U.S. stock market on June 1, 2017: thoughts and outlook


*These are our short term thoughts on the market. We combine our medium-long term model and discretionary outlook when making investment decisions. We’re looking at how the market reacts to news, earnings, and other fundamental themes related to the key individual sectors.

Stock index & news

We mentioned this morning that bearish investors like us have a problem. The finance and energy sectors have gone from being bearish factors for the S&P 500 to being bullish factors. With that being said, the S&P soared to new all time highs today.
This is normal. Big rallies within bull markets (as predicted by our model) have a bullish bias. The market doesn’t need any news/reason to go up. The U.S. economy is improving, U.S. corporate earnings are growing, and our model is bullish.
Why interest rates HAVE TO go up
When the yield curve becomes inverted, it is a great indication that the stoc market is about to enter into a significant correction or bear market.
A lot of hedge funds use the 30 year Treasury – 5 year Treasury or the 10 year Treasury – 2 year Treasury. We use the 10 year Treasury –  3 month Treasury Bill rate on the secondary market.
This is a perfect indicator, but it is not a part of our model. This indicator has never failed before: it has called every bull market’s top, has predicted every recession in the last 67 years, and has never had a false positive.
*We’ll explain this indicator in detail  in a later post.
We don’t use this indicator in our model because sometimes the signal comes out too early. For example, the yield curve inverted in August 2006, more than a year before the bull market topped in October 2007. Our model can do better.
Right now, the 10 year stands at 2.2% and the 3 month Treasury Bill stands at 0.92%. The Fed has 2 more rate hikes this year. Our model does not foresee a bear market for at least 1-2 years. For our model and the yield curve to match up, long term rates have to rise. (I.e. rates cannot become inverted.)
We’d like to point out 3 things today:
Comey
Comey is set to testify next Thursday. Notice how the market doesn’t care about Trump-Russia news at all. It’s an irrelevant factor.
“Weak” breadth
Recently we’ve been talking about the S&P’s weak breadth. This scares a lot of investors. Contrary to conventional wisdom, we’ve been saying that “weak” breadth is not a bearish factor at all. It is irrelevant.

  1. Over the past 2 decades, less than 5% of U.S. stocks have accounted for more than 2/3 of the S&P 500’s total gains.
  2. Over the past 2 decades, a lot of small corrections and significant corrections began when breadth was very strong (i.e. more than 80% of stocks in an uptrend). “Strong” breadth isn’t necessarily a bullish factor.

Long term yields
The Fed will conclude its meeting on June 14. The Fed is expected to hike rates and also outline a plan for how it will shrink its balance sheet.
Rates are going up in the medium-long term.

  1. Smart money hedgers from the COT report are extremely bullish on rates. The COT report is used to the medium term time frame.
  2. The Fed will begin to shrink its balance sheet in late-2017. To accomplish this, the Fed will not be selling long term bonds. Instead, it will not be reinvesting the proceeds from the bonds that it holds. Selling bonds is increasing the supply for bonds. Not reinvesting in bonds is decreasing the demand for bonds. Either way, this is a bearish factor for bond prices and bullish factor for rates in the long term.

Bottom line

We’re sitting on 100% cash and waiting to buy on the next 6%+ small correction. Here’s why.
The optimal (and more risky) decision according to our model is to be 100% long stocks right now.

Sectors

Energy
Over the past few months, the energy sector had been underperforming oil significantly. We are seeing the first signs of a change today. The energy sector went up with the S&P despite falling oil prices.
First chart is XLE (energy sector ETF).

Second chart is WTI oil.

Finance
As we expected, the finance sector outperformed the S&P today because interest rates went up. Interest rates don’t have much more room to fall in the medium term.
First chart is XLF

Second chart is the U.S. 10 year yield

Tech
The tech sector underperformed the S&P today. This is normal for “big rallies” within bull markets. It’s sector rotation.

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