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The Market Wants Its Tax Cut

Market Summary

U.S. stocks closed in negative territory for the week, unable to fully bounce back from sharp losses in the middle of the week sparked by White House drama. Both the Dow and the S&P turned in a second week of losses as both shed 0.4% for the week. The Nasdaq finished the week down 0.6% while the small caps Russell 2000 was the biggest loser falling 1.2% and Midcap 400 dropped .4%. Last week comments came to fruition when we said "… Smalls caps and the Dow industrials settled near their 50-day moving averages and a breach of these technical levels could signal a more significant pullback…”

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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 overall 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. In recent week we have been saying “…MTUM is overextended and don’t be surprised if we get a pause next week to absorb over the extremely overbought condition…Stock prices are churning between buyers and sellers…” The orange square highlighted in the updated chart below indicates the stock market upward price movement has dissipated into a sideways price trend. The orange circle at the bottom of the chart confirms the bullish trend ended and converted to neutral. The most probable near term price move is range-bound trading between recent highs and last week’s lows.

 

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In the updated chart below the DOW Transportation index ($TRAN) continues to diverge lower from the Dow Jones Industrial Average ($INDU). When the DOW Transports and Industrials don’t move in synch it is considered a technical sign of a weakening trend. Recently we pointed out “…the transportation index is starting to drag down the Dow Industrials… Expect the Industrial index to retrench if the Transports don’t catch up soon…” Right on queue the stock market retrenched for the first losing week in six. As pointed out above, the recent uptrend has stalled out and now there is a possibility the Dow Industrials might fall further to converge with the Transports.

 

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The chart below displays how the Russell 2000 index small cap index (IWM) has diverged lower away from the large cap indices. It will be difficult for the overall market to sustain a confirmed breakout higher without small cap indices participation. The relative selloff in the Russell 2000 index indicates investors are somewhat risk adverse and not fully “risk on” which is required for an overall bullish market move. This offers technical signals of a weakening trend.

 

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In the updated chart below, the U.S. dollar fell against its major rivals last week, dropping to its lowest level since November as political uncertainty continued to flow out of Washington and depress sentiment. The drop wiped out all of the currency’s postelection pop seen after Donald Trump won the U.S. presidency in November. Gold prices edged higher to post their largest weekly gain since mid-April, as overall declines in the U.S. dollar and equities from a week ago fed haven demand for bullion. The precious metal scored a roughly 2.1% advance for a week, marked by rising volatility and political unrest in the White House. That was the largest such gain since the week ended April 13. Treasury bonds also moved higher last week, marking its largest weekly advance since the period ended April 13, according to Dow Jones data. This action followed New York Federal Reserve President James Bullard’s comments suggesting the central bank could rein in its “aggressive” monetary-tightening schedule in light of weak economic data.

 

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Market Outlook

The stock market wants its tax cut. One of the primary reasons the major indices attained all-time highs is the expectation of a significant tax cut. Republicans’ proposed healthcare legislation provides a huge tax for upper income taxpayers. Enacting the healthcare law is being hung-up by disgruntled constituents pushing back on the prospect of tens of millions losing their healthcare. After the healthcare revisions stalled, the Trump administration outlined possible tax legislation that proposed lower tax rates to give a big tax cut to high income earners. Massive tax cuts are generally considered to primarily benefit wealthier citizens who presumably would put the extra money to use by investing in the stock market. Especially if capital gain rates are cut that would most certainly drive stocks higher as additional funds flood the market. The problem is that turmoil surrounding the Donald Trump administration is putting major legislation on the backburner. Any Donald Trump rally ended months ago and up until recently the market rejected any significant selloff attempts. Political gaffes from the Donald Trump team are splintering unified Republicans which is required to pass major new laws. From an investor perspective, if there are questions about whether a tax cut will happen this year there is less incentive to keep money in the market.

