May 29, 2016
“Markets are never wrong – opinions often are. The latter are of no value to the investor or speculator unless the market acts in accordance with his ideas.”
S&P 500 futures closed the week just under 2100 – a level that has been visited often over the past 12+ months of range-bound price action. Our positioning with respect to stocks has alternated between neutral and bullish ever since emerging markets led the recovery in U.S. stock markets that began in mid-February of this year. At the time we noted via our social media account that emerging markets were the “tell”, bottoming ahead of U.S. stocks to mirror their leadership on the downside. Despite a handful of fundamental concerns to be discussed below, we’ve steered clear of the bear side of stocks over the past few months as the tape failed to vocalize agreement with stock index bears. In trading, being early is indistinguishable from being wrong and stock market bears have learned this lesson the hard way, even if they ultimately prove correct at an indeterminate date in the future.
Our hesitancy to jump on the bull bandwagon wholeheartedly over the past month stemmed from our concern that a strengthening U.S. dollar would reduce the attractiveness of domestic exports and consequently contribute to an earnings-driven recession. As the chart of real earnings growth for the S&P 500 shows below, real earnings have declined just over 15% year-on-year:
This is not the trend in earnings growth equities bulls would like to see, particularly at a time when valuations are near the upper end of historical ranges. The Shiller P/E ratio for the S&P 500 is graphed below, showing a current level of 26.2x. This level has only been exceeded a handful of times during the course of stock market history: during the roaring 1920’s, during the technology bubble of the 1990’s and during the housing bubble of the late 2000’s.
While a strengthening U.S. dollar may hurt the competitiveness of U.S. exports, U.S. stocks may simultaneously benefit from capital flows out of emerging market assets seeking a relative safe haven in U.S. assets. As the U.S. dollar continues to strengthen against emerging market currencies, the potential for current flare-ups in emerging markets to become full-blown currency crises increases. We believe that capital flows out of China and other emerging markets are likely to find their way into U.S. dollar-denominated assets. This “safe haven bid” may continue to provide support for U.S. equity, bond and real estate assets even in the face of historical overvaluation. Thus far, flows into U.S. dollar-denominated risk assets appear to be dominating concerns over the potential for emerging market contagion.
The chart of S&P 500 futures below depicts a “right triangle” or “wedge” formation that was broken to the upside once again last week. Measures of market breadth remain strong, with advancing issues continuing to outnumber declining issues on the New York Stock Exchange. We simply cannot endorse the bear side of stocks in the face of such a bullish tape at the present time and will look to establish long entries in equities at wholesale prices over coming weeks.
Good luck and good trading,
Despite chatter of another rate hike to come as early as June, market expectations as measured by Federal Funds futures suggests the next rate hike is likely to be delayed until the July Federal Open Market Committee (FOMC) meeting. Recent comments from St. Louis Fed President Bullard suggested the committee is comfortable hiking again without a press conference - something the committee has done in the past. We believe it is currently unlikely that the Fed hikes in June and we expect a rally in long bonds over the coming month as market participants expecting a hike in June find themselves disappointed. The flight out of emerging market assets and into U.S. dollar-denominated assets is also likely to support U.S. government bonds, even at historically expensive levels. The chart of 30-year U.S. treasury rates shows that the multi-decade downtrend in long-term rates remains firmly intact for the time being. If global markets cooperate with the Fed’s more hawkish ambitions, we are likely to see a hike in July. Until then, we will position ourselves one step at a time and we remain long 30-year bond futures into the June FOMC meeting.
Last but not least, we turn our focus to the U.S. dollar. As we highlighted via our social media account almost one month ago, we believe that the U.S. dollar has resumed its bull trend. The chart of the U.S. dollar index below displays the “bear trap” that precipitated the strong rally we’ve seen in greenbacks over the past 30 days. This bear trap occurred in the context of a “bull flag” that has been forming since early 2015. There is significant potential for a strong advance out of this consolidation area and we remain steadfast dollar bulls for as long as the tape remains bullish.