Bulls Rally, But Bears Lurk

Last week, the S&P 500 put up its best week of the year, closing above key psychological levels and breaking through bearish technical resistance, with bulls largely inspired by the dovish FOMC meeting minutes. But overall, this year’s market has been news-driven and quite difficult for traders to read. Even our fundamentals-based and quality-oriented quant models have struggled to perform. With corporate earnings season now underway, equities might take a breather at this point of the oversold rally until some clarity from key corporate bellwethers begins to take shape, particularly with respect to forward guidance. But despite severe global headwinds, there remain strong reasons for optimism here at home.

In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.

Last week, the S&P 500 closed up +3.3% for the week, its best performance of the year so far. The S&P 500 large caps and Dow Jones Industrials blue chips closed above the psychological levels of 2,000 and 17,000, respectively -- the first time since August -- as well as above their 50-day simple moving averages. Although the Russell 2000 small cap index closed above its 50-day simple moving average, it remains more than 10% below its 52-week high set in June.

A big inspiration for bulls was the September FOMC meeting minutes that were released on Thursday afternoon, showing that the Fed is concerned about persistently low inflation and the potential impact on the U.S. of the global economic slowdown. The Fed now doesn’t expect to reach its inflation goal of 2% before the end of 2018. Investors took this as a sign that the Fed funds rate won’t be increased until 2016 -- and likely it will be only a token increase at that. The minutes also indicated that the Fed was further from approving a rate hike in September than had been broadly assumed, given the formidable global headwinds led by slowing growth in China and all of the broad implications of that, including falling demand for everything from commodities to Apple (O:AAPL) products.

Now we start to hear the Q3 corporate earnings reports, although investors are more interested in forward guidance than actual performance during the prior quarter. According to S&P Capital IQ, S&P 500 companies are expected to post negative revenue growth of -1.5% versus 3Q2014 (the third straight quarterly decline), primarily due to the strong dollar, and negative earnings growth of -5.3%, the first such decline since 3Q2009. However, excluding the Energy sector’s massive -66% earnings contraction, overall earnings growth for the others would be a respectable +2.7%.

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No doubt, this market has been hard to read and even harder to trade. Certainly it has been news-driven to a large extent. Moreover, we have seen sort of an upside-down market lately in which the former leaders (like Biotech) have been taken to the woodshed while the former laggards (like Energy and Materials) have been strong, all of which is the opposite of what our fundamentals-based and quality-oriented quant models have been suggesting (see sector rankings below). Such events are certainly not uncommon. It is largely driven by short-covering on the lower-quality stuff and profit-taking/protection on the higher-quality.

Such is the case with the dominant biotechs/biopharmas, many of which still sport low forward P/Es but have been the target of some posturing politicians in this election cycle who noticed that a populist message about drug pricing was resonating, thus creating uncertainty in the minds of investors -- even though nothing concrete has changed in the company’s fundamentals. Sabrient-favorite Valeant Pharmaceuticals (N:VRX) is a case in point. This carnage among the money-making biotechs was the “last shoe to drop” so to speak in this broad market correction that essentially began in late-June. ConvergEx pointed out last week that among biotechs, stock performance this year has been inversely-correlated to profitability. But we believe investor rationality will soon return to this important market segment -- this is definitely a case of, if you liked them at the higher valuation then you should love them at these lower valuations.

Furthermore, China’s coming clean with lowered growth estimates exacerbated worries of a global slowdown. Of course, this has not only hurt the industrial and commodity oriented firms, but also impacted Apple and its main suppliers in a major way -- including favorites of ours like Skyworks Solutions (O:SWKS), Avago Technologies (O:AVGO), and NXP Semiconductor (O:NXPI), which are big winners that have suddenly fallen more than the overall market over the past few months, largely due to concerns about lowered growth projections in China.

Overall, Sabrient’s growth at a reasonable price (aka, GARP) approach seeks strong forward earnings projections selling at a reasonable price today, and the broadening concerns about global growth call into question whether corporate growth expectations will be met, or if they will be revised downward even further. Nevertheless, we still believe quite strongly that GARP is the way to invest profitably in most market conditions (except perhaps recessionary or irrationally exuberant ones). After all, buying future earnings flows at a reasonable price today is what investing is supposed to be about.

Yes, global headwinds are evident, and there are many commentators predicting either a recession or a bear market or both. Other than the wide-reaching impact of even a moderate slowdown in China, the strengthening dollar has been an issue given that so many things are priced in dollars, including oil, commodities, and global debt. All told, global 2015 GDP priced in dollars is forecast to contract about -3.5%, down to about $75 trillion, which certainly sounds recessionary. The last time this occurred was in 2009 when economic and stock market woes were reversed by massive stimulus programs. Many are wondering what it will take this time.

BlackRock came out with its global outlook, and the firm sees this as the most challenging global market environment in years that will likely lead to annual investment returns of just 4-5% over the next five years, as opposed to the robust 14% average of the past five years, pointing to a greater emphasis on defensive strategies and downside protection. Nevertheless, their outlook for the global economy is optimistic, and global recession is not their base case scenario.

And I believe there is reason for optimism. As I noted last week, household incomes and purchasing power are up, jobless claims are at the lowest level since 1973, auto sales are robust, global monetary policy remains accommodative (even here in the US, with the dovish implications of the FOMC minutes), banks are well-capitalized, corporate coffers are flush with cash, stock buybacks and M&A are active, and homebuilders are doing well. And perhaps most important of all, American innovation and entrepreneurism is more active and impressive than ever before.

Certainly last week’s market action was driven by the dovish FOMC minutes, and now Fed funds futures (which tend to be quite prescient) are forecasting only a 37% chance of a quarter-point rate hike in December and a 47% chance January. The 10-Year yield closed Friday at only 2.10%. The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 17.08, which is back below the 20 panic threshold.

The SPDR S&P 500 Trust (N:SPY) closed Friday at 201.33, which is back above its 50-day simple moving average but still below its 200-day, and the dreaded death cross remains intact (the 50-day SMA crossed down through 200-day in early September). But after some needed backing-and-filling and testing of support around 187, the prior Friday’s trading gave us a bullish engulfing candlestick, and then this past Friday provided a confirmation of the breakout back above resistance at the $200 price level and the 50-day SMA.

As I said last week, the 200 price level (corresponding to 2,000 on the S&P 500) had been tested for resistance three times, and it was likely we would soon see another retest. Now that bulls have broken through to the upside, the 204 level (former support line for the long sideways consolidation from February through late-August) is the next level of tough resistance. However, oscillators RSI, MACD, and Slow Stochastic are getting a bit extended, although they could still go further to the upside. If SPY fails in this upward move and falls back below the $200 price level and its 50-day SMA, we might see another retest of support at 187, and perhaps even the August intraday low near 182 (which is also the low of last October). But in any case, as I said last week, the chart is shaping up a lot like 1998 and 2011, and I suspect the bulls will find a way to take stocks higher by year end -- possibly to new highs.