U.S. stock market on June 8, 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.
Go to our homepage for our latest market outlook.

Stock index & news

A few things to note today.

  1. Comey’s testimony.
  2. The financial sector sector will probably outperform the S&P 500.
  3. Medium-long term: the market isn’t “climbing a wall of worries”.

Comey.
Comey’s testimony did not reveal anything substantial about Trump. Perhaps substantial evidence will emerge eventually, but we don’t have enough now.
Please ignore our opinion on politics. That’s not important. What’s important is the market’s reaction to today’s testimony. Like us, the U.S. stock market was unimpressed by the testimony.
Here’s what happens to the S&P 500 historically when the President becomes impeached. We don’t think Trump will be impeached, but he probably played some gray areas.
Why is finance leading?
Over the past few months, the financial sector has been the 2nd weakest of the S&P 500’s 11 sectors (energy was the weakest). This is because interest rates have been going down. Rates impact banks’ profit margins. Rising interest rates = expanding profit margins.
Here’s the 10 year Treasury yield.

Here’s XLF (finance ETF).

The following chart demonstrates the significant positive correlation between interest rates and finance. Here’s the 20 day rolling correlation between TLT (10 year bond) and XLF. The negative correlation between TLT and XLF = a positive correlation between rates and XLF.

We think that the financial sector will go up over the short-medium term (i.e. 1 week – 1 month) because rates will go up. Here’s why we think rates will go up:

  1. In the COT report, commercial hedgers are extremely bullish on rates (bearish on bonds) while speculators are extremely bearish on rates (bullish on bonds). Over the past 1.5 years, hedgers have been consistently right and speculators have been consistently wrong. If this pattern holds up, then the hedgers should be right again. Rates should rise.
  2. There is a strong positive correlation between the U.S. dollar and interest rates right now. The U.S. dollar is oversold and will probably make a technical bounce. If this correlation still holds, then the U.S. dollar and rates should rise together in the short-medium term.

Here’s the COT hedgers position on 10 year Treasury bonds. Bearish on bonds = bullish on rates.
Here’s the correlation between TLT and UUP (10 year bond ETF and USD Index ETF). The negative correlation = a positive correlation between rates and the U.S. dollar index.

The following chart overlaps the USD Index and its weekly RSI. Notice how the weekly RSI is low. (Weekly RSI is more important than daily RSI.)

The Euro is going down (and USD is going up) partially because the ECB is more dovish than expected. Earlier this year, investors expected that the ECB would start to hike rates in mid-2017. The ECB completely squashed those expectations today.
If the USD and rates go up in the next 1-4 weeks, then the finance sector will go up. The finance sector will go from lagging the S&P 500 to leading the S&P 500.
The market isn’t “climbing a wall of worries”.
Let’s ignore the short term for a second and focus on the medium-long term. Some big-name hedge fund managers have recently said “Be careful. The market is climbing a wall of worries. Valuations are too rich.” We think they’re wrong on all accounts.
Yes, valuations are “rich”. But historically speaking, valuation has not been a good timing indicator for bull market tops. For example, the average P/E ratio since 1996 is much higher than the average P/E ratio before 1996. Here’s a chart from GMO.

Anyone who trades or invests solely based on valuation will miss out on massive bull market rallies.
The U.S. economy isn’t a worry. In fact, the U.S. economy’s growth is the sole reason why this bull market isn’t over. See our post on the current state of the economy. According to our model, this bull market still has at least 1-2 years.
Some people are concerned that GDP growth is low compared to historical economic expansions. There is a simple reason why we will not experience the same levels of GDP growth as we did during the 1980s and 1990s.

Look at demographics. The labor force participation rate soared in the 1980s and 1990s and more women joined the workforce. Hence, aggregate GDP growth was higher. Today, the participation rate is falling. Hence, aggregate GDP growth is lower.

Demographics play a big role in the GDP growth rate. We ignore GDP because it’s not a good indicator. It is plagued by seasonality problems, is very noisy, and suffers from massive revisions.
The Trump-Russia investigation is not a worry unless the investigation widens and substantial evidence against Trump emerges. The special prosecutor on the Trump-Russia case will not comment on the ongoing investigation. It is not standard practice to comment on ongoing investigations because the prosecutor doesn’t want the public to misconstrue an incomplete investigation. Details will emerge a few months later (i.e. fall-winter 2017).
The stock market is going up because the economy is improving. The economy is improving with or without Trump’s infrastructure and tax policies.

Bottom line

We’ve been getting a lot of questions about our investment/trading strategy. Let’s clarify.

  1. We have a medium-long term model. This model is purely quantitative. It predicts bear markets and significant corrections. When the model doesn’t foresee a bear market or a significant correction, the market is in a “big rally within a bull market”. Over the super-long term (i.e. 30-40 years) the stock market has a natural bullish bias.
  2. The optimal decision is to follow the model to the letter and be 100% long UPRO (3x S&P 500 ETF) when it’s a “big rally within a bull market”.
  3. We go against the optimal decision and adjust our position size within the “big rallies”. By adjusting our position size, we’re reducing our performance but also reducing our portfolio’s volatility.
  4. Big rallies are broken down into “small rallies” and “small corrections”. Small corrections are 6%+ corrections. “Small rallies” are everything outside of “small corrections”.
  5. We adjust our position size based on how long the current “small rally” has lasted.
  6. We created a distribution curve for how long all of history’s “small rallies” lasted. As the current small rally ages, we slowly shift into cash.
  7. Our short term discretionary outlook only impacts the speed at which we shift into cash.

As you can see, our short term discretionary outlook isn’t that important. We don’t really use it to trade. So please take our thoughts with a grain of salt. We’re much more quantitative than discretionary. We’ve tried many approaches and realized that a quantitative approach works best in the U.S. stock market.
Right now:

  1. Our model says that this is a big rally in a bull market. Click here to find out our model’s EXACT value today.
  2. We’re still sitting on 100% cash. Here’s why.
  3. We’re waiting for the next 6%+ small correction.

Sectors

Many sectors diverged significantly today. Half of the sectors were up more than 0.5% while the other half were down more than 0.5%.
We don’t think this divergence means anything. We’ll look into it if it persists.
 

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