U.S. stock market on May 8, 2017

*These are our short term thoughts on the market. We invest purely based on our medium-long term model. We’re looking at how the market is reacts to news, earnings, and other fundamental themes related to the key individual sectors.

Stock index

The S&P 500 gapped up on April 24, 2017 following the first round of the French election. We expected that the S&P would not rise again on May 7’s second round of the French election. It turns out we were right. The market had already priced in a Macron victory.

  1. The S&P 500 fell a little on Macron’s victory today.
  2. The Euro fell a little too. We expected this in “Will the Euro fall during the next few months?

The S&P not rising on Macron’s victory is not a guaranteed bearish factor. But it certainly isn’t a bullish factor.
In addition, VIX (volatility index) got crushed today and fell below 10. This is not a short term bearish factor for the U.S. stock market (see our post here). Yes, eventually VIX will spike and the S&P will fall. But the S&P can rally for months after VIX falls to 9-10.
Warren Buffett (on CNBC) acknowledged 2 points that we have mentioned before:

  1. The U.S. economy is growing nicely, so the U.S. stock market is still in a bull market.
  2. However, the renewed weakness in the energy sector will hurt the S&P 500 in the short-medium term.

As we’ve mentioned before, the year-over-year change in oil prices has a big impact on energy sector earnings (and hence XLE, the energy sector ETF). If oil remains at $45, oil will be down $5 year-over-year.

Sector breakdown

The energy sector rose today because oil prices rose. There’s nothing unexpected about this.
We maintain our view that if WTI oil prices remain at $45, then the energy sector’s earnings will come under pressure. This will be bearish for the energy sector.
History shows that a falling XLE will only push the S&P down after XLE (energy sector ETF) has fallen a lot. A small XLE decline is not enough to push the S&P down. XLE has fallen significantly since December 2016, so if XLE falls a little more, the S&P 500 will probably make a small correction.
XLE’s bounce over the past 2 days is perfectly normally. It is still trending downwards in a tight channel.

*We need to clarify something from our Market Wrap Up on May 5. We said that the year-over-year change in interest rates impacts banks’ profits. This isn’t entirely true. What matters for banks’ profits is their net interest rate spread. This spread is the difference between what a bank pays on deposits and what it gets on loans. The interest rates that banks pay on deposits tend to move more slowly than the interest rates that banks lend at. That’s why the financial sector ETF XLF tends to follow the interest rates that banks lend at. The 10 year Treasury yield is a pretty good indication for where U.S. rates are headed.
As you can see, there is now a long term upwards bias for global interest rates.

  1. After Macron’s victory, one would expect the 10 year French bond yield to go down (no more political uncertainty in France). The yield went down a little initially and is now back up.
  2. The 10 year Treasury yield is up again, mirroring the French yield.

The upwards bias for rates comes from 2 reasons:

  1. The U.S. economy continues to grow.
  2. The Federal Reserve will maintain its rate hike path. In addition, it will start to sell trillions of dollars worth of bonds in late-2017.

We mentioned before that continued weakness in oil prices will cause the inflation rate to fall a little. That will temporarily dampen earnings in the financial sector. This will put temporary pressure on financial stocks but should not be a long term concern. With or without rising energy prices, interest rates are going up in the long term. There will be hiccups along the way, but rates are going up.
In addition, XLF’s price action today is bearish. Despite rising interest rates and rising oil prices, XLF fell a little today.

Information technology

As we expected, tech stocks continue to rise after a very strong earnings season for this sector. There’s nothing bears can do about it. Tech companies like Amazon are eating everyone’s lunch.
Yes, it’s true that many tech companies are insanely overvalued. But overvaluation is not a problem until the bull market is over. Our model states that this bull market is not over.
In conclusion, the tech sector is not a short-medium term bearish factor for the S&P 500. Yes, XLK’s daily RSI is high. But it can get much higher before it falls. (XLK is the tech sector ETF).

A lot of retail sector companies are releasing their earnings reports within the next 3 weeks. The earnings will probably continue to be “bad”, just as they have been over the past few quarters. This should not worry investors. Retail weakness will not have a meaningful impact on the S&P 500. Investors forget that the retail sector had a lot of problems even during great years! In 1995, K-Mart and a lot of other retailers that are no longer around closed hundreds of stores.

Bottom line

Who knows if the S&P will make a marginal new all-time high in the next few days. But we are sticking to our short term outlook.

  1. The S&P 500 will probably make a small correction soon.
  2. If we get a correction from late-May to early-July, Q2 earnings season in late-July will be a perfect boost for the S&P. The U.S. stock market doesn’t always go up on earnings season. But when it falls before earnings season, the odds of it rising on earnings season are much higher.

The short term weakness in the energy sector and finance both rest on oil’s shoulders. If oil remains at $45 or goes lower, the energy and finance sectors will take a hit.

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