Solid 1H2017 Bodes Well For Equity Bulls, Even With The Pullback In Large-Cap Tech

The major US stock indexes continue to hold near their highs, awaiting the next upside catalyst, supported by persistently low-interest rates, record share buybacks, net solid economic reports, and continued organic growth in corporate earnings – in spite of disappointments in the fiscal policy front. The S&P 500 has held solidly above 2,400, the Dow has stayed above 21,000, the Russell 2000 has held 1,400, the Tech-heavy Nasdaq Composite has held 6,000 despite a severe pullback in the market-leading large-cap Tech stocks, and oil has held above the critical $40 mark despite being in a general downtrend since the start of the year.

Recent momentum resides in Transportation, Financial, and small caps, which is a bullish development. In fact, the Dow Jones Transportation Average is setting new highs and is in full-on breakout mode.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review Sabrient’s weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas. In summary, our sector rankings still look slightly bullish, while the sector rotation model maintains its bullish bias and the climate overall still seems favorable for risk assets like equities – particularly dividend payers, small caps, and GARP stocks (i.e., growth companies among all caps selling at attractive forward PEG ratios). Moreover, July is typically a solid month for stocks, a strong first half typically bodes well for the second half, and the technical picture still looks favorable.

Market overview:

Looking at performance for 1H2017, the S&P 500 price index was +8.2% (and +9.3% total return, with dividends), Dow +7.7%, Nasdaq Comp +14.1%, Nasdaq 100 +16.1%, and Russell 2000 +4.7%. As for sectors, Technology led the pack at +16.3% despite its recent retrenchment, followed closely by a resurgent Healthcare at +15.4%. At the bottom was Energy at -15.0% (as oil was down -18.7%) and Telecom at -6.4%. The rest of the sectors were essentially tightly bunched around the S&P 500 return. Homebuilders have been notably solid all year, up +21.5% during 1H2017.

The Russell 2000 small cap index appears to be back in gear now, buoyed by its overweight in a resurgent Financial sector, and the S&P 500 large cap index is challenging its highs once again, while volatility remains low. Technicians had been warning of a head-and-shoulders tip pattern in Financials just one month ago, which could have been disastrous for the broader market, but now Financial appears to have made a bullish reversal, at least in part due to the increasingly hawkish tone from the major central banks (implying higher interest rates ahead), along with US banks passing the Fed’s stress tests, which means they likely will be returning capital in the way of share buybacks, redeeming preferred stock, and boosting dividends. This will be important for offsetting the low interest rates that have hit banks’ net interest margins and low volatility that has hurt their trading volume and profits.

The CBOE Market Volatility Index (VIX), aka fear gauge, closed Wednesday at 11.07. The slow but steady melt-up in stocks has led to the lowest sustained volatility in 24 years. This complacency can persist for a long time. However, I want to continue to warn that, as an oscillator, VIX will eventually spike again.

The past few weeks have produced both the worst day of the year for Tech stocks and the best day of the year, and June was the worst month for the Nasdaq Comp since October. Tech and Healthcare provided leadership for the first half of the year, while Energy is still looking for a bottom from which to participate in the broader bull market, as well. Some observers are predicting an imminent major correction given that large-cap Tech has slumped after providing the fuel for the broader market for so long, but instead of a correction what we are getting (at least so far) is a rotation to other market segments. I don’t consider the pullback in Tech to be a warning sign of bad things to come. Rather, it was long overdue from a technical standpoint, which is why it has been so severe. I wouldn’t count out Tech quite yet – the rotation is simply allowing other segments to catch up a bit, which is what we all should want to see in a healthy bull market.

Europe has displayed a welcome resurgence this year that has attracted the attention of investors. The euro is +8.2% YTD versus the USD, while the Mexican peso is +13.7%. Including local currency strengthening versus the dollar, Greece is +38.5% in USD, Poland +32.9%, Mexico +24.7%, Spain +20.9%, Germany +16.2%, and Euro Stoxx 50 +13.2%.

Here at home, ISM Manufacturing index came in quite strong (57.8) on Monday, the first day of 2H2017, which gave a shot in the arm to many lagging segments. Notably, the New Orders component hit 63.5. And just this morning as I go to post this, ISM Nonmanufacturing came in strong at (57.4). The Q2 GDPNow estimate was raised to 3.0% on of July 3, with an update due later today. Friday brings the closely-watched jobs report. On the negative side, the International Monetary Fund (IMF) just lowered its forecast for US economic growth to 2.1%, mainly based on lowered expectations regarding President Trump’s ability to introduce fiscal stimulus. But even without it, year-over-year corporate EPS growth has been robust such that prices can increase further without multiple expansion, and equity investors have taken notice.

Highly-respected and widely-followed portfolio manager and prognosticator Jeffrey Gundlach of DoubleLine Capital has essentially called a bottom in Treasury yields, with an expectation that the 10-year will rise toward 3% this year and hit 6% by the next presidential election in 2020. Part of his reasoning likely accounts for QE programs globally starting to be reined in, thus reducing the profitability of the carry trade. On the other hand, the iShares 20+ Year Treasury Bond ETF (TLT) on June 19 formed a technical “golden cross” of the 50-day simple moving average, moving up through the 200-day, suggesting higher bond prices (and lower yields) ahead, which indeed we got for the ensuing five days, peaking on June 26. Although bond prices have retreated since TLT peaked, it may simply be a normal pullback to retest its 50-day SMA, much like what happened after a previous short-term peak on April 18, with lower yields ahead.