Taking a look at some technical and fundamental data points that have evolved in September, below we provide insight into our thoughts on the market over the next few quarters.
We look at a number of technical indicators, i.e., charting technicals, in an effort to gain some insight into investors' trading sentiment. A number of recent technical indicators have, what we would call, rolled over, which is a negative from a short term market direction point of view. As the below chart indicates, both the PPO and Stochastic indicators are indicating a negative trend for the S&P 500 Index.
However,
according to the stock trader's almanac,
"September is still the worst performing month and it is beginning to live up to this reputation once again this year. Average losses since 1950 for September are: DJIA –0.8%, S&P 500 –0.5% and NASDAQ (since 1971) –0.5%."
So, although September tends to be a poor returning month for the market out of all months in a calendar year, the average losses are not significant. Further noted in the Almanac about September,
"Historically speaking September weakness has been a great time to load up on stocks ahead of the “Best Six Months” of the year, November to April and an even better time in midterm years ahead of the best two consecutive quarter span of the four-year-presidential-election cycle."
"The market’s sweet spot of the Four-Year Cycle begins in the fourth quarter of the midterm year (2014). The best two-quarter span runs from the fourth quarter of the midterm year through the first quarter of the pre-election year, averaging 15.3% for the Dow, 16.0% for the S&P 500 and an amazing 23.3% for NASDAQ. Pre-election Q2 is smoking too, the third best quarter of the cycle, creating a three quarter sweet spot from midterm Q4 to pre-election Q2. Applying these average gains to yesterday’s closing prices puts DJIA at 19675, S&P 500 at 2315 and NASDAQ at 5656 at the end of Q1 next year."
One factor we believe influenced the market last week is the coming week's 2-day Fed meeting beginning on Tuesday. The Fed announcement will be at 2:00pm on Wednesday. Some strategist are concerned about the Fed's end of quantitative easing in October, along with the Fed's focus on getting interest rates to a more normal (higher) level. Janet Yellen's indicators du jour are related to employment. On Friday, September 5, the August non farm payroll report of 142,000 was below the consensus estimate of 230,000. One would expect this weak number to indicate the Fed will not hike rates anytime soon. On the other hand, the August payroll number is nearly always revised and the market is anticipating a revision higher; hence, higher rates sooner versus later?
In the short run, at the onset of an increasing interest rate cycle, equities can face some headwind in the initial stages of rate increases. At HORAN, we do not see the Fed increasing interest rates before mid-2015 though. In anticipation of higher rates, the market can cause rates, especially longer term ones, to rise in advance of a Fed rate hike. Some of the equity market's weakness this month is related to this. For example, the 10-year treasury rate has increased from 2.33% at the end of August to 2.61% at Friday's close. Until a clearer perspective is gained on the Fed's rate view, we believe the 10-year trades in a range from 2.30% to 2.75%, maybe as high as 3%.
One factor keeping a lid on higher interest rates in the U.S. is the fact rates in the U.S. are much higher, relatively, than rates outside the U.S. A part of this rate differential is being driven by the ECB's desire to embark on a significant QE program as well. This is resulting in foreign investors allocating investment funds into U.S. bonds and other U.S. investment assets. Also, with the recent increase in U.S. interest rates, this has led to a strengthening U.S. Dollar as evidenced by the trade weighted U.S. Dollar Index below. Since July the Trade Weighted Dollar Index has increased from 76.5 to 78.7 in September.
A strengthening Dollar, versus other currencies, results in foreign investors gaining additional return when they convert the Dollar back into their home currency. A strong Dollar also results in imports being cheaper, the U.S. is a net importer, thus providing for potentially cheaper goods for consumers. A strong Dollar also results in oil prices declining which translates into cheaper gasoline at the pump. Therefore, cheaper import prices and cheaper gasoline can be a positive for U.S. consumers which can lead to improved retail spending. As
noted by Econoday, Friday's retail sales number of .6% matched expectations, but July was revised higher at .3%. These retail numbers alone suggests the economy may be stronger than the labor market numbers might suggest. Consumers account for nearly 70% of GDP or economic growth, so this could lead to improved GDP growth in the U.S. During the last week of August, the second reading on second quarter GDP saw an increase to 4.2% versus 4.0% in the first reading at the end of July. Lastly, related to the consumer, we are seeing other commodity prices decline. For example, in agriculture, commodities such as corn have fallen over 27% since May. We believe this will eventually lead to lower beef, pork and chicken prices.
From a broad perspective, outside the U.S., economic data suggests economies are still growing. And although some recent data shows slowing economic activity abroad, the data is not suggesting contraction. On the margin then, foreign economies have stabilized.
With respect to geopolitical concerns and there certainly seems to be many. This type of risk might be reason enough for the market to climb that proverbial "wall-of-worry." The middle east issues do not have the same impact on the U.S. as in the past given the U.S.'s improved domestic energy market, primarily a result of fracking. Putin and his war in Ukraine is certainly one we continue to watch. The middle east and Ukraine issues are known and are likely mostly reflected in current asset prices. Of bigger concern might be the unknown unknown. It is this type of event that is not reflected in current asset prices.
In concluding, the market has had a great run since the end of the financial crisis. We are going on three years without the market incurring a 10%+ market correction. It would not surprise us to see one. Because corrections are difficult to predict or time, we do believe the structure of our client portfolios is such we would be able to fund client lifestyles without upsetting the long term return goals of a portfolio. And, at the end of the day, it is corporate earnings (cash flow) which ultimately drives stock prices in the long run. To that end, we continue to see improved earnings results and outlooks from corporations in their earnings reports. Ned Davis Research (via Charles Schwab) succinctly noted three potential market outcomes in their recent monthly market digest:
WHERE DO WE GO FROM HERE?
Breaking down the five-year run allows us (NDR) to identify the likely next phases. Below are three scenarios and likely leadership trends if each unfolds.
1. Escape Velocity
- Description: Renewed corporate confidence leads to more hiring and capex. The Fed would be able to normalize policy as real GDP approaches 3-3.5%.
- Leadership: Dividend (and to a lesser extent buyback) fixation could be replaced by capex beneficiaries. Mid and late-cycle sectors such as Industrials, Energy, and Technology have capex support. Styles could be less Growth-oriented.
2. Bubble
- Description: If escape velocity is unattainable at this time, the Fed may choose to remain extremely accommodative by not raising short-term rates or even instituting QE4. The combination of the Fed’s forcing investors into riskier assets and lack of earnings growth could push valuations to levels not seen since the late 1990s Tech bubble.
- Leadership: Bubble phase - Growth stocks that can deliver in a slow-growth environment and yield plays.
- Bubble aftermath – defensive sectors not caught in the bubble.
3. Valuation Correction
- Description: If the economy fails to reach escape velocity but the Fed normalizes policy, then stretched valuations suggest the market is vulnerable to a correction. As long as a recession is avoided, any correction should be limited to less than 20%. Continued modest earnings growth would lower multiples.
- Leadership: Large-caps over small-caps.
- Defensive Value sectors, which would benefit from the likely decline in long-term interest rates during a correction.