Stocks are experiencing big daily moves from a new all-time closing high on Monday to the worst day of the year so far on Wednesday. Selloffs triggered solely as the result of political blunders by the Trump administration can easily bounce right back. Alternately, the market could be starting to react to some “Sell in May” jitters, political instability, monetary policy tightening and some buying exhaustion. In this case then a 10% correction is not out of the question. In a landscape devoid of blockbuster earnings and policy catalysts, the stock market is likely to remain hostage to political uncertainty, setting the stage for continued daily triple-digit price moves and while the outcome of the current bear versus bull battle has yet to be known, most analysts believe the bulls have a slight edge. Synchronized global growth, continued stimulus around the world, and improving U.S. economic data all support the bullish case. On the other hand, concerns about asset valuations and the aging bull market, central banks’ plans to normalize interest rates, and elevated leverage tip the scale in favor of bears, according to some market pundits. The updated graph below displays investors’ nervousness buying more bonds and gold. Nasdaq remains the unabashed leader driven primarily a select group high value stocks.

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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. In the updated chart below the CBOE Volatility Index exploded on Wednesday as the stock market crashed. Investors got nervous over concerns about the Trump presidency. The Justice Department announcing the appointment of former FBI director Robert S. Mueller III as special counsel to investigate the Trump campaign appears to have assuaged investors’ concerns. On Friday Volatility index sank back toward normal ranges.

 

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 05/17/2017. This week's readings are almost exactly the same as what was registered the week before the November elections. The readings on November 2, 2016, were bullish: 23.6%, neutral: 42.0% and bearish: 34.3%.

Optimism among individual investors about the short-term direction of stock prices fell to a new 2017 low in the latest AAII Sentiment Survey. At the same time, the percentage of individual investors describing their outlook as "neutral" is at a new high for the year. Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 8.9 percentage points to 23.9%. The drop keeps optimism below its historical average of 38.5% for 17 out of the last 18 weeks. Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 4.8 percentage points to 41.9%. The rise keeps neutral sentiment above its historical average of 31% for the eighth time in nine weeks. At current levels, optimism is at an unusually low level and neutral sentiment is at an unusually high level. Both are more than one standard deviation from their historical averages. Since our survey was started in 1987, the S&P 500 has realized above-average gains over the six-month periods following unusually low bullish sentiment readings, rising in price nearly 85% of the time. There is no guarantee that this trend will continue in the future, however. Bearish sentiment, expectations that stock prices will fall over the next six months, is 4.0 percentage points higher at 34.3%. Pessimism is above its historical average of 30.5% for 15 out of the past 18 weeks. The survey period runs Thursday through Wednesday. As such, most of this week's responses were recorded prior to yesterday's nearly 2% decline in the S&P 500. Most of the responses were also recorded before the appointment of former FBI Director Robert Mueller as a special counsel to investigate foreign interference in the 2016 U.S. presidential election. As noted last week, we have continuously seen President Trump and the potential impact of his administration’s policies brought up in response to our weekly special questions, even when the questions have nothing to do with Washington politics.

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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 05/17/2017. First-quarter NAAIM exposure index averaged 92.85%. Last week the NAAIM exposure index was 92.95 %, and the current week’s exposure is 92.13%. Last week we said “…It appears money managers might be taking advantage of the stall in upward stock price movement to “buy the dip”. Absent an actual pullback, stock prices are pausing before the next move which presents an opportunity to catch the next big wave…” This is playing out as advertised with investors already stepping in to buy on Friday after Wednesday’s big dip.

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Trading Strategy

As reported by Jeff Hirsh in the Almanac Trader, over the last 21 years, DJIA has advanced just 47.6% of the time during the week before Memorial Day weekend. Of the five major indices we frequently cite, it is the weakest averaging a 0.29% loss. S&P 500, NASDAQ and Russell are better, but average performance over the last 21 years is still just a fractional gain. Russell 2000 has the best track record, up 71.4% of the time with an average gain of 0.42%. Since 2003, Russell 2000 has been even stronger, up 12 of 14 weeks with an average 1.17% gain. The updated graph below confirms investors are in a bullish mode with all the S&P sectors moving higher over the past month. The path of least resistance is higher and “buying the dips” continues to be a viable investment strategy. Also we are generating good profits from credit spreads as stocks basically continue to trade range-bound.

 

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By Gregory Clay for Safehaven.com

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