Wednesday's Rally: Truly Bullish Or Just Debt Ceiling Relief?

by: Chris Ciovacco

Not Surprising, Deal Reached At 11th Hour

Human beings function primarily based on the principle of self-preservation, a concept that translates easily to politics where elections are always around the corner. While numerous observable pieces of evidence said the rally off last Wednesday's low was not surprising, the best weapon against all the hype may have been common sense.

The politicians always seem to (A) push up against "disaster", and then (B) find a solution before the clock runs out. Market participants have seen this story unfold in one form or another numerous times. From Reuters:

Stocks surged on Wednesday, nearing an all-time high, after Senate leaders said they had reached a deal to raise the government debt ceiling, one day before the U.S. defaults on its debt.

Sector Leadership Shows Economic Confidence

We can learn much about the market's conviction during an advance by scanning the sector leadership lists. If Wednesday's pop in stocks was led by defensive consumer staples (NYSEARCA:XLP), utilities (XLU) and healthcare (NYSEARCA:XLV), it would have cast serious doubt on the sustainability of the rally. That is not what we saw. The sectors providing leadership after the debt deal was announced were economically sensitive energy (NYSEARCA:XLE) and financials (NYSEARCA:XLF). Some big-name investors have mentioned valuations as a driver of interest in energy stocks. From Forbes:

Sometimes the most attractive energy assets aren't found in the ground but listed on the stock exchange. Billionaire businessman Carl Icahn is one investor seeing value in energy companies. The hedge fund manager recently announced his purchase of 60 million shares in the Canadian oil and gas producer, Talisman Energy (NYSE:TLM). Icahn has built up a nearly 6 percent stake in the Calgary-based energy producer, worth a whopping $300 million. Even though the company has been a perennial underperformer, after Icahn's tweet, the stock climbed to the highest level in more than a year.

The Energy Select Sector Spider provides exposure to a diversified basket of energy stocks, including Exxon (NYSE:XOM), Chevron (CHV) and ConocoPhillips (NYSE:COP). As the chart shows below, XLE has established a bullish weekly trend relative to the broader S&P 500 Index (NYSEARCA:SPY).

Bank of America Pops After Earnings

Longtime market watchers often say, "you can't have a sustainable rally unless financials are on board." After Bank of America (NYSE:BAC) posted satisfying results, the Financial Select Spider jumped 1.85% on well-above average volume. From Reuters:

Bank of America posted a higher-than-expected quarterly profit on Wednesday, fueled by growth in its consumer and wealth management arms, underscoring the bank's progress in businesses it picked up during the financial crisis. Profit at its largest unit, the consumer and business bank, soared 32 percent as revenue rose, credit costs fell, and the bank sold additional products to its existing customers. It issued more than one million credit cards during the quarter, the highest number since 2008, and nearly two-thirds went to existing customers.

Investment Implications

Our market model told us to start buying stocks last week even with the threat of a U.S. default. Wednesday, we continued with our incremental allocation shifts by adding some exposure to the energy sector.

Just as defensive assets told us to be open to bullish outcomes during the debt ceiling talks, Wednesday's leadership from energy and financials continues to support a "risk-on" stance. If the markets begin to tip more of a "concerned about the economy" hand in the coming weeks, we are happy to adjust accordingly.

Disclosure: I am long XLE, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.