April was a solid month for equities across the globe with both U.S.-based indices and global equity indexes producing solid monthly gains. The Bloomberg Aggregate Bond index caught a bid, ending the month up 1.57% for the year. Commodities and the U.S. Dollar continued their weak performance.
|U.S. & International Stock Index Returns|
|S&P 400 (Midcap)||0.79%||4.35%|
|S&P 600 (Small Cap)||0.86%||1.60%|
|Barclays Agg. Bond||1.57%|
|CRB Commodity Index||(5.60%)|
|U.S. Dollar Index||(3.05%)|
Source: Morning Outlook May 1, 2017
April was a good month for equity investors with indices across the board posting positive returns. Coming off a slightly negative March, however, the move higher for the S&P 500 simply moved the index back up to the previous highs, but not beyond. Small cap stocks (S&P 600), in contrast, have been on either side of even all year. After a strong 2016 we are not surprised to see smaller stocks consolidating around current levels.
The big performance numbers so far in 2017 is the foreign indices. The MSCI World and MSCI EAFE have been strong performers up 7.26% and 8.89% respectively in 2017. After years of underperformance relative to the U.S. markets we are witnessing what could be a major change in relative strength from US equities to global developed markets (Europe and Japan). Such a shift would be significant for investors.
Chart #2 is what is referred to as a ratio chart, this one comparing the S&P 500 to the MSCI EAFE Index for the past 16 years. What makes the chart move up or down is not the positive or negative direction of the markets, but which market is outperforming at any given point in time. When the trend line is moving down the MECI EAFE is outperforming the S&P 500; a rising trend line shows relative outperformance for the S&P 500. Since early 2009 the U.S. stock market has outperformed global equities by a significant amount. And right now we see the current chart setup as indicating a likely change in relative strength back to international equities.
For investors this would be an important change in trend. The prudent investor, in our opinion, should assess their asset allocation. When such trends hit extreme levels many investors are under allocated to the long underperforming asset class for a variety of reasons.
The post-Presidential election consolidation in yields for the 10-year US Treasury continued on during the month of March. This has happened as The Governing Board of the Federal Reserve Bank (The Fed) increase short interest rates and noted the likelihood of more 2017 rate increases. The 10-year rate is important for the housing industry as mortgage rates are set based off of 10-year Treasury yields. Economically, the spread between short-term and longer rates are important as well. Generally speaking, the wider the spread the healthier it is for the economy. In the event that short-term rates are higher than long rates (an inverse yield curve) an economic recession is sure to follow.
One of the reasons we follow the currencies because of the affect they have on other markets. U.S-based companies with foreign operations get an earnings tailwind when the dollar weakens against foreign currencies. In the past we have looked almost exclusively at the bigger picture. Our focus has been on where these markets have been moving over the long-term on long-term charts. In fact just last month we detailed our thoughts on the big trend in currencies.
Big changes start as small changes … breaks in the short-term trends. Problem is a potential problem in the short-term is just that – a potential problem. In technical analysis there are many different ways to interpret the same data. We have always gone by the simple is best mantra when “reading the charts.” This leads us to take a look at Chart #4.
What you are looking at is referred to as either a symmetrical wedge or symmetrical triangle pattern. This pattern is considered to be a continuation pattern, meaning after the pattern has completed itself the previous trend (higher or lower) will resume. It is important to note that this is NOT a guarantee that the trend continues, just that it is likely to continue.
What we see is a symmetrical triangle that has moved below the pattern. We did not use the phrase “broke to the downside” because, in our opinion, it is too early to tell if this is indeed the case. The break happened a few trading days before the end of the month and is still hanging around both the bottom of the pattern and is right at the 200 day moving average (which is an important technical level). We would suspect that during the month of May the US Dollar Index will either move back up into the pattern or have a real break and head to lower levels. Depending on the strength of the break, we believe a move lower would stop anywhere between 92 and 97. Such a breakdown, it should be noted, would not be an end to the long-term US Dollar bull market.
For the U.S.-based investor a weaker dollar would mean better earnings for U.S.-based corporations with foreign revenues. While no guarantee of a higher stock market, it does give the market an earnings boost.
For more than a year now this chart has basically not changed as the overall commodity market, after a hard, multi-year collapse, has stayed within a trading range. This goes with our long-term theme that commodity prices have bottomed and will remain in a sustained period of consolidation at these lower levels. Individual commodities will at times, based off of supply-demand dynamics, see pricing volatility until normal market dynamics return to the commodity. So for example, the price of orange juice would move substantially higher if negative weather conditions resulted in a crop shortage. Once the shortage resolves itself the price of orange juice would normalize.
For the third year in a row we enter the month of May knowing that the historic best six months for the stock markets is behind us. You can read more about this phenomenon here, here, and here. What history also tells us is that “sell in May and go away” does not work every single year. Equity markets right now are strong and could be the exception to the rule. In the words of Greg Harmon author of Trading Options and founder of Dragonfly Capital:
“… all it took for renewed strength was an election that turned into a runoff between a Communist and a guy who married his high school teacher in France. What does this tell you about equity markets around the globe? It certainly does not instill the feel of strong investor confidence. There is an apprehension to put new money at risk ahead of any major decision now. And then once the event has passed it floods in. Money is not selling hard into events, it is just pausing. This is a sign of a very strong bull market.” – https://dragonflycap.com/renewed-strength-in-equities/
At the same time the market is not “cheap.” After eight years of positive markets investors have become increasingly comfortable paying up for equities. Currently we are arguably “overvalued” with market P/E ratios above the long-term median. Being overvalued does not mean the bull stock market run is over, it just means there is more risk associated with the current market. And by risk, we mean price volatility (which is the jargonish way of saying lower stock prices). We do not mean permanent loss of capital.
Yet this bull market run could go on for longer than you might reasonably expect. Maybe it already has. Market extremes happen not because of rational pricing of corporate America. No, markets get to extremes based on emotions. At the bottom of a market it is fear that drives prices lower, greed at market tops. In the words of the great John Maynard Keynes, “markets can stay irrational longer than you can stay solvent.”
Are we saying that the stock market will continue to move higher, higher, higher? No. What we are saying is right now markets are strong. We are saying that this strength can continue on for some time – maybe a few more weeks; maybe a few more months or even years. This eight year run will eventually end.
Sometimes the market just runs out of new buyers and the correction quietly begins. Other times there is a piece of news, or a piece of analysis that changes the way investors look at the stock market. A great example is the end of the tech bubble in 2000. Looking back at it a cover story in Barron’s titled “Burning Fast” in March 2000 that questioned the desire to own profitless companies, pointing out the cash burn rates of many of these companies and showing when they would run out of cash. https://thereformedbroker.com/2017/04/25/contra-einhorn/
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com