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Has The Federal Reserve Returned To Its Dovish Mindframe?

Market Summary

U.S. stocks closed at record highs on Friday in response to a mixed batch of corporate bank results and poor data on retail-sales and inflation, which led market participants to believe the Federal Reserve, is firmly back in a dovish frame of mind. For the week, the main equity indices posted gains with the blue-chip Dow Jones Industrial Average up 1.0% and S&P 500 rising 1.4%. The Nasdaq led the way jumping 2.6%, while the smaller cap MidCap 400 and Russell 2000 both rose approx. 1.0%. All the main asset classes remain in positive for the year.

A tool to help confirm the overall market trend is the Bullish Percent Index (BPI). The Bullish Index is a popular market “breadth” indicator used to gauge the internal strength/weakness of the market. Like many of the technical market internal indicators, it is used both to confirm a move in the market and as a non-confirmation and therefore divergence indication. Over the past eighteen months Nasdaq stocks have led market direction. We have been saying recently “…It is reasonable not to expect the major equity indexes to return to their highs until the BPCOMPQ breaks out into a sustained uptrend…” The orange line in the current chart below confirms the BPCOMPQ reversed course into an uptrend and is leading stocks to new highs as we thought it would.

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. Last week’s analysis played out as advertised when we said “…stocks are trading range-bound going into quarterly earnings season. This pause is necessary for stocks to absorb overbought conditions…” In the updated chart below you can see the MTUM ETF broke higher out of the recent trading range as identified by the orange rectangle. Technical signals indicate the market is getting overbought, but this condition can continue indefinitely before stock prices pull back.

In the updated chart below, the U.S. dollar weakened last week, dropping to its lowest level since September 2016 after a pair of data releases pointed to waning inflation and weakness on the part of the consumer, two reads that market participants may delay the Federal Reserve’s next policy move. Gold prices on Friday marked the highest finish of the month and their first weekly rise since early June, as data on retail sales and inflation stoked concerns that the pace of economic growth may not merit lifting U.S. interest rates again in 2017. Lower rates tend to be supportive for gold futures, which don’t offer a yield. Government bonds sold off last week, driving yields higher, as investors anticipated further evidence of a tapering of longstanding easy-money policies that have supported bond prices.

Market Outlook

The upcoming week is July options expirations and Jeff Hirsch in a recent Almanac Trader article talked about how since 1982, the Friday of options expiration week has a bearish bias for DJIA declining 18 times in 35 years with two unchanged years, 1991 and 1995. On Friday the average loss is a significant 0.29% for DJIA and 0.31% for S&P 500. NASDAQ’s record is even weaker, down 21 of 35 years with an average loss of 0.46%. DJIA posts the best full-week performance, up 22 of 35 with an average 0.41% gain. The week after options expiration also leans bearish for S&P 500 and NASDAQ over the longer-term with average losses. In recent years the track record had been improving until 2015’s across the board, greater than 2% loss. Though the Dow Jones industrial average set a new record high on Friday, it, the S&P 500 and the Russell 2000 index were generally lower most of the week. Still, some investors remain encouraged by this year’s record highs for the Dow, the S&P 500 and the Nasdaq. However, others fret about the level of valuations. The Trump administration’s ability (or lack thereof) to move forward on economic and tax policy remains at the forefront of many investors’ minds and is having a significant impact on sentiment. Other factors playing roles are earnings, concerns about the possibility of a pullback in stock prices and interest rates/monetary policy. The updated graph below shows that with exception of gold, all the major asset classes are higher since the beginning of the second quarter. Low interest rates and a growing domestic economy depressed ‘risk-off’ assets like gold and boosted riskier equity investments.

Put/Call Ratio is the ratio of trading volume of put options to call options. The Put/Call Ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment, and vice versa. Technical traders have used the Put/Call Ratio for years as an indicator of the market. Most importantly, changes or swings in the ratio are seen as instances of great importance as this is commonly viewed as a change in the tide of overall market sentiment. Investors are buying call contracts as an inexpensive way to bet on higher stock prices during quarterly earnings.

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. Quarterly earnings results are starting to roll. Thus far results have met expectations and the volatility crashed as equity indices reached new highs. It was reported that the VIX posted its third lowest finish ever, according to FactSet data. The CBOE Volatility Index closed down 3.9% at 9.51, which marks the lowest level for the so-called fear gauge since 1993. The indicator has only closed lower on two other occasions both in December 1993 at 9.48 and 9.31. As we suggested last week “…Don’t expect a sustained upward trend in the CBOE Volatility index chart unless there is a series of disappointing quarterly reports from high profile companies. Any unexpected geopolitical news will probably only briefly ignite volatility…”

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 07/12/2017. Optimism declined to the very bottom of its typical historical range, while neutral sentiment stayed above 40% for the third consecutive week. The latest AAII Sentiment Survey also shows small declines in both optimism and pessimism. The proportion of individual investors describing their outlook for stock prices as “neutral” is above 40% for a third consecutive week. This is the first such streak in nearly a year. Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 1.6 percentage points to 42.1%. Neutral sentiment remains above its historical average of 31.0% for the 11th consecutive week and the 16th out of the last 17 weeks. The last time neutral sentiment was above 40% on three consecutive weeks was July 27 through August 10, 2016. Readings above 40% are unusually high (more than one standard deviation above average). Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.3 percentage points to 28.2%. Optimism was last lower on May 31, 2017 (26.9%). The decline keeps bullish sentiment below its historical average of 38.5% for the 20th consecutive week and the 25th time out of the last 26 weeks. At current levels, optimism is right at the border between typical and unusually low readings. Bullish sentiment has been gradually trending lower over the past three weeks. Bullish sentiment levels of 28.1% or lower are considered unusually low. Historically, unusually low levels of optimism have been followed by better-than-average gains in the S&P 500 index over the next six- and 12-month periods. There is no guarantee that these trends will continue in the future. Bearish sentiment, expectations that stock prices will fall over the next six months, declined by a modest 0.2 percentage points to 29.6%. Pessimism remains below its historical average of 30.5% for the ninth time out of the last 11 weeks.

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 07/12/2017. Second-quarter NAAIM exposure index averaged 85.08%. Last week the NAAIM exposure index was 92.85 %, and the current week’s exposure is at 89.90%. Last week’s analysis remains in play where we stated “…Quarterly earnings season is starting up and money managers will probably maintain a high level of NAAIM Exposure as results start rolling in. If investors interpret good earnings numbers as expected, the index should go to the highest exposure…”

Trading Strategy

As reported by Sue Chang in MarketWatch, another quarter of stellar earnings could juice an already primed stock market, pushing key indexes to new records in coming weeks. Wall Street analysts are forecasting earnings to grow near double digits as corporations beat expectations, putting second-quarter results on pace to be among the best since fourth-quarter 2011. John Butters, senior analyst at FactSet, projected earnings per share to rise 6.5% in the April-June quarter but noted that actual increase could top 9% given that growth rates tend to adjust about 2.9 percentage points higher as more companies announce quarterly performance data. Of the handful of S&P 500 index companies that have reported so far, 80% have beat mean EPS estimate while 83% have exceeded mean sales target, he said. In the updated chart below Healthcare shares are leading the way over the past month in anticipation of possible Republican healthcare legislation. Technology, Industrials, and Materials growth sectors have rebounded higher as investors are trading “risk-on”. The Financial sector remains elevated on dovish comments from the Fed.

By Gregory Clay

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