U.S. stock market on May 9, 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

Like the past few days, there were divergences in the broad S&P 500 index today. This caused the S&P to close almost flat today.
Some bearish investors state that the U.S. economic data is weakening. This is true only for the unimportant data (e.g. economic confidence indicator). The important economic indicators (e.g. retail sales, new home sales, employment report) all show that the U.S. economy is growing decently. No worries on this front.
There was no important news today that drove the markets today.

Sector breakdown

As we expected in the stock market summary for May 8, oil’s recent bounce would not last long. After a 2 day bounce, oil is going down again.
The media and other investors attribute oil’s bearish outlook to 2 factors:

  1. A slight slowdown in China’s economy.
  2. Increased oil production and supply from the U.S. Shale is coming back online.

Whether this is true or not we don’t know. We don’t trade oil. However, we think that the first factor is false while the second factor is true. In the short-medium term, supply has a much bigger impact than demand on crude oil prices. As variable shale production costs come down, U.S. producers are pumping a record amount of crude.
We still believe that if WTI oil prices remain below $50, then the energy sector’s profits will take a hit because the year-over-year change in oil prices will be negative. History shows that when the energy sector’s profits fall too much and XLE (energy sector ETF) falls too much, a small-big correction for the S&P will follow. Since our model does not see a big correction down the road, then a small correction is more likely this time.
Tomorrow we will have a post demonstrating the historical correlation between XLE declines and S&P declines.
As is normal, the weakness today in energy spilt over to the Utilities sector and the Basic Materials sector. Both of these sectors are filled with commodities-related companies.
As we’ve said before, the financial sector is tied with oil right now. Normally the financial sector is correlated with interest rates because net interest rate spreads determine banks’ profits. However, the finance sector went down a little today despite rising interest rates. (XLF down 0.2% while 10 year Treasury yield up 1.3%). This is because oil prices are falling.
Yes, perhaps bond king Jeff Gundlach is right in saying that yields will rise in the short term. That is merely a technical bounce. However, the financial sector in the medium term is driven by oil prices right now. A falling year-over-year change in oil prices will drive inflation lower, which will put downwards pressure on interest rates in the medium term. Thus banks’ earnings growth will decline. That will push pressure on bank stocks and XLF.
Here is a chart of the 10 year Treasury yield (top) vs XLF (bottom). As you can see, the yield is clearly outperforming XLF.

Both the 10 year Treasury yield and XLF have retraced 50% of their March-April 2017 decline.

Information technology

Tech stocks continue to rise. This is to be expected. Although tech companies are overvalued, their earnings are growing solidly. The good thing about tech sector earnings is that it isn’t dependent on an uncontrollable factor like the price of oil. The tech sector tends outperform the broad S&P until

  1. A significant correction occurs
  2. A bear market begins

Our model states that the S&P 500 is still in a rally within a bull market.

Bottom line

We maintain our short-medium term outlook. The S&P will probably make a small correction before this summer is over. It will be driven by lower oil prices.
We remain 100% long UPRO (3x ETF for the S&P 500). We invest purely based on our model, and our model focuses on big rallies and big corrections. We ignore small corrections.

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