The U.S. economy has been growing for the past few years, albeit, at a slow rate. Many have attributed the sluggish growth to secular stagnation due to weak household demand, impact of structural changes on employment, weak private investment, political gridlock and global slowdown.
Some of these factors will last for many years and some may see up-and-down movement. Nevertheless, there is no danger, at least not in the near future, for the growth to reverse. The economic data is supportive of this outlook. We expect the economic trend to continue despite slowing down of some indicators. This means that the tail-wind will continue to lift the market. However, there is reasonable probability of a short pullback in near term.
Monetary and Economic
Inflationary pressures are becoming meaningful and inflation is nudging higher. This will help commodities and related sectors. Federal Reserve has increased its benchmark rate in December 2016. Majority of FOMC participants expect the rates to increased by 50 to 75 basis points or 2 to 3 rate hikes in 2017. In our opinion this will negatively impact the growth, and the stock markets later in the year.
Increasing Employment and Average Earnings
In the month of December the economy added 156K new jobs, the U.S Labor Department announced on Dec 6 2017. This means that the U.S. has added jobs every month for the past 75 months. Still, the number of jobs added in December is below market’s estimate of 175K and November’s reading of 204K.
For the past twelve months, U.S. added nearly 2.16 million new jobs. The 3-month average is 165K. However, the pace of jobs growth has slowed down (see Figure 1). The 3-months average has declined from the previous reading of 182K.
One bright spot in December’s Jobs report is that the average hourly earnings increased by +0.4% from previous month. This means that over the year the hourly earnings increased by 2.9%. However, the weekly average earnings increased by 2.3%, as the hours worked reduced to 34.3 from 34.5 a year ago. Since October 2014, both the annual earnings change and its three-month average is on an uptrend (see Figure 2). This has implications for the inflation.
Economy Still Expanding But Slowing Down
As we have noted in out past few commentaries, that although the economic expansion is continuing, it is slowing down. The recent data does not change that observation.
The annual increase in the real disposable personal income (dotted purple line in Figure 3). Has been declining since December 2014. The annual growth in total non-farm payrolls (sold red line in Figure 3) is perceptibly showing a downtrend since January 2015. The same is true for the retail and food services sales (solid green line in Figure 3).
The real per capita growth (dotted turquoise line in Figure 3) has ticked up over the last two quarters but it has been mostly declining after peaking in 2014 second quarter. The annual growth in industrial production (solid blue line in Figure 3) has been negative since September 2015 but it is improving beginning December 2015.
The figure uses monthly data except for per capita, which is quarterly. Also, the last reading for the per capita is 2016 Q3 and for payrolls is December 2016. All other are up-to-date till November 2016.
Expansion Expected To Continue
Few months before the onset of any recession in the U.S.A – at least since 1980 – the spread between the 10-Year Treasury Constant Maturity and the 2-Year Treasury Constant Maturity has fallen below zero (see Figure 4). The economy, on an average, took 15.6 months to dip into recession after the first reading of below zero of this indicator.
This ratio climbed above zero in June 2007 and has stayed above it since then. In February 2010, it reached the highest level of 2.83. It then fell to a low of 1.28 by July 2012, before rising again to 2.56 in December 2013. Then it mostly declined from January 2014 to August 2016. The ratio made a low of 0.82 in August 2016.
If the track-record of this indicator holds then there is no danger of a recession for at least 12-15 months. However, the economic data starts to deteriorates first and then the market picks up the clues.
Inflation Indicators Rising
The inflation indicators continue their rise (see Figure 5). The 5-Year, 5-Year Forward Inflation Expectation Rate (solid blue line), which measures the expected inflation (on average) over the five-year period that begins five years from today, has inched up to 1.98 as of November 2016, the last available data point.
The University of Michigan Inflation Expectation (red dotted line), a survey of consumers that measures the median expected price change over the next 12 months, is at 2.4%.
The annual rate of change of producer price index (solid brown line in the Figure 5) crossed over zero for the first time since October 2014. It has been rising since making a double bottom in September 2015. The 5-Year, 5-Year Forward Inflation Expectation Rate seems to follow the PPI with a lag.
Corporate America is doing quite well. Its 2016 third quarter performance had been good and better than last few quarters. The projections for fourth quarter of 2016 are encouraging. The earnings and revenue are also expected to grow.
The forward P/E ratio for S&P 500 companies is 17.1, which is above 10-year average of 14.4. The slope of EPS growth is still up (see Figure 6). The slope of S&P 500 trend was similar to that of EPS until first quarter of 2013. After that, the slope of index became steeper than that of the EPS. These call for a caution.
Quarter 3 2016 Performance Was Robust
According to Thomson Reuters, as of January 6 2017, the earnings of S&P 500 companies grew by 4.3% year-over-year in the third quarter of 2016 (see Figure 7) compared to contracting by -2.1% in the second quarter.
