Market Breadth Improves As Investors Rotate Back To Quality

The stock market rally off the February lows initially was led by the usual combination of short-covering, oversold bottom-feeding, and speculation (on “junk"). But then market action started showing signs of improving market breadth and a rotation back into higher quality companies—the types of companies with characteristics Sabrient typically seeks in our GARP (growth at a reasonable price) selection process. It is notable that price action for the S&P 500 was very similar during 2015 to what occurred in 2011. When it happened in 2011, the market quickly got back on track to start 2012, but this year it took until mid-February before markets launched a concerted recovery, and it was a few weeks after that before the flight to quality began.

Economic reports continue to show mixed but mostly positive results, and yet investors are seemingly unconcerned about the Fed talking up the possibility of a June rate increase, and some market commentators suggest that investor are now embracing another rate hike as a sign of more robust economic growth. However, from my vantage point, the fed funds futures have not changed very much.

In this periodic 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 ETF trading ideas.

Last week, technology and biotech led the market surge, with the NASDAQ gaining +3.4% for the week (the most since February), while financials gained +2.6%. Notably, Tech, Healthcare, and Financial sectors make up 50% of the S&P 500, thus serving to boost that index, as well.

However, for the month of May, it was all about the NASDAQ, which rose +3.6% while the Dow Industrials gained less than +0.1% and the S&P 500 large caps gained +2% (total return basis), as did the S&P 400 mids and S&P 600 smalls. The Technology sector gained +6% for the month, while Financials gained +1.8% after a late surge. Not surprisingly given the aforementioned, Growth outperformed Value.

The Commerce Department revised its first-quarter GDP estimate up to 0.8% from 0.5%. In addition, the final reading for the University of Michigan Consumer Sentiment survey for May was a solid 94.7. Then on Tuesday, the Conference Board Consumer Confidence came in at 92.6 for May, which is decent, but the Chicago PMI report for May fell to 49.3, which is the sixth time it has registered below 50 (the dividing line between manufacturing activity expansion and contraction) during the past 12 months. Other important reports due out this week include ADP employment, PMI manufacturing, construction spending, and ISM manufacturing on Wednesday, and then Friday brings the Government Employment report and ISM services.

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Home price appreciation has been strong—albeit with help from the Federal Reserve’s asset-inflating monetary policies. Both existing and new home sales and prices in April were considerably stronger than expectations, and sales of new homes are the strongest since way back in January 2008. Moreover, the median price of a new single-family home hit a record high ($321,100) in April, while the average price of an existing single-family home is near the all-time record from June 2015.

Nevertheless, the slope of the domestic yield curve remains pretty darn flat, as global liquidity continues to seek the safety and higher returns of US Treasuries. The 10-Year yield closed Tuesday at a 1.83% while the 2-Year closed at 0.88%, indicating a spread of 95 bps, which remains below the 100 bps threshold of concern.

Fed funds futures are indicating only a 22.5% probability of a rate hike in June. Although it has risen significantly, it is still relatively low. Many economists give a June rate hike more like a 60% chance, but the Fed funds futures show the consensus of many smart traders with money on the line, and it tends to be quite prescient. However, the probability rises to nearly 60% come July, and then 62% for at least one hike by September, and 77% probability of at least one rate hike by December (and 33% chance of two rate hikes by then).

The US dollar closed the month of May with a +3.2% gain against a basket of 16 currencies, as tracked by the WSJ Dollar Index, thus ending three consecutive months of declines. Still, for the year, the dollar is down -2.5%. Oil eclipsed the $50 mark on Tuesday as it attempts to test resistance at the October high ($50.90), but then closed the month at $49.10/bbl. Gold lost -5.8% during May. The CBOE Market Volatility Index (VIX), aka fear gauge, closed the month at 14.19, although intraday on Tuesday it briefly touched the 15 fear/complacency threshold before falling back late in the day.

Overall, markets are looking healthier and investors appear to be looking forward to stronger GDP growth and corporate earnings in the second half of the year. But looking back, there is no doubt that market conditions during the August-February timeframe confounded many smart and highly successful fundamental-driven investors. Not only did their performance suffer, but also many sparkling reputations were tarnished. Although the major cap-weighted indexes held up okay during that period, if you pull back the curtain there was very narrow market breadth -- characterized by a handful of big winners while most stocks languished, mostly due to a combination of global uncertainty and abundant global liquidity.

