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Why Stocks Should Jump Following Memorial Day Week

Market Summary

As reported in Reuters, Wall Street capped off its strongest week since March after U.S. Federal Reserve Chair Janet Yellen said an interest-rate hike would likely be appropriate "in the coming months." Yellen's is the most important voice in a chorus of policymakers recently suggesting that the U.S. economy has improved enough to warrant tighter borrowing costs, with a growing number of investors now expecting a hike in June or July. While higher interest rates choke liquidity in stock markets, many investors see a potential rate hike as a vote of confidence that the struggling U.S. economy is finding its legs. "As we look at our place in the global economy, things just seem to be improving to a point where it certainly looks likely that June or July will be the next launching point," said Paul Springmeyer, portfolio manager at the Private Client Reserve of U.S. Bank. "With the increased strength, we should get up off of those historically low levels where we are." For the week, the S&P 500 rose 2.3% and the Dow added 2.1%, the best weekly performance for both since March. The Nasdaq gained 3.4% for the week, its best weekly result since February. The small cap Russell 2000 also surged 3.4%. Just 5.6 billion shares changed hands on U.S. exchanges, well below the 7.1 billion daily average for the past 20 trading days, according to Thomson Reuters data.

YTD Performance

A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the general stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend. As highlighted in the chart below, the MTUM established a new trading range over the past few weeks. Neutral momentum suggests MTUM should remain range-bound for a while.

MTUM Daily Chart

As reported by Reuters, gold has entered a phase of consolidation due to stronger views that the U.S. Fed will raise rates this summer," said Carlo Alberto de Casa, chief analyst at ActivTrades. The prospect of an interest rate increase, as indicated by U.S. Fed meeting minutes released last week, and a strengthening dollar have pushed gold down more than 5% so far in May, putting it on track for its biggest monthly decline since November. Higher interest rates increase the opportunity cost of holding non-interest yielding gold. Treasury prices tumbled last week after Federal Reserve Chairwoman Janet Yellen said another rate increase may be appropriate in coming months if the economy continues to improve. In remarks at Harvard University, Yellen noted continued improvement in the labor market, albeit with caveats about sluggish wage growth and full-time employment. Yellen said that if the economy overall continues to improve, it would be "appropriate" for the Fed to "gradually and cautiously increase our overnight interest rate over time." That means a rate rise could be appropriate in coming months, she said. That was perhaps a stronger statement than investors had expected. The remarks saw Treasury yields, which move in the opposite direction of prices, extend even higher.

UUP Daily Chart

Market Outlook

The questions posed in an article published in the Reformed Broker is has the market corrected through time, rather than through price, enough to spark the next bull leg higher? Since the AAII Sentiment Survey started in June 1987, a neutral sentiment reading above 50% has only been recorded 28 times. Only six of those readings were recorded after 1989 (January 1991, July 1991, August 1994, February 2003, December 2015 and this week). The remaining 22 readings are all from the approximate two-year span of December 1987 through October 1989. On average, the S&P 500's 26- and 52-week returns following such occurrences were 8.4% and 20.5%, respectively. Even rarer is having bullish sentiment below 20% and neutral sentiment above 50% on the same week. This week is just the sixth time such a combination has happened. It previously occurred four times in 1988 and once in 1989. On average, the S&P 500's 26- and 52-week returns following those five occurrences were 11.2% and 25.7%, respectively. In the graph below you can see the real estate sector is the top performer in the second quarter as investors anticipate higher interest rates should benefit real estate investments.

Quarterly Performance

The CBOE Volatility Index (VIX) is known as the market's "fear gauge" because it tracks the expected volatility priced into short-term S&P 500 Index options. When stocks stumble, the uptick in volatility and the demand for index put options tends to drive up the price of options premiums and sends the VIX higher. Similar to what happened in the beginning of April, the VIX has descended to its lowest level as investors trade "risk-on" and push stock indexes back toward all-time highs.

VUX Daily Chart

The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The current survey result is for the week ending 05/25/2016. The AAII reports that the percentage of individual investors optimistic about short-term gains occurring in the stock market is at its lowest level in 11 years. At the same time, the percentage of investors describing their outlook as neutral is at its highest level in 16 years, according to the latest AAII Sentiment Survey. Optimism is below 20% and neutral sentiment is above 50% on the same week, for just the sixth time in the survey's history. Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.6 percentage points to 17.8%. This is the lowest level of optimism recorded by the survey since April 14, 2005 (16.5%). It is also the 29th consecutive week and the 62nd out of the past 64 weeks that bullish sentiment has been below its historical average of 39.0%. Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 6.3 percentage points to 52.9%. Neutral sentiment was last higher on April 12, 1990 (56.0%). Neutral sentiment has now been above 40% for 12 consecutive weeks and above its historical average of 31% for 17 consecutive weeks, as well as for 69 out of the past 73 weeks. As a contrarian indicator the current AAII reading points to a continued short-term bounce toward the market highs.

AAII Sentiment

The National Association of Active Investment Managers (NAAIM) Exposure Index represents the average exposure to US Equity markets reported by NAAIM members. The blue bars depict a two-week moving average of the NAAIM managers' responses. As the name indicates, the NAAIM Exposure Index provides insight into the actual adjustments active risk managers have made to client accounts over the past two weeks. The current survey result is for the week ending 05/25/2016. First-quarter NAAIM exposure index averaged 45.89%. Last week the NAAIM exposure index was 60.17%, and the current week's exposure is 64.67%. Expect professional money managers to lingerin a holding pattern ahead of the FOMC meeting in a few weeks.

NAAIM Exposure %

Trading Strategy

According the Stock Trader's Almanac, Next week's shortened trading week has a mixed record going back to 1971. Back in the May/June Disaster Area days when DJIA and S&P 500 were down 10 of 17 Mays from 1971-1987, the week after Memorial Day was a poor performer. DJIA, S&P 500 and the Russell 1000 all declined more frequently than not with average losses ranging from .22% to .39%. NASDAQ and Russell 2000 performed slightly better. Since 1995, the overall record is mixed. There was a four-year span of respectable gains from 2006 to 2009, but since 2010 losses have dominated. DJIA, S&P 500, NASDAQ, Russell 1000 and Russell 2000 have all been down in five of the last six Memorial Day weeks. If post-Memorial Day strength fails to buoy the market, then it would we susceptible to profit taken especially now that it is near resistance once again. If the market does stall next week, it might be a good opportunity to load up on technology stocks on your watch list. As confirmed in the graph below, tech stocks are leading the recent market surge as investors are now trading "risk-on". If the major equity indexes do make a move toward 52-week highs, don't be surprised if HFT algorithms kick-in and sell off stocks at the highs.

30-Day Performance


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