“Santa Claus Rally lasts the final five trading days of the year and first two of next year. During this period, S&P 500 has been up 73% times since 1970 with an average gain of +0.8%.”
“In November market’s price action turbo-charged it and gave clarity to many of the patterns that have been evolving for many months. The result is that the market has more reasons to go higher from already high levels.”
The way to profit in investing is to buy low and sell higher or sell (short) high and buy (cover) lower. However, this concept is often misunderstood. The high and low points are relative to each other and are not absolute levels. So you would still be right to buy at a high level if the market dynamics point to higher prices. Conversely, you would also be right to sell at a low level if the market dynamics point to lower price.
The reason this makes sense is that in market, strength begets more strength and weakness begets more weakness. Or in other words, prices follows Newton’s First Law i.e. they remain in their state of motion unless an outside force changes the motion. The trick is to have right tools and techniques to know which way the motion is going on.
We rely on technical analysis and many indicators to help us determine the long-term and short-term market direction.
Slow and Steady
We developed a market timing strategy to determine the general direction of the market using weekly data and a combination of moving averages. This strategy uses S&P 500 and 30-Year US Treasury bond prices to determine whether to be in equities or bonds.
Using this strategy, a portfolio of $10,000, started in April 1978, would have grown to $594,500 or 5845% by December 8 2016. This results in 11.1% annualized return over 38.7 years. The buy and hold strategy would have returned 4284% during the same time period.
Since 2000 and using index ETFs, our strategy has produced 20 trades for a combined total return of +393% or +10.4% annualized. The current state of the strategy is to be long equities, which triggered on March 16 2016.
Monetary and Economic
The inflation expectations indicators that we track are rising (Figure 1), which favors a Fed Funds rate increase in December.
The 5-Year, 5-Year Forward Inflation Expectation Rate measures the expected inflation (on average) over the five-year period that begins five years from today. It bottomed in February 2016 and then started to increase. In Summer of 2016, it briefly fell before turning around again in August. It is at 1.98, which is the highest it has reached since August 2015.
Two other indicators, 10-Year Breakeven Inflation Rate and 5-Year Breakeven Inflation Rate mirror the pattern of inflation expectation rate. The breakeven inflation rates are the measures of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 5-Year Treasury Constant Maturity Securities.
The University of Michigan Inflation Expectation is a survey of consumers that measures the median expected price change over then next 12 months. The Figure 1 shows data up to September 2016, when it was 2.4%. This reading has stayed the same for the last two months.
This strengthens the case for a Fed-Fund rate hike on December 14. The CME Group FedWatch tool puts a probability of 97.2, on December 8, for a rate hike by 25 basis points in December 14 meeting. We also believe that it is very likely. What is still unclear is whether the Fed will pursue the policy of gradual rate increase.
Will Economic Expansion Continue
The current economic expansion has been going on for a long time. Although, the growth has been sluggish, it is real.
Economic expansions do not die of old age and recessions are very difficult to forecast but there are good arguments that age does take a toll on the growth rate, which makes recession more likely.
Many economic indicators are showing that the U.S. economic growth has slowed considerably. The year-over-year change of employment, industrial production, real retail sales, real disposable income and real per capita GDP has been trending down since 2014 year end (Figure 2).
Usually a decline in these indicators that lasts many months leads to recession (Figure 3). Of particularly concern is the industrial production. It’s year-over-year growth rate has been negative since September 2015. Most of the times when this measure turned negative, the recession either followed in few months or was already ongoing (Figure 4).
This makes the impending Fed-Funds rate hike very interesting. Even though the Fed’s monetary stance is very accommodative and a 25 basis point rate increase will not change it much, the U.S. economy is facing tightening market conditions. The bond yields and U.S. dollar has risen sharply over the past few weeks. This has nullified some of the impact of the loose monetary policy.
In this environment a rate increase coupled with expectation of further rate hikes and weakening industrial production would meaningfully increase the odds for a recession. This is not a forecast nor are there any clouds gathering over the horizon. What this means that we should not become complacent.
The fundamental picture of U.S companies is healthy and the trend is in no danger of reversing. In Q3 2016, S&P 500 earnings grew in year-over-year comparison. Revenues also grew. The growth will persist in Q4 2016 and in the year 2017. Most of the statistics are doing better than their multi-year averages. This indicates that the market is not at a very elevated level and that it has more room to run to the upside.