The best performing sector was technology (+11.5%) followed by Utilities (+10.9%), Industrials (+10.9%) and consumer discretionary (+8.6%). The worst performing sector was energy, which shrank by -67.5%. Telecom was the other sector that saw a shrinking year-over-year earnings. In second quarter, five sectors had negative earnings growth.
S&P 500 Companies’ Earnings Expected To Grow
For Q4 2016, the earnings growth of S&P 500 companies is estimated to be 3.0%, as of January 6, 2017. If this turns out to be the case than it will be the first time that earnings will grow year-over-year for two consecutive quarters since Q1 2015. However, the earnings estimate revisions are to the down-side. On December 26 the estimates were for 3.2% increase, which on per-share basis, is lower by 2.2% from the estimates on September 30. This is, still, better than 5-year average of -4.3% and 10-year average of -5.6% decline.
Utilities sector is expected to lead with earnings growth followed by materials and financials. The laggards are expected to be telecom, industrials and energy (see Figure 8).
The estimated revenue growth for Q4 of 2016 is 4.8% (FactSet). If that happens then it will also be first time that year-over-year revenues grew for two consecutive quarters since Q4 2014. For the year 2017, the earnings are forecasted to grow at 11.5% and revenue by 5.9%.
In the most recent survey, on January 11 2017, 43.6% of American Association of Individual Investors (AAII) member are bullish. A week before that 46.2% member were bullish, which was the highest reading since November 24 reading of 49.89.
The survey indicates that 27.0% of member were bullish and 2.4% were neutral, gaining +1.7% and +0.8% from previous week respectively. In mid-July 2007, when the S&P 500 made a new high, the bullish percentage was 43.6% and the bearish percentage was 26.36%. In early October 2007, when the S&P 500 a double top, the bullish and bearish percentages were 54.6% and 19.6% respectively.
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 9). Also, the spread between bullish and bearish percentages gives a hint for future direction of the S&P 500. These do not indicate any weakening of price in the near future.
Business and Consumer Sentiment
The University of Michigan Consumer Sentiment recorded a reading of 93.8 in December 2016. It was unchanged from November. The index has mostly trended up in the fourth quarter of 2016. Since July 2015, it has stayed with 92-789 range.
The conference Board Consumer Confidence Index rose to 113.7 in December from 109.4 in November. It has been rising since April 2016 after moving sideways from October 2015 to Mar 2016.
The NFIB Small Business Confidence Sentiment index jumped to 105.8 in December from 98.4 in November. It has turned up in April 2016 after a down trend that started in December 2014.
A composite index of these three sentiment survey has good correlation with S&P 500 (see Figure 10). However, this is not a leading indicator.
CBOE Market Volatility
Market volatility has been reduced since November. The average daily change in $VIX, the CBOE Market Volatility Index, has been -0.1% since December 1. During this period, the S&P 500 saw an average daily change of +0.1% and an average daily range of 0.9%. The corresponding numbers for Dow Jones Industrial Average are +0.2% and 0.9%. NASDAQ Composite’s averages are +0.1% and 1.0%.
On January 17, the $VIX closed ate 11.87. Since November 10, it has stayed within a high of 14.72 and a low of 10.93 (Chart 1). The extended period of low reading of $VIX bodes well for the market.
The Put-Call Ratio, which compares the total number of puts traded with total number of calls traded on CBOE was 0.980 on January 13. The ratio is higher than December 2 reading of 0.920.
More call options than put option mean that the market is bullish (See Chart 2). However, a rising ratio means the bearish bets are increasing. Usually a reading above 1.15 hints for a near-term reversal in price.
The 10-day simple moving average is 0.970. Both , the ratio and its 10-day moving average, are rising since mid-December 2016..
The IBD proprietary High/Low Ratio was 2.00 on January 17. It has remained unchanged since late November 2016. During correct or falling market this ratio falls toward zero. A bottom in the market occurs when the indicator turns up after falling below 0.5.
The NYSE New High / New Low ratio (see Chart 3) has been on an uptrend since early November. It made a high of 32.54 in early December before declining to 1.01 by the middle of the month. In January it failed in its attempt to rise above December, which calls for a caution.
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 November, i.e. the last available data, the total NYSE outstanding margin credit was $500 billion. This 5.9% higher than November 2015 (see Figure 14).
January is the best performing month for the NASDAQ Composite since 1973 with 2.5% average monthly gain (see Figure 12). It is the fifth best month for S&P 500, Dow Jones Industrial Average and NYSE Composite Index since 1970. For Dow Transportation Average and Russell 2000 it comes sixth and seventh since 1970 and 1988 respectively.
The major U.S. indices haven’t fared as well in January since 2000. During this period, the month of January has ranked in the last three places for major U.S indices in terms of average return. For the last three consecutive January, U.S. market was negative.
