- Stocks breakout to new all-time highs after 19th longest stretch without a new one-year high.
- Investor sentiment has rebounded, but remains subdued.
- Economic upside surprises have been numerous and broad-based.
Happy summer? From its Brexit-related low on June 27, U.S. stocks have staged an impressive 8.5% rally. I’ve been peppered with questions—from investors, financial consultants and the media—about how it’s possible the market is trading at all-time highs with so much global uncertainty and angst. Perhaps the best explanation is one of the oldest in the market’s book: stocks like to climb a “wall of worry.”
Wall of worry
One of the best setups may have come courtesy of investor sentiment. In Schwab’s mid-year outlook, published earlier this month, I noted the extreme dearth of bullishness at the end of the second quarter via the American Association of Individual Investors (AAII) survey. Coupled with the high reading of the “neutral” camp, we were seeing the lowest level of bullishness and highest level of uncertainty since the aftermath of the Crash of ’87. Remember, sentiment tends to work as a contrarian indicator at extremes. The cautious stance (and likely portfolio positioning) meant there was fuel for the market with even a small catalyst—in this case, notably better economic data.
As you can see in the chart below, bullishness has increased alongside the rally, but remains fairly subdued. As I’ve pointed out many times over the past couple of years, although we believe the market will be subject to significant bouts of volatility and perhaps a greater frequency of pullbacks, it’s likely in the context of an ongoing secular bull market.
Source: American Association of Individual Investors (AAII), FactSet, as of July 15, 2016.
But sentiment alone doesn’t explain the market finally breaking out of what had been a remarkably narrow two-year trading range. Fundamentally, the improvement in the economy—coupled with the forecasted improvement in corporate earnings—worked its catalyst magic for stocks as well. One of my favorite mantras is “better or worse usually matters more than good or bad when it comes to the stock market.”
Case in point would be the improvement in economic surprises, seen in the chart below. After an 18-month stretch with the Citigroup Economic Surprise Index (CESI) unable to break into positive territory, the latest string of data releases launched it firmly north of zero. Remember, the CESI measures whether economic data is coming in better or worse than expectations—it does not measure the absolute level of growth.
Source: FactSet, as of July 15, 2016.
Representing the “better” category of data:
- Industrial production up 0.6% in June vs. 0.3% consensus
- Retail sales up 0.6% in June vs. 0.1% consensus
- Initial unemployment claims down to 254k as of July 14 (weekly) vs. 265k consensus
- NFIB small business optimism index up to 94.5 in June vs. 93.9 consensus
- Payrolls up 287k in June vs. 180k consensus
- ISM Non-Manufacturing index up to 56.5 in June vs. 53.3 consensus
- ISM Manufacturing up to 53.2 in June vs. 51.3 consensus
Many of the above economic indicators—including jobless claims and the ISM readings—are leading indicators. The stock market is a leading economic indicator as well. To see them collectively moving higher is not surprising. There are implications for Fed policy: in the immediate aftermath of Brexit, the fed funds futures market was forecasting a 15% chance of a rate hike by year-end; while as of Friday, it was up to nearly 45%.
STUB has stubbed its toe
Outside of the stock market, U.S. Treasury yields rose (meaning bond prices fell), while other safe-haven asset classes sold off as well, including utilities and gold. At the same time, more cyclical areas of the market have performed well. With classic timing, just as the “STUB” acronym (staples, telecom, utilities and bonds) became a hugely popular investing “strategy,” those same areas came under pressure last week—both staples and utilities were down on the week. Since the June 27 low, the top-three performing sectors are all cyclical: industrials, financials and materials.
Technically, the market’s rally to new highs has been impressive, albeit not perfect. The three week decline in the volatility index (VIX) has been the largest on record. The 10-day advance/decline is at its highest level since late-2011. However, individual new high data hasn’t expanded as emphatically according to Strategas. And seasonality could spoil the bulls’ party as July strength has historically often led to a weaker August-September (especially in election years).
19th longest stretch
Prior to the market’s breakout, the S&P 500 had gone 413 days without a new one-year high. According to Ned Davis Research, that was the 19th longest stretch in the S&P 500’s history. The three longest stretches were each over 1,200 days (ending in November 1942, May 1933 and September 2003). The median returns looking forward after the prior 18 longest stretches were well above normal (especially one year later), as you can see below.
Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2016 © Ned Davis Research, Inc. All rights reserved.)
We continue to recommend investors remain at their long-term strategic weighting to U.S. stocks, using volatility to rebalance around those normal weights.
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