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Market Outlook

A Summer Melt Down before a Later Melt Up

By Elliott H. Gue, on May. 25, 2017

Editor’s Note: This market outlook was published in Capitalist Times Premium in early May, providing timely and detailed market analysis to subscribers. That’s in addition to Capitalist Times Premium’s model portfolios and investment ideas. Consider subscribing today!

US economic growth in the first quarter came in at just 0.7 percent, marking the third year out of the past four when the US economy managed growth of less than 1 percent in the first quarter.

US markets shrugged off the early 2017 weakness, and for good reason.

Most US economic data is seasonally adjusted to account for certain calendar effects, such as cold winter weather in the first quarter, auto factory retooling in summer and retail sales and employment increases during the fourth quarter’s holiday season.

However, in recent years, we’ve seen a trend toward improper seasonal adjustments in the first quarter that are historically reversed in the second quarter. A significant portion of that weak first-quarter data likely reflects this residual seasonality rather than a real slowdown in growth.

Moreover, we continue to see signs of strength in other data series.

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(Click to enlarge.)

The US Leading Economic Index (LEI) is comprised of 10 US economic indicators with a long history of leading the broader economy. These indicators tend to turn up before the economy improves and turn lower before the economy deteriorates.

A good, basic rule of thumb: When the monthly change in LEI is 0 or negative in six of the past 12 months, the risk of recession in the next 12 months is high. A string of negative LEI readings in late 2015 and early 2016 had us worried, but recent readings in the 0.4 percent to 0.6 percent range are more consistent with an economic acceleration.

Manufacturing data, not just in the US but all over the world, has experienced similar moves.

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(Click to enlarge.)

While the exact timing differs slightly, the Manufacturing Purchasing Manager’s Index (PMI) for the US, Eurozone, Japan and China looked weak through last summer and has improved sharply since the middle of 2016. This represents the first synchronized global economic recovery since the immediate aftermath of the 2007-09 Great Recession and financial crisis.

Historically, the US stock market tops out roughly 12 months before the US economy enters recession. And the final 24 months of a bull market account for about 40 percent of total gains in the entire cycle. This is the “melt-up” rally the S&P 500 typically witnesses at the end of a bull market.

With little sign the US is headed for recession by the middle of next year, there’s more upside for stocks this cycle. It’s dangerous to sell too soon and miss the final months of the bull market.

Of course, we doubt the rally will be a smooth ride higher.

On May 8, the S&P 500 Volatility Index­–a measure of market volatility priced into S&P options–closed at 9.77. That marks only the 11th day in the 27 years since the VIX was created (meaning 6,893 total daily observations) that it closed below 10.

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(Click to enlarge.)

The VIX has traded at current depressed levels on only a few occasions in history, such as late 1993, mid-1995, mid-2006 and mid-2014.

The market endured a roughly 10 percent sell-off in 1994 and late 2014. A series of low VIX readings in 2006 occurred slightly more than one year before the start of the vicious 2007-09 market collapse and Great Recession.

The idea behind the VIX as an indicator is simple: when the VIX is high, market participants are scared and periods of elevated fear tend to signal key market lows. That was the case in late 2008-early 2009 and, more recently, at the height of the “Flash Crash” in August 2015.

In contrast, a low reading on the VIX suggests investors are complacent and markets are vulnerable to any shred of bad news.

While such a low reading on the VIX is a huge warning sign, it’s worth noting that the indicator has a much better track record of calling market lows than market tops. That’s because fear is a more powerful emotion than greed; market bottoms are typically sharper and take less time to form than tops.

For example, investors who sold stocks in early to mid-2006 when the VIX dropped near current levels would have missed a 20-plus percent move to the October 2007 top.

We also remain concerned by the market’s increasingly narrow leadership.

The S&P 500 is currently within a few points of its all-time high of just over 2,400. Yet only 59 percent of stocks trade above their 200-day moving average. That’s down from around 70 percent of all NYSE-traded stocks in late February and early March, the last time the market traded near that level.

The 200-day moving average–the average closing price of a stock over the past 200 trading days–is a solid trend indicator. If a stock trades above the 200-day, it’s in an uptrend; below the 200-day is a downtrend. The fact that the broader market is near a high even though less than 60 percent of NYSE stocks are in an uptrend suggests that strength has been supported by a small handful of large-cap stocks that have an outsized impact on the S&P 500 Index.

In fact, the so-called FAANG stocks–Facebook (NSDQ: FB), Amazon.com (NSDQ: AMZN), Apple (NSDQ: AAPL), Netflix (NSDQ: NFLX) and Alphabet (NSDQ: GOOGL)–are up an average of 28.8 percent in 2017 compared to a 7.5 percent gain for the S&P 500.

These large-cap names have paced the index’s gains so far this year. Should any or all of these stocks falter, the S&P 500 could quickly lose altitude.

Our conclusion: the bull market in US stocks that started in 2009 is in its final innings but isn’t done. Expect a final melt-up in stocks during 2017 or early 2018 that will profit investors. However, in the near-term and as we enter the seasonally weak summer months, there’s risk of a 5 to 10 percent correction in the S&P 500 that will provide a final buying opportunity for the current bull market.

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Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

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