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Market Outlook

This Bull Still Has Legs

By Roger S. Conrad, on Oct. 9, 2017

The S&P 500 has gone 459 days without suffering a 5 percent pullback, its fourth-longest streak since the 1920s. Historically, the index suffers a correction of this magnitude roughly three times per year.

The market’s resilience this year looks particularly impressive when you consider the laundry list of potential downside catalysts in play:

  • Delays to US tax and health care reform;
  • Rising geopolitical risk in Iran and North Korea;
  • Volatile oil prices;
  • The Federal Reserve planning to shrink its balance sheet;
  • Stretched equity valuations; and
  • Extreme complacency among investors.

Narrowing market leadership since April made us wonder whether the market could be due for a pullback. While a relatively small number of stocks powered the index to new highs, many small- and mid-capitalization names lagged over this period. As recently as mid-August, for example, fewer than 50 percent of the names listed on the New York Stock Exchange (NYSE) traded above their 200-day moving average. The S&P 500, in contrast, hasn’t traded below its 200-day moving average since the US presidential election.

Today, almost two-thirds of NYSE-listed stocks are in an uptrend, the highest proportion since April.

The S&P 500 has gained about 3.75 percent since Aug. 15, lagging the S&P 600 Small Cap Index, which has returned almost 10 percent. Meanwhile, the tech-heavy Nasdaq 100, which has led the market for much of the year, has gained 2.7 percent since mid-August.

Recent strength in small-cap stocks and improving market breadth suggest that this bull still has legs, even if the tech sector has taken a bit of a breather after a furious run-up earlier in the year.

These trends also reflect growing confidence in the US economy. Names growing their earnings at an above-market rate tend to outperform when GDP growth decelerates; these companies don’t need as much help from the broader economy. By the same token, cyclical sectors like banks, energy and industrials tend to lead the way during periods of economic strength.

Through Aug. 15, the Russell 1000 Value Index had returned 5.1 percent on the year, lagging the S&P 500’s 11.5 percent gain and the 17.6 percent upsurge in the Russell 1000 Growth Index. These trends started to shift in September, with the Russell 1000 Growth Index up 2.6 percent and the Russell 1000 Value Index up 3.8 percent.

Similar developments have played out in the bond market, with the yield on 10-Year US Treasury securities declining from a high of 2.45 percent at the start of the year to a low of 2.04 percent in early September. Bond yields fall when investors bid up the price, suggesting that investors gravitated toward this haven for the first nine of the year, abandoning concerns about inflation or the Fed tightening monetary policy.

However, these dynamics have reversed. The yield on 10-year Treasury bonds has surged to 2.36 percent, and the futures market has priced in 78.5 percent odds that the US central bank will increase interest rates by 25 basis points at its December 2017 meeting—up from a less than 25 percent chance as recently as early September.

Incoming economic data suggest that the US economy has strengthened. The Bloomberg US Economic Surprise Index—an indicator that compares economic data to analysts’ consensus estimates—recently broke higher. And the Federal Reserve Bank of Atlanta’s GDPNow model estimates that the US economy grew by 2.9 percent in the third quarter.

Despite the headline loss of 33,000 jobs, the US employment data released last Friday wasn’t that bad when you consider the vagaries associated with Hurricane Harvey and Hurricane Irma. An estimated 1.474 workers reported that bad weather prevented them from doing their jobs—the highest number since January 1996, when a blizzard blanketed the East Coast with 2 to 4 feet of snow. The storms also reduced payrolls at bars and restaurants by about 100,000; these service industries usually only pay employees for the days they come to work.

On an encouraging note, the labor participation rate climbed to 63.1 percent—the highest level in four years. This important indicator measures the total labor force (the employed, unemployed and those actively seeking a job) as a percentage of the total working-age population.

Historically, a strong employment market has tempted more people to seek or take employment, boosting the labor-force participation rate. Chronic weakness in the US economy, coupled with demographic factors, has driven a big decline in this metric, which tumbled from 66 percent in December 2007 to a low of 62.4 percent in September 2015. The labor-force participation rate appears to be stabilizing, if not improving.

Average hourly earnings have also increased 2.9 percent from year-ago levels, the strongest growth rate since the great recession. Rising wages drive consumer spending, which accounts for about two-thirds of the US economy.

Rising wages also tend to drive inflationary pressure over time; continued strength in this indicator over the next few months might ease concerns about weak inflation, which remains well below the Fed’s 2 percent target. All these signs of a strengthening economy support expectations that the US central bank will continue to increase interest rates at a modest pace.

The combination of a recovery economy and rising interest rates should support cyclical sectors, especially financials.

Capitalist Times Premium subscribers have already benefited from sells to our model portfolios that captured existing gains and recent additions that are already turning a profit as part of this move toward cyclicals.

If you aren’t a subscriber to Capitalist Times Premium, do so now! You’ll receive twice-monthly issues with specific stock ratings and two model portfolios that include updates and alerts.

Roger S. Conrad is chief editor of Conrad’s Utility Investor. He co-founded Capitalist Times and Energy & Income Advisor with Elliott H. Gue.

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