S&P 500 Companies Are Reporting Earnings Growth
According to FactSet, by November 25, 98% of S&P 500 companies had announced 2016 Q3 earnings. 72% of these companies reported better than analysts’ mean estimates, which is higher than 5-year average. In aggregate, the reported earnings exceeded the estimates by 6.3%, which is also above 5-year average of 4.4%.
For Q3 2016, the blended earnings (reported and estimated) growth rate for S&P 500 is 3.2%. This is the first time that the index has seen a year-over-year earnings growth since Q1 2015. Only three sectors – energy, telecom services and industrials – reported year-over-year earnings declines.
Still, the Trailing 12-Month EPS is declining since Q4 2014 (Figure 5). But, the Trailing 12-Month Trailing P/E Ratio is rising and is at 2.01 (Figure 6). It was 19.2 at the end of October. Last time this ratio was so high was in 2009, when it was falling from a high near 24.
Shiller P/E ratio, the cyclically adjusted price-to-earnings ratio, is 25.94 (Figure 7). Since June 2014, it has fluctuated between 25 and 27. In the past, it had stayed within this range from September 2003 to Dec 2007, just before the market melt-down during the global financial crisis. So it can stay in this range for much longer without the price getting into bubble territory.
The Shiller P/E ratio had reached very high levels during 1999-2000 dot-com period, which truly was bubble. In November 1996, Shiller P/E ratio started its rise above 27 and reached the highest reading of 44.19 in December 1999.
Sales and Book To Price Ratio
By November 25, 54% of S&P 500 companies had reported sales above the median estimates by analysts, which is equal to 5-year average.
The blended sales growth for Q3 2016 is 2.7%, which is the first time that index has seen year-over-year sales growth since Q4 2014. Nine sectors reported year-over-year revenue growth. Only Energy and materials reported declining revenue.
The estimated price-to-sales ratio of S&P 500 companies was 1.94 by the end of November (see Figure 8). This is the highest level that the ratio has reached since 2000.
The November-end estimated price-to-book ratio of S&P 500 companies was 2.86 (Figure 9). This is at the highest level since September 2007. However, the ratio is much below the highs reached during 1999-2000 dot-com bubble.
Growth Will Continue in Q4 and in 2017
FactSet compiled data indicates that the estimated aggregate earnings growth rate for the S&P 500 companies was 3.3% at the end of November. However, analysts have lowered their estimates by 2.0% from 5.3% at the end of September. This lowering of estimates is better than historical average. Over the past 20-year period, the average decline in earnings estimates in the first two month of a quarter has been 3.4%. The 10-year average is a decline of 3.9%.
For Q4 2016, so far 73 companies have issued negative earnings guidance and 35 have issued positive guidance. The percentage of companies issuing negative guidance is 68%, which is below 5-year average of 73%.
In Q4 2017, four sectors -energy, telecom services, materials and industrials – are estimated to record negative earnings growth. Real Estate, Consumer Discretionary and Utilities are expected to lead the growth (Figure 10).
In Q4, the S&P 500 revenue is estimated to grow by 5.0%, which is the highest growth rate since Q1 2012. Health Care, Consumer Discretionary and Real Estate are the top three sectors for revenue growth (Figure 11)
For Q1 2017, the projected growth rate for earnings is 11.5% and for revenue 8.0%. The respective numbers for Q2 2017 are 10.7% and 5.7%. For all of 2017, the earnings are estimated to grow by 11.4% and revenue by 5.7%
The forward 12-month P/E ratio for the S&P 500 at the end of November was 16.7, which is higher than October’s reading of 16.4. The 12-month EPS estimate is $131.19. This is above 10-year average of 14.3 (Figure 12).
The psychological indicators that we track are not flashing any signal one way or the other. This means that the current inertia of market will continue, which at the moment is a slow upward move.
Bullish Vs. Bearish Advisors %
This is a contrarian sentiment indicator. The bullish sentiment with Investors Intelligence Bullish Advisors % has moved up to 56.30% from 47.10% since the end of October. The Bear Advisors % has moved down to 22.30 from 23.10%. When the percentage of bears crosses over the bulls, the market bottom is likely. Last time bears were over bulls was in March 2016.
AAII Investor Sentiment Survey
As of December 1 2016, 43.8% of members of AAII are bullish regarding markets direction over next six months. compared to 31.1% of members who are bearish and 25.1%, who are neutral. One month ago, these numbers were 24.8%, 34.1% and 41.2% respectively.
Bullish percentages is above the historical average of 38.5% for the fourth consecutive week. The bearish percentage is below the average of 30.5%, also for the fourth week in a row.
The bullish percentage fell -6.1% and the bearish percentage rose by +3.0% from November 24.
