U.S. stock market on May 22, 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

Once again, the U.S. stock market’s long term bullish bias is at play. This is why it’s impossible to consistently catch the top of small rallies (although it’s much easier to catch the top of big rallies, which our model does).
Divergence
Since the beginning of 2017, large cap stocks (and particularly tech stocks) have vastly outperformed small cap stocks. The following chart shows that the Russell 2000 has been flat year-to-date while the Dow, S&P 500, and NASDAQ have all soared.

History shows that when the divergence between small cap (Russell) and large cap (Dow) exceeds 8% as it did in March 2017, the market falls more often than it rises over the next few months. More on this in a later post.
Interest rates vs oil
We have been speculating that oil and interest rates will go down together, which will propel the S&P 500 into a small correction (i.e. 6%+). Oil and interest rates have a modest positive correlation right now because oil prices impact inflation, which impacts interest rates.
But perhaps we are wrong. Here’s why.
We thought the next medium term movement in interest rates will be downwards. But the latest COT Report shows that hedge funds are extremely long bonds, which means that they’re betting on falling rates. Over the past year, hedge funds have been a great contrarian indicator in bonds. They were bullish on bonds and bearish on rates in 2016. Rates soared in late-2016. Then they turned bearish on bonds and bullish on rates in early-2017, just as interest rates topped. Here’s the COT chart.

So if hedge funds continue to be a good contrarian on bonds, does this mean that rates will rise? Perhaps. Bond King Jeff Gundlach certainly thinks that rates will go to 3% this year. But then again, that’s because he doesn’t think oil will remain below $50.
Oil on the other hand continues to face supply problems. The Saudi Energy Minister said today that he does not see opposition from OPEC’s member nations to an extension of OPEC’s oil cut. OPEC is scheduled to meet this Wednesday (May 25).
But even if OPEC does announce an extension of its oil cut, OPEC’s cheaters will become bolder. Many OPEC and non-OPEC members have failed to meet their production cut goals that were set out last November (e.g. Iraq, United Emirates, Russia). Who’s to say the cheating won’t worsen when they see that U.S. shale production is soaring?
Although we think that oil will fall, we don’t think it will crash. Perhaps oil will retest its flash-crash low on May 5 2017 of $43.76. Perhaps oil will hit support on $40. Who knows. U.S. shale’s average break-even price is around $37.5-$38. Historically, the break-even price has been a floor to oil, whose price usually bounces above this support.
Oil has already risen to our $51 minimum target ahead of Wednesday’s OPEC triggers. Any more gains past this point are a 50-50 bet. Some traders think that oil will rise to $52-$52.75. Who knows.
So we think that oil will fall in the medium term. But we don’t know if interest rates will fall.
The big question is, how do we reconcile rising interest rates with falling oil? We don’t know. There is still a modest positive correlation between the two. Perhaps the correlation will break. If so, only the energy sector will drag the S&P down. The finance sector will not drag the S&P down.
When confused by two diverging factors (e.g. oil and interest rates) , the best thing to do is to simplify.
We’re not good at using correlation to predict the S&P 500 because we don’t understand other markets that well. But we do understand the S&P very well. If we only look at the S&P 500, this is still one of the longest small rallies of all time. From purely a time perspective, a small correction should soon. Perhaps the S&P will continue to rise, but bullish investors face significant short-medium term risks.
*Our model still says that this is a big rally in a bull market (i.e. no significant correction)

Sectors

Energy
Just as we thought, the energy sector is the weakest of the S&P 500’s sectors. This is bearish. XLE (energy ETF) fell even though oil prices rallied today! You can see the divergence between XLE (first chart) and WTI oil (second chart). XLE’s bounce has been miserable while oil has bounced back significantly.


We still think that energy weakness will be the driver of the S&P’s next small correction.
Finance
The finance sector underperformed the S&P 500 today just like the energy sector. This is bearish because interest rates and oil went up today.
Here’s XLF’s chart (XLF is the finance ETF).

Here is the 10 year Treasury yield.

Information technology
Once again, the tech sector continues to be the leader of this bull market. This is not surprising and is not bearish. It’s normal. Tech’s strength is also the reason for large cap’s outperformance compared to small cap. (Big companies like Apple, Google etc are large cap).
Here is XLK’s chart (XLK is the tech ETF).

Bottom line

Who knows when the small correction will begin. But overall, nothing has changed.

  1. This is still one of the longest stock market rallies without a small correction in history.
  2. Our model does not foresee a significant correction or a bear market. Based on our discretionary outlook, we agree with our model.
  3. Oil is still a risk to the S&P 500.

Read our other posts:

  1. What happens to U.S. stocks after VIX soars 40%.
  2. The Economic Surprise Index does not say that stocks must fall now.

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