sell signal” remains intact in the lower part of the chart as well as the “weekly sell signal” in the chart above. Both of these suggest warnings suggest pressure is to the downside currently as we head into the month of July and the “Dog Days Of Summer.”

From a portfolio positioning standpoint, nothing has really changed at the current time. As I noted in last week’s missive:

“During last week’s pullback, we added modestly to our broader-based ‘core’ holdings for the second time over the last couple of months. to participate with the breakout. Stops have been moved up and remain very tight.

While I remain very cautious on the overall market, the trend remains bullishly biased which keeps portfolios allocated on the long side for the time being. However, I will not be surprised by a reversal and failure of the breakout leading to us getting stopped out of positions.”

We remain extremely “alert” to the underlying strength of the market and are not taking on excessive risk with portfolio allocation models.

With volatility suppressed, legislative agenda stalled, economic data weak and earnings growth expectations at risk, remaining somewhat cautious, and alert, makes sense to us. As stated, while we remain long at the moment, we do so with a very “twitchy trigger finger.” 

Sector By Sector

With that bit of analysis in place, let’s review the market environment for risks and opportunities.

ENERGY

The OPEC oil cut has likely run the majority of its course and with Permian Basin production on the rise, the pressure on oil prices from supply/demand imbalances remains an issue. I discussed the headwinds to oil prices in May of this year as oil prices approached $50/bbl.

“While investors have chased energy stocks on expectations of minor production cuts from OPEC, little has been done to resolve the fundamental valuation problems which face a majority of these companies, and investors have paid the price as of late. Which is why I had suggested selling energy stocks in November of last year as noted below.”

“Importantly, note the weekly ‘sell signal’ (vertical dashed red line) at very high levels currently for oil.While there is hope the production cuts will lift oil prices in the short-term, the longer-term technical backdrop suggests a bigger correction may already be in the works. 

With respect to investors, the argument can be made that oil prices could remain range-bound for an extremely long period of time as witnessed in the 80’s and 90’s. It is here that lessons learned in the past will once again be re-learned with respect to the dangers of commodities, fundamentals, leverage, and greed.”

Over the last few months, “Seemingly Bulletproof Market” in the sector allocation models below that energy exposure should be severely reduced or eliminated entirely. That has been profitable advice since then.

“Energy – Oil prices dropped below support at $45 on Friday and is now set up to test the lower range of $40/bbl in the weeks ahead. The supply of oil remains a problem with rig-counts rising and economic weakness setting in. With a major sector sell signal, and the cross of the 50-dma below the 200-dma, we remain out of the space for the time being. “

As I have warned, the failure of support at $48/bbl would likely see oil sliding back to the low 40’s. With oil at the lower end of the current range, there is a three-pronged attack being waged currently.

1. While energy-related earnings have helped the overall S&P 500 earnings rebound over the last quarter, it is likely transient and forward earnings estimates will likely have to be ratcheted down rather sharply for the rest of the year. 
2. Inflationary pressures, which appeared with the rebound in oil prices last year, has led the Fed into a “comfort” zone thinking the inflation rise was due to economic growth. As suggested on Friday, this is not the case and the Fed’s plan to hike rates further make come to a frustrating conclusion. 
3. Economic growth also ticked up with rising commodity costs, however, that tailwind has once again reversed. Reductions in planned CapEx expenditures, drilling and operations, may weigh into the Q2 and Q3 economic outlooks as well as earnings forecasts by companies.