Well I can’t say that last week’s rebound rally was a surprise after all the positive technical set ups we saw on 10/15 (listed last week). What did surprise me was both the strength and magnitude of the move pushing right into the close on Friday. Bulls are still very much in charge of this market but the corrective work still isn’t quite finished on a more intermediate term basis. The market is also speaking loudly about the future of the economy, which is at odds with current reports. Something’s up – pay attention.
Correction Not Likely Complete
First let me tell you the good news. Last week, the S&P 500 was able to retake the breakdown point at roughly 1905 on the index after tagging the 200-day moving average with perfect precision. If the index can hold above that level on any pullback, the odds are good that we’ll retest (or exceed) the all time highs before year end. There was also a brief attempt by the Dow Transportation index to make an all time new high but that was snuffed in the final hour on Friday. Maybe today – looks likely. Transports are no doubt benefitting from lower oil which is still trading under $80/ barrel to the chagrin of Putin and his tribe of Petro-dictators. Meanwhile utilities are and have been breaking out to all time new highs and have gone parabolic. The Dow theory guys have to be looking at Transports and Utils and begin to expect an eventual all time new high for the Dow itself. Rarely do these three horseman diverge for long. Healthcare, select pharma and biotech and consumer staples are also at all time new highs.
Now if one looks at the character of the above mentioned sector strength, we see the financial markets still deeply committed to a traditional recession trade where defensive sectors rule. Growth sectors like small caps, energy, internet, tech, banking and financials to a degree have not been getting the type of buying enthusiasm we might hope for. These groups are thankfully participating but not leading. Now here’s why this is important from an overall market trend perspective. Due to the sector weightings in the S&P 500, we simply cannot, have not, nor will see, a sustainable market rally without heavy participation and leadership coming from technology, financials, healthcare, consumer discretionary and industrials which combined account for 70% of the S&P 500 (see below). Energy is also significant at 10% but has also been a drag on the markets. Along those lines, I think it’s also important that small caps lead the market higher from a sentiment perspective and indicative of an environment where traders are accepting of some risk. Small caps have been underperforming the broad US stock market since early April. Right now, I see a market that has bounced impressively as a whole but unfortunately lead by the wrong groups. I’m going with the premise that our correction, which really began in early July (with a failed attempt at a new high in Sept) has some more work to do. That means, we should be preparing for the next down leg in the markets and we’ll want to be very watchful of relative strength during that decline. If the “right” groups hold up well and see new enthusiasm among buyers, I think we could have an explosive finish to the year. As I write, I’m watching some of this happen today with the S&P 500 marginally down and tech, financial and healthcare sectors are trading slightly up. Conversely, if the “right” groups lead lower and sell off aggressively, it would be safe to say the high is in for the year and probably into early 2015.
Economy and Market Arguing
As is often the case, the financial markets regularly move ahead of the economy by 6-9 months. I chuckle when I hear people say things like “the stock market caused the real estate crash”. No, that’s simply poor understanding. The US stock market peaked in mid 2007, real estate and the economy completely fell apart in early 2008. The stock market caused nothing but simply reflected investors’ underlying fears and concerns about the real trends in overbought real estate and the rate of deceleration in the economy. Perception of the strength and weakness in the economy drives prices higher or lower, not the reverse. Today, we have a similar set up where the market is speaking loudly about the future likelihood of a US recession as mentioned above. Meanwhile practically every economic report continues to chug higher including employment (jobless claims at a new 14 year low!), consumer confidence, leading indicators at all time highs, general business conditions (still positive and favorable) and yes even earnings thus far (65% beating expectations). We haven’t yet even started to decelerate economically according to last month’s reports.
Still, technical guys would be very wise to watch some of the predictive macro indicators for additional signs of economic strain. Specifically, the spread between the 10 year and 20 year Treasury bond rates is now only 48 basis points – very tight. Yield curve folks know that when the 10 year bond rate moves above the 20 year rate, we have an inverted yield curve and that condition can often lead to recessionary conditions in a short period of time. For that to happen we would need to see a complete collapse in the price of the 10 year bond and I don’t see that as likely. So who has it right? The market or the economy? We’ll see but the most notable condition is the wide disagreement between the two. Conditions are changing, perceptions are changing but are real conditions changing that much? Could this be about politics going into mid term elections? Could this be a yield grab as investors chase income from consumer staples and utilities? Or might we actually be within 6-9 months of a recession? We all hate surprises so let’s pay close attention to this argument.
Netflix, Amazon and Yelp Ouch!
I find it interesting that some of our big name technology companies are getting hammered this earning’s season. They did post some tough earning’s numbers and the market is letting them know that’s not ok (-20%). But the interesting part is that we may be witnessing more of a long term top in the innovation cycle. Amazon has a growing number of on-line retail mega portals to contend with like Alibaba. Netflix is competing with Amazon in terms of distribution of movies and now has to pay much more for fresh content than when they first captured our hearts and eyeballs. Google, Amazon, Apple, Samsung are all delivering more and more hardware and mobile devices while god knows we’ve all got enough of that junk in our homes now. Cloud computing, streaming media, search, on-line retail, mobile communications are all going to be part of our permanent household and business budgets for the foreseeable future but the supply side space is getting a little crowded now. There is plenty of growth opportunity overseas in developing countries for all this stuff but here in the US, we’re more than saturated. Furthermore, I’m just not seeing the type of earth shaking change since we saw the first Ipad come out or when Netflix put Blockbuster out of business. The whole space feels like it needs to grow, wants to grow, but can’t as so many mega companies worldwide have crowded in. In a nutshell, it feels like we are approaching the top of the S-curve for consumer facing technology and perhaps investors will not LOVE the future growth rates. Still, we need these companies and have no plans to stop using their products and services. Back end companies that make it all happen in terms of telecom and data networks, cloud storage, software as a service, fiber, routers and switches, cable and satellite, even hardware components might be good bets for continued growth in technology. We’ll be watching these developments in the coming months.
That’s it for this week – first snow in the Steamboat valley last night.