Likewise, Sabrient’s portfolios struggled during that timeframe. Our core stock selection approach starts with a proprietary GARP quant screen to identify a short list of candidates for further fundamental analysis. This is entirely bottom-up and numbers-driven and relies heavily on our data feed of forward estimates of earnings and revenue expectations from the Wall Street community of sell-side research analysts who closely follow these companies and their industries. Thus, when those estimates got turned on their heads beginning last summer, it severely impacted our portfolios.

For the past two years, the broad market has been stuck in a trading range. For the S&P 500, the range has been roughly 1900-2100. It has been characterized by a series of micro bear markets, so to speak, seemingly moving from one sector to the next. First, it was energy and commodities starting in late 2014, which by extension led into industrials and then financials. Next, biotech was targeted, and then semiconductors and other technology segments, including Apple (NASDAQ:AAPL). Some of this was driven by election campaign rhetoric targeting banks and biotechs, and some was caused by China coming clean on its slowing growth, which influenced forecasts for everything from construction equipment to iPhone sales. Most recently it was consumer retail -- with the exception of Amazon.com (NASDAQ:AMZN), which hit another all-time high on Tuesday, and a few other retail segments that avoid competing directly with Amazon, like the home improvement and one-dollar stores.

To illustrate the lack of market breadth, let’s take a look at how large caps have performed versus smalls, and how cap-weighted indexes have performed against equal-weighted. In a healthy market, equal-weighting typically outperforms as many stocks from various market segments garner investor attention, including many well-positioned small caps. However, for 2015, the cap-weighted SPDR S&P 500 Index Trust (NYSE:SPY) was up +1.2% while the equal-weighted Guggenheim S&P 500 Equal Weight ETF (NYSE:RSP) was down -2.7%. Moreover, the broad-based iShares Russell 2000 ETF (NYSE:IWM) was down -4.5% while the Russell 2000 Equal Weight Index was down -10.7%.

Thus, the performance spread between the cap-weighted large caps and the equal-weighted small caps was about 12% during 2015. However, this entire gap formed during the second half of the year. There was no performance gap at all during the first half. It is notable that this same price action and breadth occurred during 2011, although the performance gap described above was somewhat less pronounced during the second half of 2011 (approximately 7.7% between SPY and the R2000 Equal Weight Index).

Although the 12% gap was large last year, it got even wider during the first couple of months of 2016, reaching a 16.4% spread in mid-February. Since then, the spread has swung dramatically the other way, indicating to me a significant broadening of the market, which bodes well both for active stock-picking (vs. passive indexing) and for equal weighting (vs. cap weighting). Indeed, since February 11, SPY is up +15.3% through end of May, while the RSP is up +19.0%, IWM is up +21.7%, and the Russell 2000 Equal Weight Index is up +23.6%. This all speaks to improving breadth as small caps outperform large caps and equal weighting outperforms cap weighting.

Notably, the “FANG” gang of Facebook (NASDAQ:FB), Amazon, Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOGL) has been underperforming this year -- up only +1.8% YTD, and AAPL is down -5.2% YTD. Meanwhile, the S&P 500 total return is +3.5% YTD.

History tells us that markets eventually reward higher quality companies that display solid business models, balance sheets, management, products, and service, which is what Sabrient tries to identify. After all, we believe this is what investing is supposed to be all about, as opposed to short-term trading or speculation. It appears to me that we now are seeing signs of improving market breadth and a rotation back into higher quality stocks.

The SPY closed Tuesday (and the month of May) at 209.84 and is back above all its major moving averages. It is testing resistance at 210 (corresponding with S&P 500 index at 2100), and could soon challenge its all-time high from last May 2015 at 213.34.

After a strong rally from the mid-February edge-of-the-cliff reversal, SPY topped out in mid-April right around this same 210 level and then fell into a sideways channel, even forming a minor head-and-shoulders top with a downside target of 197 (if the pattern confirmed). However, the neckline of the head-and-shoulders formation (around 203.5) held strong, and the bearish pattern never confirmed, instead serving as a launching pad for further upside. Notably, current price action has a lot of similarities to what we saw around the first of December, which has led many chartists to shy away from being too bullish.

I have shown several lines of support and resistance that could come into play in this highly congested chart, including a number of gaps during the last couple of weeks that will act as a magnet. I still believe that we are most likely in store for more sideways action during the summer, whether it tops out right here or perhaps a little higher, without setting a new all-time high. However, I also believe we will see a new all-time high before year-end. Oscillators RSI and Slow Stochastic are looking toppy and ready to roll over, although MACD looks more neutral.