The worst performer in January since 2000 has been Dow Jones Industrial Average with -1.6% average return. However, Russell 2000 has the worst percentage of wins. It had been positive only 35% of times since 2000.
Devised and popularized by Yale Hirsch, founder of Stock Traders Almanac, the January Barometer (JB) says that as the S&P 500 performs in January so des the rest of the year. Since 1970 it has 72% accuracy.
It acts as a better predictor when S&P 50 is positive during January. When January had been positive, he year was positive 89% of times from 1970 and 71% of times since 2000 (see Figure 14).
The average return for the rest of had been +7.3% since 1970 and +5.5% since 2000 (see Figure 15). If January was positive then the return for rest of year was 11.1% and 4.8% since 1970 and 2000 respectively.
Stock Traders Almanac also uses two other indicators. We covered one of them, Santa Claus Rally (SCR), in our last newsletter. The second one is First Five Days (FFD) of the year, which it calls early warning system.
If the SCR and FFD were positive for the year, which is the case this year, then January was positive 79% of times since 19760 and 57% since 2000. Also, when both SCR and FFD were positive, then the year was positive 65% and 64% of times since 1970 and 2000 respectively. The average gains from Feb was 9.7% and 12.0% respectively.
Trifecta effect, when SCR, FFD and JB were positive, is more bullish. In that case the year was positive 93% and 80% of times since 1970 and 2000 respectively. The average gains from Feb were 11.4% and .6% respectively.
Financial markets – bond, stock, commodity and currency – are linked in some way, domestically and internationally. They don’t move in isolation and understanding of one gives clues about others. Business cycles capture the expansion and contraction of economic activities, which provides an economic framework to understand the linkages between financial markets.
Near the end of an economic expansion, bonds usually turn down before stocks and commodities. During the early stages of recession, bonds turn up before stocks and commodities. Commodities are generally the last to change direction. In the early stages of the expansion, financial assets – stocks and bonds – are preferred. In the late stages commodities do better (for more on this see John Murphy’s book Intermarket Analysis).
Since the beginning of July 2016, bonds as depicted by $USB, 30-year US Treasury Bond price, have been declining (first panel of Chart 4). Equities, depicted by $SPX, S&P 500, are moving higher after making a low n the February 2016 (second panel of Chart 4). Commodities, depicted by $CRB, Reuters/Jefferies CRB Index, turned around at the start of 2016. Since July they are essentially moving sideways (third panel of Chart 4). U.S. dollar, $USD, turned up in April (fourth panel of Chart 4). Since commodities are priced in U.S. dollar strengthening dollar puts downward pressure on commodities prices, which is a major reason that $CRB is essentially moving sideways since July.
The bonds are in a downtrend so the big question now is whether the stocks and commodities will follow them or will bonds turn around rise.
Bonds & Yields
The US 30-year Treasure Bonds, ZB #F, peaked at 177.11 in the first week of July 2016. By the second week of December 2016 it had declined by -16.9% to 147.04 (see Chart 5). This was equal to 61.8% Fibonacci retracement of the rally from a low of 127.23 in December 2013.
At its low point in December, the 14-week RSI dropped to 26.01, the lowest level since May 2006. The bond price is below the downtrend line ‘A1’ in Chart 5. The RSI was bounded by ‘A2’ till the end of December. The RSI broke above its downtrend line in early January. It is usually, but not always, a precursor to price breaking above its downtrend line. In prior reversal, i.e. price turning higher after significant decline, it had generally made a double bottom with a positive RSI divergence. In 2006-07, the double bottom was spread over a one year period. The gap was four months in 2013.
The 30-year U.S. Treasury Yield, which is inverse of bonds, has been rising after making all time low of 2.102% in July 2016. Now it is approaching June 2015 high of 3.255%, line UB1 in Chart 6, which is also at 61.8% Fibonacci retracement level of the decline from December 2013 high to July 2016 low. The 14-week RSI is at the highest level, in over-bought region, since March 2006.
Yield broke above the downtrend line, DL1 in Chart 6, in early November. The downtrend line on 14-week RSI, DL2, was broken to the upside in early September nearly eight week ago.
In late December, 14-week RSI broke below the uptrend line UL2 in Chart 6. The yield is quite extended from its uptrend line, UL1, but has been falling since id-December.
Price action of bonds and yields is indicating conflicting pressures. The recent history indicates that the yields are either at a near term top or nearing it.
The U.S. Dollar Index, DX #F, broke out of a 2-year long horizontal trading range in November (see Chart 7).
The break out found the resistance at 103.815, high in early January 2017, which is near the 61.8% Fibonacci retracement level of the decline from July 2001 high of 121.29 to April 2008 low of 71.05.
The high of January is also near the 100% extension of symmetrical triangle that the index broke out of in September 2016.