At extreme readings, this gauge works as a contrarian indicator but at other times, it provides signs for future direction of the market. We have found that the current slope of the 4-week simple moving average of the bullish percentage gives a good sign for the slope of the S&P 500 4-weeks later (Figure 13). Also, the spread between bullish and bearish percentages gives a hint for future direction of the S&P 500.
In the most recent reading on December 1, the 4-week bullish percentage average increased to 44.8% from 39.8% on November 24. After making 2016 high during the week of July 28, the 4-week average has mostly declined before turning around beginning November 3. This is good sign for S&P 500. However, this just gives an indication regarding the direction and not the magnitude of the move. The 4-week average of bullish-bearish percentage spread is positive for the past three weeks, i.e. there are fewer bears than bulls.
CBOE Market Volatility
Unlike October and September, November saw a decrease in market volatility. After reaching a high of 22.51 in early November, $VIX, the CBOE Market Volatility Index, declined for most of the month before turning up in November’s last few trading days (Chart 1). On December 2 it was at 14.12, the 10-day SMA was 13.00 and the 20-day SMA was 14.41. The volatility index is indicating that the market anxiety has subsided which bodes well for S&P 500.
A contrarian sentiment indicator that helps determine major and short-term market tops and bottoms is the Put/Call Volume Ratio, which compares the total number of puts traded with total number of calls traded. The ratio was 0.920 on December 2 as compared to 0.970 by the end of October (Chart 2). A reading above 1.00 indicates that investors are turning bearish and a reading above 1.15 usually confirms a positive reversal.
The 10-day moving average gives a better indication of short-term bottom. The December 2 value is 0.945, which is lower than October-end value of 0.979.
This is an IBD proprietary indicator that helps in determining rebounds from immediate corrections during bull markets. It was at 2.00 on December 2 as compared to 1.083 at the end of October. A short-term bottom usually occurs when it turns up for the first time after crossing below 0.5. During bear market this threshold level drops to 0.1.
The NYSE New High / New Low ratio has trended down since July as it has been mostly making lower highs and lower lows with one higher high during in mid-September, which was followed by a lower low. December 2 reading was 1.2876 (Chart 3), which is the first higher high since September.
Another contrarian indicator is the year-over-year change in NYSE margin debt, which can help flag major tops in bull market. When optimism is high this will exceed 55%, which means that investors are borrowing heavily during the late stages of bull market.
At the end of October, i.e. the last available data, it was +2.6%, which means that the investors have increased their margin debt from the year-ago level (Figure 14). However, the margin debt is lower by -3.4% than it was in September.
Since 1970, December has been the best month for S&P 500, Russell 2000 (since 1987) and NYSE Composite Index (NYA). It has been the second best month for Dow Industrial Average (DJIA), Dow Jones Transportation Average (DJTA) and NASDAQ Composite (since 1973).
Its performance since 2000 is somewhat different. During this period, it is still the best month for Russell 2000 but not as good for other indices. It is the fifth best month for S&P 500 and DJIA. It ranks #7 for NASDAQ, #6 for DJTA and 3 for NYA.
The best winning percentage for the month is by Russell 2000. It has been positive 86% of times since 2000 and 75% since 1987 in December. S&P 500 and NYA have been positive 74% of times since 2000 and 69% fo times since 1970. DJIA and DJTA have been positive 70% of times since 2000 and 63% and 69% respectively since 1970. NASDAQ has not fared as well in December. It has been up only 56% since 2000 and 50% of times since 1973 in December.
December’s Triple Witching Week Favors S&P 500
December Triple Witching Week is more favorable to the S&P 500. The index has been up during the week 75% of times since 2000 with an average gain of +0.5%.
Santa Claus Rally
Stock Trader’s Almanac has popularized the Santa Claus Rally, which starts from fifth to the last trading day of December and ends on the second trading day in January. Since 2001, S&P 500 has been up 73% of times during this period with an average gain of +0.8%. This year the time period if from December 23 to January 3.
In November, the 30-year US. Treasury bonds, $USB (top panel Chart 4), kicked up the pace of its decline that started in early July. Equities, $SPX (second panel), on the other hand, got a fresh boost to their advance since February. So did the U.S. Dollar index, $USD (fourth panel). Commodities, $CRB (third panel), are still meandering along with an upward bias.
Rising dollar puts a downward pressure on commodities as they are priced in dollar. The dollar index has been generally moving up since April. During most of this period, commodities as represented by Reuters/Jefferies CRB Index, $CRB, have moved sideways. This means that the demand for them is increasing despite rising dollar. This will increase the prospects of inflation, which will put more downward pressure on bonds.
