Stocks provided a volatile and sweat-inducing ride last week in what many investors and traders thought might be the big selloff that so many have been predicting. Although the market tends to follow a path that fools the greatest number of people, sometimes it behaves in a self-fulfilling prophesy. It simply had to selloff eventually — to shake out the weaker holders and provide an irresistible entry point to attract fresh capital from the high-conviction bulls. Now the market finds itself approaching a critical crossroads in which it must decide whether to go for a bullish breakout…or make a bearish reversal that ultimately tests critical support levels, including the 200-day simple moving average.
Historically, equity and bond prices move in opposite directions. Periods of strong economic growth typically led to rising equity prices (risk on), while periods of weaker growth led to rising bond prices (risk off). More recently, however, equity and bond prices were highly correlated as Fed liquidity drove cheap capital into both. But ever since the Fed announced its intention to taper quant easing, correlations have fallen and equities have greatly outperformed bonds. However, there has been no massive selloff in bonds as part of an expected “Great Rotation†into equities, at least not yet, and in fact the latest “flight to safety†has pushed capital back into Treasuries.
The 10-year Treasury yield is now at 2.68%, and a yield below 3-3.5% is highly supportive of current stock valuations. In fact, the trailing P/E of the S&P 500 is still around the historical average in the mid-16s, which means that prices have further to go to the upside before the market can be considered frothy, especially with the low fixed income yields that help justify higher P/E multiples.
Nevertheless, improving economic fundamentals eventually will drive longer-term interest rates higher. But rather than be concerned that stock valuations will be pressured, the trade-off will be that a steepening yield curve is historically reflective of a healthy economy and rising corporate earnings growth.
U.S. GDP grew at a +3.2% annual rate during Q4 and +4.1% in Q3, which was the best 6-month growth in over a decade. Continued GDP acceleration, helped along by flat or falling energy prices as domestic production increases, will allow corporate earnings to rise, as well.
Among the ten U.S. business sectors, Utilities and Healthcare are still the leaders so far in 2014, and in fact they are the only sectors in positive territory, with both up about +2%. However, Technology has held up reasonably well, too, only down about -1%. Leading the latest rebound has been Consumer Discretionary and Industrial, followed by Financial and Basic Materials.
SPY chart review:
The SPDR S&P 500 Trust (SPY) closed Friday at 179.68, which is just below the psychological threshold of 180 (corresponding with 1800 on the S&P 500). I have redrawn the boundaries of the rising bullish channel to correspond with the lows of the past 12 months, and from this viewpoint, the market made a bullish reversal intraday on Wednesday by bouncing from the uptrend line, followed by two very strong days on Thursday-Friday (in spite of the lackluster jobs report). On the other hand, if I draw a similar uptrend line under the lows for the Russell 2000 small caps, the recent selloff created a definitive failure of the uptrend line, which is admittedly worrisome.
