The S&P 500 (SPY) scared investors last week as it breached key levels and earnings from some bellwether companies were weak, most notably IBM (IBM) and General Electric (GE). On the positive side, consumer staples continue to lead the S&P 500 and the big banks generated good enough Q1 results. Every week I analyze the four drivers of the S&P 500's summer slump last year: jobs, Federal Reserve policy, Europe and S&P 500 earnings. The bigger picture is not bearish. The S&P 500 may need to pause after a strong Q1 rally, but instead of a big risk-off move like last year we may see more of a stock-pickers market with pockets of strength and weakness. In this article I will look at the performance of the S&P 500 and each of the indicators. I am still cautious, but on the bullish side.
S&P 500 Performance
The S&P 500 broke through a key trendline that I have been watching for a few months. It also breached the 50 day moving average for the first time in 2013, but closed above it.
The bullish explanation for the price action is that the S&P 500 was overdue for a pause after the Q1 rally. In fact, the S&P 500 has been trading sideways since early March. The pullback has not (yet) been deep and dip buyers came in at the end of the week. The S&P 500 was at record highs only a few days ago and investors should expect some turbulence as the S&P 500 moves past the highs of 2000 and 2007. Despite the drop last week, the overall trend is still up.
The bears would say that the S&P 500 is due for a pullback or correction. Now that the trendline has been breached, investors should expect more volatility and another move to the downside. The S&P 500 had momentum that pushed it up to new highs, but the current level is not sustainable with a high multiple relative to the last few years and low earnings growth.
Summer Slump Indicators
The following is a summary of how I view the indicators discussed below. If a box is left blank that means that there was not enough "new news."
This is just my view. I am interested in hearing other opinions, so please feel free to give feedback in the comments section below.
The monthly nonfarm payroll report is the key number for the job market and we need to wait for the April update. As a reminder, here is the latest data:
Last week's jobless claims showed a bit of incremental weakness in the jobs market, but the number is volatile so I don't attach too much importance to it:
In the week ending April 13, the advance figure for seasonally adjusted initial claims was 352,000, an increase of 4,000 from the previous week's revised figure of 348,000. The 4-week moving average was 361,250, an increase of 2,750 from the previous week's revised average of 358,500. (Source: US Deaprtment of Labor)
I expect the Federal Reserve to proceed with its $85 billion of monthly bond purchases until the end of Ben Bernanke's term as Fed chairman in January 2014. Furthermore, I expect the Fed's balance sheet to rise to approximately $4 trillion, up from $3.2 trillion today.
Although there has been talk about the Fed "tapering" down its monthly bond purchases sooner rather than later, the weak March jobs report probably pushed back the timeline for any change to the current policy.
Additionally, some members of the FOMC recently expressed concerns that inflation may be too low, which would warrant more, or longer, quantitative easing (QE). Bloomberg reported:
"Three regional Federal Reserve bank presidents said a further decline in U.S. inflation below the Fed's 2 percent goal may signal a need for more accommodation. "If inflation looked like it was going to sag further on a persistent basis, I would certainly consider stimulus for the purpose of bringing inflation up to target," Richmond Fed President Jeffrey Lacker said today, adding he doesn't see an imminent disinflation risk. Minneapolis Fed President Narayana Kocherlakota today called for guarding the inflation target "from below," while James Bullard of St. Louis said yesterday, "we should defend the inflation target from the low side."" (Source: Bloomberg)
The big story from last week was the drop in the price of gold (GLD) which coincided with (or was the driver of) a broad based drop in commodity prices. The weakness in industrial metals, especially copper (JJC), and oil is putting downward pressure on inflation.
The Fed is predominately focused on wage inflation, not inflation in commodity markets. However, the drop in oil and gasoline has ripple effects across the economy, helping to keep down the price of some goods. The Fed has been worried about inflation not reaching its 2% target and now the doves have more support for their position.
The S&P 500 has performed well during periods of QE (please see my previous articles about this), and I expect the S&P 500 to benefit from the Fed's current program. As opposed to last year, the Fed is very accommodative and it looks like any change is many months or quarters away.
There are always problems in Europe. Hopefully, Italy is finally making progress on forming a government (Italian Lawmakers, After Stalemate, Re-elect President to Second Term).
Despite the problems, the euro (FXE) and European sovereign bonds are performing well. The euro closed the week at $1.3049 and has rebounded since the Cyprus crisis.
European bond yields were down last week and the Spain-Germany and Italy-Germany spreads tightened. This strength may be a result of the Japanese quantitative easing and the global search for yield. However, if there were immediate problems European securities would not perform this well. I discuss the European outlook in more detail here: Europe Is Calm: The ECB's Next Move And Impact On The Euro.
S&P 500 Earnings
In an article a few weeks ago, I outlined my roadmap for Q1 earnings season (Roadmap For Navigating The Upcoming Earnings Season...), which focuses on the following categories and sectors.
S&P 500 Earnings (Aggregate)
As of April 18, 104 companies reported earnings and 70 beat estimates. It is too early to judge the aggregate S&P 500 earnings. However, the current run-rate of companies beating estimates is higher than the beat rate in the last few quarters. For more details about the S&P 500's aggregate earnings, please see: S&P 500's P/E Down To 16.1x: A Tale Of Two Markets.