The 30-year US Treasury Bond price has fallen almost 15% from its July 2016 high. On weekly timeframe, the indicators are flashing oversold conditions (Chart 5). The 14-week RSI is at 29.82 and the MACD is deeply in negative territory. Prior such readings have usually resulted in a bounce. Last time RSI was below 30 was on September 2 2013, and the price rose from a low of 128.19 to 135.24. Price then dipped below 127 in December but RSI did not dip below 30, which created a divergence. The bounce from that confluence took the bond price to 166.07 by March 2015 before retracing again.
In normal market environment bonds and equities trend in the same direction. Also, in such an environment. bonds turn direction earlier than stocks. Bonds have been declining since July but the equities have been rising. How long this disconnect lasts is matter of time. One of these two have to reverse course for the relationship to get back to normal.
U.S. Dollar Index
The U.S. Dollar index has been trading within a range since early 2105 (Chart 6). At the beginning of that period the index was near 93.00. It was the time when the Fed-Fund rate hike prospects became more real. The actual rate hike took almost a year to materialize. By then the index had reached 100. Despite the rate hike the index did not break that level and retraced back to the lower limit near 93.
Now we are again at a point quite similar to that in December 2015. The index is near 100 and the Fed-Fund rate hike is around the corner. For the past three weeks the index has struggled to break above the resistance level. The week of November 21 formed a doji candle after the touching a high of 101.97. The week after that was a bearish engulfing and the current week is also shaping up to be a bearish engulfing.
A break below 99.00 will be critical for the dollar and could open up the path for a decline to 96.00. On the other side, a break above 102 will initiate a break out of a horizontal channel with targets near 110.
The dollar and commodities are inversely related. A rising dollar also favors U.S. bonds and stocks. The current chart pattern favors a retracement in dollar on purely technical basis.
Reuters/Jefferies CRB Index has been finding a support at its 39-week SMA since May 2016. It made a multi-year low in early January but its 14-week RSI did not make a fresh low, thus, creating a divergence (Chart 7).
From mid-2010 to late 2014, the index had formed a symmetric triangle. In November 2014, it broke below the pattern. The 2016 low was just above the measured target of that triangle pattern.
The confluence of these technical levels created an impetus for reversal and the index bounced off the low of 154.85 to 195.88 in Early June. Since then it has been forming a rounding arc pattern.
The right top of the arc is at the 89-week SMA, which is posing a resistance for the index. If the index breaks above 195.00 then it will complete the rounding pattern and the measured target would be near 235-to-250 level, which was the low reached in mid-2010.
Commodities to Bond Ratio
The slope of the commodity/bond ratio gives an indication regarding the direction for many asset classes.
A rising commodity/bond favors inflation stocks like precious metal, energy and basic material stocks. A falling commodity/bond ratio favors interest rate sensitive stock including consumer staples, drugs and utilities.
This ratio, $CRB/$USB (middle panel Chart 8), had been falling since July of 2015. During this period, gold, $GOLD (top panel), was drifting higher and consumer staples , XLP (bottom panel), was rising. The ratio turned direction in early 2016 and the direction of gold and consumer staples changed few months later.
Dow Theory Says All Clear
In January 2013, Dow Jones Transportation Average made new high, an all time high at the time. It’s industrial counterpart, Dow Jones Industrial Average made similar high in March 2013. From then till 2014, both indices were making newer highs with few weeks apart. The reaction following the high of late 2014 was more sever, and occurred earlier, for Transport than Industrial. Industrials continued to make newer highs till May 2015 before declining.
Following the reaction of 2015, Dow Jones Industrial Average reached a newer high in mid-2016 (Chart 9). But Transports lagged behind. Finally, in early December 2016, Transports made a new high (Chart 10), which, according to Dow Theory, confirmed the continuation of primary bull market.
Breaking Above Trading Range
In the past few week, major U.S. equity indices broke out of long-term chart patterns that give us good idea about their targets.
Dow Jones Industrial Average convincingly broke above a rectangle trading range that it was in for more than two years (Chart 9). The lower limit of the range is near 15400 and the upper limit is 18350, giving us a measured target near 21300, which is approximately 8% above current levels. A break below 17000 will nullify this target.
Dow Jones Transportation Average broke above a symmetrical triangle in summer (Chart 10). The high of the patterns is 9214.77 and low is 6403.31. The breakout point is near 8000, giving us measured target near 10800, which is 15% away..
