Sell in May and go away? Maybe not. Equity market indicators were mostly positive this month with global indices outperforming US stocks. The Bloomberg Aggregate Bond index has been surprisingly strong as both the U.S. dollar and commodities index continue to weaken.
|U.S. & International Stock Index Returns|
|S&P 400 (Midcap)||(0.67%)||3.68%|
|S&P 600 (Small Cap)||(1.60%)||(0.69%)|
|Barclays Agg. Bond||2.38%|
|CRB Commodity Index||(6.62%)|
|U.S. Dollar Index||(4.92%)|
Source: Morning Outlook June 1, 2017
In our opinion, one of the requirements of long-term investing success is to recognize the big investment trends. It is not necessary to catch it at the very beginning, but the sooner you can reasonably recognize the change of direction the faster you can adjust your portfolio. Because there can be many a false start of a new trend one should not react before having confirmation of the likely change of direction. Emotionally this can be hard to do. Most of us are programmed to either front run the change (which may or may not happen) or deny the change is happening in real time. I think we all have a story or three of the trade we never made or the one we made in anticipation of the change of trend that never occurred.
In our April report, we discussed a possible change in trends we are following as global equities have started to outpace US stocks. Everything is set up real nice – valuations overseas are much lower than at home, US outperformance has been happening for 7+ years, and the ratio chart (Chart #2) really looks like it is going to break. Yet, as of the end of May 2017 the status quo persists. While we believe should having foreign investment exposure is prudent, in our opinion, there is no reason to make a substantial tactical change to increase foreign equity exposure until there is a real change in the long-term direction for the ratio chart.
Speaking of changes in direction, we are also monitoring the S&P 500 for a possible change in direction as well. It has been a very good year thus far with the index up almost 9% in just 5 months of trading. What we are seeing is a negative divergence with two of our favorite indicators – the RSI and MACD – that is suggesting some sort of market correction. Again, the problem with trying to front-run the possibility of a correction is there is no guarantee of lower prices. Other possibilities include a sideways correct where the index stays relatively flat but corrects over time or a continued move higher.
Yields on the 10-Year Treasury bond have remained strong but within the trading range/consolidation that began in late-2016. In that respect, nothing has changed. There is, however, a more subtle change in the bond market that we think is worth noting; a change that can have implications for the economy.
What has changed is the yield spread (difference in yield) between the 10 year and the 2-year Treasury bonds. At the end of 2016 this spread was about 1.25%. At the end of May that spread had tightened to 0.93%. This is noteworthy because the spread in yield indicates how investors are viewing the economy, with a wider/widening spread indicating a stable and growing economic future. When spreads are tight/ tightening it indicates an unease regarding future growth. Historically a flat or inverted yield curve (when 2-year Treasuries have a higher yield than the 10-year Treasury) indicates a looming economic recession.
At Magellan Financial we are concerned with both the direction and the relative tightness of the yield spreads. The last two times this yield curve was flat or inverted was in 2000 and 2006-7, prior to the two previous recessions. So while not at an alarm stage right now, the spread is something we will continue to keep an eye on.
In our Monthly Stock Market Review – April 2017 we noted the possible breakdown or the US Dollar vs. foreign currencies and the implications of dollar weakness. The technical pattern we referenced broke early in May leading to a weaker dollar. We expect the dollar to remain weak, but not outside of the long-term trading range. This means we see the downside being limited to 92-93 on the index.
Not much to see that we haven’t discussed over the last year or so. Consolidation within a range continues.
Looking Ahead At The Stock Market
“Summertime and the livin’ is easy.” – Du Bose Heyward/George Gershwin/Ira Gershwin
“Whoso neglects learning in his youth, loses the past and is dead for the future.” – Euripides
According to the Stock Trader’s Almanac 2017 the “summer rally” in most years is the weakest of all four seasons (pgs. 56, 72). At the same time, the summer months are best described in most years as boring and uneventful. Said in a less cryptic manner, there are stock market rallies that happen throughout the year, and those that happen during the summer months are typically weak. There are any number of reasons we can give for this reality – just as the CNBC talking heads give for why the markets were up or down in any given session. What matters is what actually happens, not the “reason” it happened. Knowing history helps you have some perspective on what could transpire in the coming days/weeks/months.
Knowing what has happened in the past leads us to be more cautionary in the short-term. As we enter the summer months there are a few market-related issues that need consideration:
- Markets have had a good run so for in 2017 and one-third of the gains made in the NASDAQ and S&P 500 this year are the result of the positive action of just five stocks.
- Stock market volatility continues to sit near all-time lows, a result of investor complacency.
- Commodity – specifically oil – have moved lower of recent.
- Bond prices have rallied hard over the past few months, bringing interest rates to their lowest levels of the year at a time when The Fed is actively increasing short-term interest rates.
- The U.S. dollar has notably weakened against a basket of foreign currencies.
To be perfectly clear we are not calling for a massive selloff and are open to the idea that stock markets can continue to float higher in the coming months. What we are saying, however, is that right now is not the time to be blindly bullish on equities. The risks are real as we enter a seasonally weak time for markets. So while we would not be surprised if the S&P 500, Dow Industrials and NASDAQ hit new all-time high levels, it is not our base-case scenario.
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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
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