Weekly Market Summary

Summary:  All of the main US indices made new all-time highs this week. The indices appear to be supported by strong breadth, with 7 of the 10 SPX sectors also making new highs. This post reviews several studies that suggest price momentum is likely to carry the indices higher over the next several months and through year-end. That does not preclude an interim drawdown of at least 5% - we regard that as very likely, sooner rather than later - but any weakness has a strong probability of being only temporary.

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SPX, NDX, COMPQ, DJIA and NYSE all made new all-time highs (ATH) again this week. The lagging small cap index, RUT, closed less than 1% from its ATH. The primary trend remains higher.

The new highs for the US indices were accompanied by ATHs in a majority of sectors: technology, industrials, consumer discretionary, utilities, staples, healthcare and materials. With broad indices like the NYSE (which includes 2800 stocks) and 7 of 10 sectors at new ATHs, it's hard to say that healthy breadth is lacking (more on breadth in a new post here).

SPX has risen 8 of the past 10 sessions. The only two loses were a mere 0.05% and 0.12%. The recent persistence of trend has been fairly remarkable and is likely to continue to provide a tailwind for equities.

Our overall message from last week remains unchanged and is paraphrased below:

SPX has risen 7 days in a row; that type of trend persistence has a strong tendency to carry the markets higher over the next week(s). Investors should not expect the bull market to be near an important top. Markets weaken before they reverse, and the existing trend has yet to weaken at all.  

That said, the month of June is seasonally weak and there are a number of reasons to suspect it will be again this year, not the least of which is the FOMC meeting mid-month. Markets anticipate the federal funds rate will be hiked for a 4th time: the prior three rate hikes have coincided with notable drawdowns in equities (as well as a fall in treasury yields). 

In February, we reviewed "a number of compelling studies suggesting that 2017 will probably continue to be a good year for US equities": that post is here.

This week, can add several more studies that further bolster the bullish case for equities over the next several months. That does not preclude the potential for an interim drawdown, but any weakness has a strong probability of being bought for at least a retest of the prior high.

Let's review.

First, when SPX has risen at least 6 days in a row, as it did last week, then SPX has closed higher 10 to 20 days later in 90% of instances since 2012. As the chart below shows, the typical pattern is for SPX to consolidate or retrace some of its gains in the middle of this period (corresponding to the next week and a half), followed by a higher high (from @Twillo using data from indexindicators.com). Enlarge any chart by clicking on it.

June Macro Update: Employment, Retail Sales and Housing Soft

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

One concern in recent months had been housing, but revised data shows housing starts breaking above the flattening level that has existed over the past two years. A resumption in growth appears to be starting. That said, housing starts grew only 1% in the past year. Permits are up only 2%. This data bears following closely.

That leaves two watch outs. The first is employment growth, which has been decelerating from over 2% last year to 1.6% now. It's not alarming but it is noteworthy that expansions weaken before they end, and slowing employment growth is a sign of some weakening that bears monitoring.

The second watch out is demand growth. Real retail sales excluding gas is in a decelerating trend. In April, growth was just 1.6% after having grown at more than 4% in 2015. Personal consumption accounts for about 70% of GDP so weakening retail sales bears watching closely.

Overall, the main positives from the recent data are in employment, consumption growth and housing:

• Monthly employment gains have averaged 186,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading.
• Recent compensation growth is among the highest in the past 8 years: 2.6% yoy in 1Q17. 
• Most measures of demand show 2-3% real growth. Real personal consumption growth in April was 2.6%.  Real retail sales (including gas) grew 2.2% yoy in April, making a new ATH.
• Housing sales made a 9-1/2 high in March. Sales grew 1% yoy in April. Starts grew 1% over the past year.
• The core inflation rate is ticking higher but remains near the Fed's 2% target.

The main negatives have been concentrated in the manufacturing sector (which accounts for less than 10% of employment). Note, however, that recent data shows an improvement in manufacturing:

• Core durable goods growth rose 6.0% yoy in April. It was weak during the winter of 2015-16 but has rebounded in recent months. 
• Industrial production rose 2.2% in April, helped by the rebound in mining (oil/gas extraction). The manufacturing component grew 1.9% yoy in April.

Prior macro posts are here.

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Our key message over the past 5 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes. Enlarge any image by clicking on it.

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.


Employment and Wages

The May non-farm payroll was 138,000 new employees minus 66,000 in revisions.  In the past 12 months, the average monthly gain in employment was 186,000. Employment growth is decelerating.

Monthly NFP prints are normally volatile. Since the 1990s, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 50,000 this March, 86,000 in March 2015 and 43,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.

Using Breadth To Anticipate Market Inflection Points

Summary:  When equity indices move higher, you will often hear commentators suggest the rise is suspect because leadership is narrow. "Breadth is lagging," "small caps are lagging," "breadth is diverging" or "the indices are lying because the average stock is underperforming" are common warnings.

It's conventional wisdom that new highs in the stock market should be confirmed by "healthy breadth." In other words, you want to see a large number of stocks in uptrends as the index price moves higher. Similarly, small cap stocks should outperform the relatively fewer number of large cap stocks as breadth broadens.