S&P 500 also broke out of a rectangle trading range (Chart 11), which lasted nearly two years. Its upper limit is near 2130 and the lower limit near 1820, giving us a measured target near 2440 or about 9% higher (also see).
Like DJIA and S&P 500, NASDAQ Composite also broke above a rectangle trading range (Chart 12). The upper limit of the pattern is near 5230 and the lower limit near 4110, giving us a measured target near 6350 or nearly 17% from current levels.
Russell 200 broke out of a symmetrical triangle with a highpoint of 1296 and low point of 943.10 (Chart 13). The breakout point was 1250 and the measured target is near 1600, which is approximately 16% higher.
Transport The Best Index
Dow Jones Transportation Average is the best performing major U.S index for the past few months.
Dow Jones Industrial Average is outperforming the S&P 500 (top panel Chart 14), at least since September.
S&P 500 is outperforming NASDAQ Composite, albeit marginally, also since September (second panel). Whereas the Russell 2000 is significantly outperforming S&P 500 since September 2016 (third panel).
DJTA is outperforming DJIA (fourth panel) and Russell 2000 (bottom panel).
Over the past month, three S&P sectors – utilities (-2.89%), consumer staples (-1.85%) and heath-care (-0.43%) – had negative returns.
They, along with technology, also underperformed the broader index, S&P 500 (Chart 15), which gained +5.37% during this period.
The best performing sector was financials, which gained +17.52%, outperforming the index by 12.15%. Next best were industrials with +10.70 gain and energy with +9.71 gain.
Three sectors – consumer discretionary, industrials and technology – are making all time high in December 2016. Materials is advancing and is very near it’s all time high that it made in February 2016. Two sectors – consumer staples and utilities – made all time high in July and have sharply declined since. Healthcare made the all time high in August 2015. Its attempt to reach that again faltered in July and it is declining. Energy made all time high in June 2014 and then declined sharply till January. It is rallying since then. Financials made all time high if May 2007 and reached its nadir in March 2009. It is now at the highest point since February 2008
Developed Vs. Developing World
The global financial crisis of 2007-2008 did reset the world order in one way at least. Before the onset of the crisis, i.e. in 2005, the growth in per capita GDP of developing world (Non-OECD countries) was underperforming the developed world growth rate.
From 1990, the per capita GDP of the OECD countries (solid red line in the Figure 15) grew at a steeper rate than the non-OECD countries (green dash-&-dot line). The per capita GDP growth rate of U.S.A. (black dash line) was better than that of OECD countries. The World was doing slightly worse than OECD but better than non-OECD countries.
The growth in per capita GDP of the non-OECD counties overtook that of OECD countries in 2005 and the U.S.A. in 2006. Since 2009, the non-OECD growth rate is rising much more steeply than that of the OECD countries.
S&P 500 Out Performing Emerging and Developed World
Despite, higher growth rate of developing countries, S&P 500 is outperforming MSCI Emerging Markets Free Index (top pane Chart 15) since late 2010. At the beginning of 2016, the ratio of emerging market index with that of S&P 500 was turning around. However, that trend reversal hasn’t been established yet. This means that S&P 500 is still set to continue to do better than emerging market index.
The MSCI EAFE Index, which covers 21 developed markets in Europe, Australasia and Far East, has been underperforming the S&P 500 since early 2008 (bottom panel Chart 15). The trend is not showing any signs of reversing.
The U.S. equity market had been in trading range for many months till recently. S&P 500 was the first to break out of that range in July followed by DJIA and NASDAQ Composite. However, Russell 2000 and DJTA did not follow them. In summer, market retreated but the dynamics that were the motivating factors for the initial breakout did not subside.
The economy is growing, albeit sluggishly. The employment is high and the real disposable income is increasing. The corporate earnings and revenues are also improving. Seasonally, November and December are favorable months for the market when many market rallies start.
The improving economy has increased the chances for higher inflation. Fed is also inclined towards raising the Fed Fund rates, which indicates that they have more confidence in the economy.
The confluence of all these factors was catalyst enough for an upside break out of the technical patterns that were emerging over the past many weeks. In the fresh break out of prices in November and early December, Russell 2000 and DJTA joined the ranks of larger caps by making new all time high. These chart break out give us measured targets that are 9% to 17% higher.
The technical analysis is telling us that there is a higher probability that prices will reach these targets. Off course the market does not go up or down in a straight line. So there may be many retracement before prices reach these targets. This means that we do not how know long the market will take to reach these levels. However, unless some opposing chart patterns appear, these targets will stay relevant.
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