The big banks reported Q1 results, which seemed good enough. The banks outperformed estimates, but the Q1 results did not lead investors to believe that there would be robust earnings growth going forward.
Before earnings season, my outlook on the banks was:
The banks have been a market leader out of the 2008/2009 financial crisis, especially since last summer. However, bank stocks have been weak following the stress test results.
Several of the big catalysts have already played out, at least partially: discounts to book value and the stress test results. We now need new drivers for the stocks, such as more earnings growth and increasing ROE.
I am not looking for outstanding results from the banks. Instead, I am looking to see if the Q1 numbers are enough for the banks to hold onto most of their recent gains.
The banks got the job done. Although their share prices drifted down after earnings there was no big drop and the weakness may be attributed to general weakness in the broad market.
Apple (AAPL) is scheduled to report earnings on April 23. Apple's price action has been very weak going into earnings, with the share price dropping below $400.
Analysts have been cutting estimates for Apple throughout the quarter as Apple's future margins have come under question by analysts and investors
(Source: Yahoo Finance)
On the last earnings call, Apple's management changed its approach to earnings guidance. This quarter's results will be the first test of Apple's new approach. If Apple's results perform in-line with guidance, then investors may have a more reliable indicator for their projections going forward, which could provide support for the stock.
There is widespread expectations that Apple will increase its dividend and/or buyback when it announces its results. It will be interesting to see if Apple can meet expectations for higher capital allocation to shareholders.
The tech sector experienced another big earnings disappointment thanks to IBM. IBM's weak results echo the problems experienced by Oracle (ORCL), Tibco (TIBX), Fortinet (FTNT) and others. There were main two areas of weakness in IBM's report: hardware and federal sales.
The weakness in hardware for many tech companies may be a secular challenge. In both the enterprise and the consumer sectors, hardware is becoming commoditized at a faster rate. The macro environment, however, is more of a cyclical problem. The sequester in the U.S. and European stagnation are headwinds for many tech stocks.
Microsoft (MSFT) and Intel (INTC) also reported results this week. Expectations were low following the IDC's forecast for -14% PC sales growth in Q1. Thanks to the low expectations the results seemed good enough and the stock prices of Microsoft and Intel ended the week up.
Technology earnings have not been encouraging for bullish investors. The best case for the bulls is that all the problems are already priced-in as the leading technology companies trade at very low valuations. If some of the cyclical headwinds abate, there could be room for tech stocks to move up. However, it is probably too early for tech stocks to lead the market again.
The metals/mining/materials space continued its move lower. Gold was clearly leading the sector down, but the weakness was widespread.
In my roadmap I asked if Q1 earnings could halt the move lower in this sector. At this point, the earnings results may not matter because of the weakness in the commodity prices. There is probably not much that company executives could tell investors that would be bullish after the sharp drop in commodities.
The charts of the The Materials Select Sector SPDR Fund ETF (XLB) and the iPath Dow Jones-UBS Copper Subindex Total Return ETN (JJC) illustrate this dynamic:
Many stocks in the space may snap back after the big drops last week. However, that may just be a response to short term oversold conditions and it will take time to see how the sector plays out.
The cover story of Barron's describes the very bullish sentiment among advisors in the Big Money poll (here).
I have never been able to use sentiment surveys as a constructive indicator. It is very hard to grasp the historical context of the surveys. Also, the financial crisis of 2008/2009 had a fundamental impact on many investors. Investors that went through the crisis (as well as the tech bubble) will never be as bullish as they were prior to those events.
Despite the Barron's story it seems that bearish sentiment has been growing over the last few months (just my observation, not based on any survey). After a relief rally to start the year, the "sell in May and go away" crowd showed up in late March. Furthermore, the crash in gold and Apple has probably shaken the confidence that many investors had in certain trades. Also, the record highs for the S&P 500 were greeted with a lot of caution, not new bullish sentiment.
I entered the week in the cautiously bullish camp, but became a bit more cautious as gold dragged down the market on Monday. Although I moved a good chunk of my portfolio to the sidelines on Monday I was nibbling back at the market later in the week.
After the events of last year, many investors are used to expecting risk-on/risk-off moves. Although the S&P 500 may need a pause now, I do not expect a risk-off move like last summer. Europe is not going through a crisis, the Fed is very accommodative and the economy is moving forward despite fiscal headwinds.
I am bullish because I expect the economy to continue to heal. The recovery in housing is a big driver of growth and the slow decline in unemployment adds strength to the economic recovery. However, the S&P 500's multiple is relatively high compared to the last few years (but low on a long term time frame) and it needs earnings growth to sustain the current level and continue to make new highs.
It is still too early to tell how earnings season will play out. So far, there are pockets of strength and weakness in the S&P 500. If this continues, we may have more of a stock-pickers market over the next few months. That is why I am taking a cautiously bullish approach. I think there will be areas of the S&P 500 that will do well, but the rally may not be as broad based as in the past.
It will be important to see if the S&P 500's past winners continue to lead or if there is a rotation into the sectors that are currently lagging.
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