Bulls Revel In New Highs But Oil Introduces A Dark Cloud

 | Dec 08, 2014 11:49PM ET

As everyone knows, stocks do not go up in a straight line, not even during the holidays. So although the future looks bright for U.S. equities, as the major indexes continue to hit or challenge new highs, the market has been gasping for a breather to gather bullish conviction. My fear has been that we might not see it until January, which likely would have resulted in a more severe correction at that time. But falling oil prices and a weak Energy sector seems to have introduced a reason to sell this week. Correspondingly, the Energy sector is now ranked at the bottom of our fundamentals-based, forward-looking sector rankings.

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.

h3 Market overview:/h3

In the fall of 1999, my older daughter was in kindergarten, and I met another father at her school who had moved his family to Santa Barbara from Puerto Rico. He had enjoyed success with real estate and construction there and owned free-and-clear a large house in downtown San Juan. As his kids were ready to start attending school, he decided to monetize his big house by leasing it out. But rather than using the lease payments as income to live on, he took out a large mortgage on his house and gave it to his financial advisor back home to invest for him. After all, stocks were raging and his broker was enamored with the performance of the NASDAQ Composite Index. All his money was invested in NASDAQ stocks, particularly the Technology sector.

The following spring of 2000, as the index approached its incredible closing high of 5,048 (or 5,132 intraday), he was getting more and more anxious about the meteoric rise. And as the market began its fateful decline, his broker kept telling him not to worry because new technologies were the engine for all future of global economic growth. But fears of Y2K doom-and-gloom proved unfounded, and instead budgets were slashed for further capital upgrades. Software company valuations based solely on projected revenues rather than earnings were chopped off at the knees. Dot-com valuations that were based solely on web site visits (a.k.a., eyeballs) became dot-bombs. Ultimately, my friend’s investment account was decimated and his brief retirement (in his 30’s) had to end. He returned to the construction business back in Puerto Rico.

Today, the NASDAQ is once again approaching the 5,000 level for the first time in nearly 15 years. Over the past two years as U.S. economic recovery has taken shape, the index is up almost 2,000 points (70%). So the logical question is whether there is more validity to this valuation level (beyond the impact of inflation, of course).

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Well, some things are quite different this time. With a trailing P/E around 20, NASDAQ stocks display an average P/E that is actually about the same as the S&P Midcap 400 Index. But many market observers still believe that the Fed’s easy money policy has inflated the valuations for many speculative stocks.

Not to be outdone, the Dow 30 Industrials blue chip average is knocking on the door at 18,000. The S&P 500 large caps are eyeing 2,100. The combination of economic weakness outside the U.S. and increasing U.S. oil production continues to push down the price of oil, which on the surface should create a wealth effect among consumers. Hiring is on pace to make 2014 the strongest for job growth since 1999. And of course, we are in a seasonally strong time of year, which has been bolstered by recent short covering among hedge funds and share buyback activity among corporations. And despite worries about a slowdown in China’s growth, the Shanghai index is up about 40% this year.

Another bright spot in the bulls’ court is falling asset price correlations, which ConvergEx reported has fallen in November to five-year lows, with average correlations among the ten business sectors of the S&P 500 at 58%, and with other asset classes, displaying similar trends.  ConvergEx believes that the end of QE3 is allowing asset classes to perform according to their fundamentals rather than enabling highly-correlated risk-on/risk-off behavior. In other words, stock picking and asset allocation strategies matter again. Moreover, ETFGI reports that the U.S. ETF/ETP industry reached a new record of $1.98 trillion in AUM at the end of November, while global ETF/ETPs set a new record of $2.76 trillion.

However, the oil price collapse is proceeding far deeper than imagined and might be shaping up as a dreaded Black Swan-type event in many ways -- not only for the energy sector and oil-producing nations directly but also indirectly for the banking sector through the junk bond market. Those countries that depend upon oil revenues are in deep trouble, since there seems to be little in the way of near-term catalysts to drive oil prices higher. And high-yield bonds have been showing a technical divergence from equities for well over a year, which has been worrisome for the economy. Energy high-yield debt represents 16% of the $1.3 trillion market, which leaves many banks holding that debt seriously exposed.

The U.S. 10-Year Treasury bond yield closed Friday at 2.33% and seems unwilling to move higher, while the 2-Year Treasury bond yield is up significantly. In other words, the yield curve is getting flatter, even without the new injections of bond-buying from the Federal Reserve.

The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, fell even further to close Friday at 11.82. In this bullish climate, the VIX remains well below the important 15 level.

h3 SPY chart review:/h3

The SPDR S&P 500 Trust (ARCA:SPY) closed Friday at 208.00, and in the process set new intraday and closing highs. Two weeks ago it closed at 206.68, so not much has changed. As the month began, the market flirted with the idea of a pullback that it very much needs, closing the gap from November 20, but the bulls just wouldn’t let it happen -- at least not yet. Price is creeping higher beneath the strong resistance line from the long-standing rising bullish channel, but not even attempting to break through. The 20-day simple moving average seems to be offering temporary support. The overbought technical condition has not abated, as oscillators RSI, MACD, and Slow Stochastic all quickly returned to overbought but really need to cycle back down if a concerted breakout attempt is to have any chance of success.