After a nice little rally from mid-February until early June, investors started taking chips off the table, ostensibly in anticipation of Thursday’s Brexit vote. But Monday brought a fresh hint of optimism that Britain will vote to remain in the union, and the market responded with a healthy, broad-based rally. On balance, there appear to be good tailwinds for U.S. equities over the near term. I still see improving global stability (even with the impending Brexit vote), stable oil prices (in the range of $40-60, and currently near $50), and modest inflationary pressures on wages and prices.
I still think the S&P 500 will finish the year with a low double-digit return (currently up about +2.4% YTD as of Monday close). However, we likely will see continued sideways price action until a catalyst emerges — perhaps improving forward guidance during 2Q earnings reports, which start next month, or perhaps when 3Q reports commence in October.
In this periodic 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 ETF trading ideas.
Market overview:
From approximately June through February, stocks traded more based on news rather than fundamentals, which is not a healthy long-term approach to investing. But then in mid-February, the market reversed, starting with the usual short-covering and speculative rally that launches every bullish reversal. However, unlike the last big rally attempt last fall, this one began to rotate into more sustainable characteristics, such as improving breadth, lower sector correlations to the major index, and a flight to quality, which is a positive environment for anyone picking stocks based on fundamentals and forward valuation (including Sabrient).
Then on June 8, investors started taking chips off the table (in a return to their cautious, news-driven, risk-on/risk-off M.O.) in anticipation of any fallout from Thursday’s Brexit vote. But Monday’s broad-based relief rally helped breathe renewed life into those aforementioned positive market trends.
ConvergEx recently noted that monthly industry correlations to the index fell to around 70% for the past few months from the mid 90% range where they had lingered for much of the previous several months. In addition, by early June, broad indexes like the NASDAQ, Russell 2000, and the transports had all recaptured their 50-day and 200-day simple moving averages, and the equal weighted versions of the major indexes had been greatly outperforming the cap-weighted versions, with small caps greatly outperforming large caps. These are all positive signals for equities in general and fundamentals-based stock picking in particular.
Of course, the bogeyman of the moment is the Brexit vote in which U.K. voters decide whether to remain a part of the European Union (EU), which essentially was formed as a treaty among 28 European countries to create a more efficient economic zone through common trade policies and open borders for the unrestricted movement of people, goods, services, and capital among them. Britain has the fifth largest economy in the world, thus the anxiety of global investors as to what might come next. Indeed, the bond market has been signaling a flight to safety as the 10-year yield fell last week to around 1.60% and the 30-year to about 2.40%, while German 10-year bunds crossed into negative territory for the first time ever. So, for a little more than a week, it was risk-off. Oil fell and gold rallied. The average mutual fund’s cash holding reached nearly 6% (more than in 2008 or 2011).
However, I don’t think an exit decision will have a huge long-term impact on global trade or the equity markets. For one thing, the referendum is only advisory and not mandatory, so a vote to exit does not necessitate an exit. Secondly, Britain will still trade with its neighbors, whether as part of the EU or not, although it would need to set up alternative trade agreements. In fact, a definitive decision to exit the EU would trigger a lengthy 2-year exit process during which Britain would renegotiate everything with each of the other 27 countries.
Not to be overlooked, on Friday (the day after the Brexit vote) the widely-followed Russell Indices will implement their annual rebalance, so volatility is likely to reign later this week. After that, no matter what the result, I expect markets to eventually return to rational behavior, including broadening and low sector correlations in a general flight to quality and fundamentals-based investing.