All of this sounds intuitively correct: a broader foundation should equal a more solid market. Conversely, a narrowing market should be a warning of a likely market top. This is how most pundits use breadth to anticipate market inflection points.

But there are two problems with this view on breadth.

Most importantly, the conventional wisdom about "healthy breadth" being critical for future stock market returns is empirically false. Indices have typically been driven higher based on a small number of stocks contributing disproportionately large gains. Over the past 20 years, just 4% of stocks have typically accounted for almost 70% of annual gains in the SPX.

Moreover, most market drops over the past 15 years, including those with declines of more than 10% or 20%, have started when 80-90% of stocks have been in an uptrend. In fact, over the past 5 years, the SPX has gained more than 3 times as much over the following month when breadth was weak compared to when breadth was "healthy." Risk/reward has been more than twice as favorable when breadth has been weak as when it was healthy. The conventional wisdom on breadth and future market returns has been exactly wrong.

The second problem is that stock pundits' views on breadth conflict with their views on investor sentiment.  Important market tops are defined by excessive investor bullishness: "everyone" is a bull by the end of a bull market. But think about what this means for breadth: if investors are bullish, they should be less selective about which stocks they own. They should seek to own the riskiest, highest beta stocks in the market. This means that market tops should be defined by broad, not narrow, breadth. By the time breadth is "healthy", investors are overwhelmingly bullish and the market tops.

No single indicator is sufficient in assessing market inflection points. Using breadth has serious drawbacks.  But this post suggests a far more logical and useful methodology for using breadth to anticipate market inflection points than "lagging breadth," "breadth divergences, " or outperformance by small caps stocks.

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It's conventional wisdom that new highs in the stock market should be confirmed by "healthy breadth." In other words, you want to see a large number of stocks in an uptrend, trading above their moving averages, as the index price moves higher.

Yet, consider the following:

At the October 2007 peak in the stock market, almost 85% of stocks were above their 50-dma. The index dropped 10% in the next month and 50% in the next year. 

In April 2010, almost 95% of stocks were above their 50-dma and 200-dma. The index dropped 15% in the next two months. 

In May 2011, 80% of stocks were above their 50-dma and more than 90% above their 200-dma. Just three months later, the index was 20% lower and feared to be in a new bear market. 

These are not isolated examples where breadth was considered "healthy" and the index was near a significant top. Others are highlighted below. In the past 15 years, almost every significant market drop was preceded by an overwhelming majority of stocks in the SPX being in an uptrend. An exception was the initial 10% fall in August 2015. Enlarge any chart by clicking on it.

Weekly Market Summary

Summary:  US equity markets made new all-time highs again this week. By Friday, SPX had risen 7 days in a row; that type of trend persistence has a strong tendency to carry the markets higher over the next week(s). While a period of higher volatility than what has been seen so far this year is odds-on, investors should not expect the bull market to be near an important top. Markets weaken before they reverse, and the existing trend has yet to weaken at all.

That said, the month of June is seasonally weak and there are a number of reasons to suspect it will be again this year, not the least of which is the FOMC meeting mid-month during which markets anticipate the federal funds rate will be hiked for a 4th time. The prior three rate hikes have coincided with notable drawdowns in equities (as well as a fall in treasury yields).

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SPX, NDX and COMPQ all made new all-time highs (ATH) again this week. Including dividends, the DJIA also made a new ATH for the first time since March 1. The primary trend remains higher.

The new highs for the US indices were accompanied by ATHs in several large sectors: technology, industrials, utilities and staples. The consumer discretionary sector had its highest ever weekly close.  The healthcare sector is within 0.5% of its March high. Likewise, the very broad NYSE is just 0.2% from a new ATH. With 6 sectors and the NYSE at or near new ATHs, it's hard to say that healthy breadth is lacking.

Notably, SPX has now risen 7 days in a row. In the past 5 years, this has occurred only 5 other times, 4 of which were during the 2013 boom. In all 5 instances, SPX closed higher again within the next 5 days by a median of 0.7%. By Day 5, SPX was higher 4 of the 5 times.

For a larger sample size, consider the strong performance after SPX has risen 6 days in a row. SPX closed higher either 10 or 20 days later in 9 of 10 instances since 2012. Risk/reward (defined as max gain versus max loss) during the next 10 days and the next 20 days was 6 times. Clearly, trend persistence overwhelmingly led to further gains and favorable risk/reward (table from Twillo using data from indexindicators.com). Enlarge any chart by clicking on it.

The Worry About Indexing is Overblown

Summary:  Investors are clearly shifting away from actively managed funds to those based on index strategies. Only time will tell, but this has the look of a durable, secular change in investment management. But much of the perceived threat to market stability of indexing is overblown. Overall, the stock market is still dominated by active management. And while the number of index products has clearly exploded, 96% of these are of insignificant size.

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Bloomberg recently reported that the number of indexes has exploded and now exceeds the number of stocks in the US.  Enlarge any chart by clicking on it.