The current momentum is to the downside. The next meaningful support is between 99.090 and 99.490. On January 20, the index closed at 100.690.
Euro has the largest weight in the index and it is flashing a reversal too. In early January EUR/USD reached the lowest level since 2002 (see Chart 8). It also breached briefly the 2015 low of 1.04590. It is bouncing off the lows. The resistance above is at 1.12996, which is 5.6% away from the close on January 20 of 1.06994.
Commodities bottomed in early 2016 and are on an uptrend since then. The Goldman Sachs Commodity Index, $GSC, has been forming an inverse Head-&-Shoulder pattern (see Chart 9). Since December it has been trying to break above the neck line.
The target for the pattern is near 503.83 or nearly 26% above its January 20 close of 399.41.
The Goldman Sachs Commodity Index is made up of 24 commodity components weighted based upon the average dollar value of their production over the trailing five year period.
Energy dominates the index with 75% weight. Hence it is not surprising that the West Texas Light Crude Oil, Cl #F, is also making a similar inverse Head-&-Shoulder pattern (see Chart 10). It target is near 75.79 or nearly 44% away from its January 20 close of 52.42.
Copper, HG #F, broke out of an up sloping triangle at low levels at the end of October 2016 (see Chart 11). It reached the 161.8% Fibonacci extension of pattern height in November. Since then it has formed a horizontal channel. A break above his channel will have a target near 3.000. The 261.8% extension of the triangle is near 3.20.
The S&P 500 has been trading in a narrow range since December 12 2016. On daily timeframe it is forming a broadening pattern, which looks like a sideways move on weekly timeframe. The 14-week RSI has risen to a downtrend line, DL1 in Chart 12, which the indicator has not crossed above since November 25. Two prior touches to line DL1 has resulted in price pulling back a little.
The S&P 500 first broke above a horizontal trading range in early July 2016 (see Chart 12). It then fell back in the range before breaking above again in early November. The last pullback into the trading range formed the Wave 4 of a secondary Elliot Wave within the primary Elliott Wave emerging since 2009.
The Wave 1 of this secondary Elliott Wave was from February 2016 low of 1810.10 to April high of 2111.05 or 300.95 points. The Wave 3 was from June low of 1991.68 to August high of 2193.81 or 202.13 points. Since making Wave 4 low at 2083.79, the index has risen to 2282.10 or 198.31 points. In an Elliott Wave the Wave 3 in a Motive wave is never the shortest.
Our assessment based upon price action, RSI and Elliot Wave rules is that we are at the end of Wave 5 and the S&P 500 is ripe for a pullback. The next Corrective Wave or the pullback is expected to be a short one as the index has not reached the targets of prior chart patterns.
On Daily time-frame the S&P 500 is forming a broadening pattern, which is like an inverted triangle (see Chart 13).
A broadening pattern is a topping formation. It is made up of five distinct minor reversals, each going farther than the last one.
The emerging broadening pattern has one weakness. The third touch point is farther than the first touch point on close basis but not on intra-day high. Nevertheless it has real significance that will come into play if the price falls below 2233.62, the low of the fourth touch point, before rising above 2282.10, the high of the fifth touch point.
Global Economic Outlook
The International Monetary Fund estimates the annualized global output growth rate to be 3.0% for the third quarter of 2016. For 2016, the growth rate is expected to be 3.1% (see Table 2).
The Fund views the global economic activities in 2016 as lackluster but expects a pickup in 2017. It says that the outlook for advanced economies has improved for 2017-2018, citing stronger activities in the second half of 2016 and the projected fiscal stimulus in the U.S.
It also says that the growth prospects for emerging economies have worsened, mainly due to tightening financial conditions. China’s near-term growth prospects have improved, due to policy stimulus, but worsened for India, Brazil and Mexico.
The IMF expects less gradual normalization of monetary policy by Fed due to the steepening of U.S. yield curve, the rise in equity prices, and the strengthening of the U.S. dollar. It views the balance of the risk to the down-side with some upside risk to near-term growth. Factors that may impact upside risks mainly include expected policy stimulus in the U.S and China. Factors that may influence downside risks include a possible shift toward protectionist policies, sharper than expected global financial tightening, increased geopolitical tensions, and a more sever slowdown in China.
The global growth is estimated to be 3.4% in 2017 and 3.6% in 2018 (see Table 2). The emerging market are still going to out-perform the advanced economies. Within the developed economies, the U.S. has the highest expected growth rate followed by Spain and Canada.
As a group, emerging Asia is estimated to grow by 6.4% and 6,3% in 20017 and 2018 respectively. The growth rate for ASEAN countries is 4.9% and 5.2% respectively. India is estimated to grow by 7.2% and 7.7%, China by 6.5% and 6.0%, Mexico by 1.7% and 2.0% respectively in 2017 and 2018.