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By Thomas J. Smith, CFA

There have been a host of indicators, calls or tea leaf readings that have explained why the market can’t keep going higher over the past several months. There has been the call that we are due for a 10% correction for a long while. The NASDAQ is rolling over was trumpeted recently as a signal for danger ahead. That head and shoulder pattern on small caps frankly did look fairly ominous. Many have talked about breadth not being strong enough to maintain a healthy market. Over the past few weeks the VIX has been en vogue as the tool to use to point to a dangerous level of complacency. And lastly, many feel that lower bond yields point to a weakening economy.

There are a variety of issues in any market that we must closely monitor. There are learned men and women on each side of the debate that will try to convince you that they offer the best insights into the economy or the market. How do we balance these conflicting arguments? First, it is a good idea to get as much information as possible on each side of the issue and then let the market be the tie breaker on particularly tough issues.

The call for the 10% correction has been very heavy handed for me. It is quite lazy in my estimation. 10% is a big round number and makes you look smart when you go on TV, I guess. There have been 10% pullbacks in the Russell 2000 and Russell 1000 since this bull market began. There was a sharp pullback and test of support this year. The major averages went below support levels and key moving averages. The fact that the retreat did not hit a round percentage level is not that important to me. To put a predictive number out there is just wasted effort in my opinion. The market tested support on all of the major averages after breaking out. That is what markets do. When a stock or broad market average breaks out to a new high, it is bullish. When support is tested and holds, the bullish trend has to be given the benefit of the doubt.

If we just go back to the middle of last month, there were major warning signs building in the market. The NASDAQ was below its downward sloping 50 day moving average. The S&P 500 broke out above 1900 and failed to hold that level and closed back below its 50 day moving average. Some were calling for the next level of support to be tested at the 1860 level. Those that were more pessimistic were pointing to the then 200 day moving average at 1785. This was less than a month ago!

At that point, to me, it appeared that we needed to get out our rulers and pencils and draw some trend lines and figure out what could happen over the next few weeks. The Russell 2000 was the weakest of the averages that I follow. On May 12th, the Russell had an aggressive move higher and reclaimed its 200 day moving average. Many were pointing to the Russell 2000 as the catalyst that would lead to a weaker market. It is important to point out exactly what the Russell 2000 is and how to use it in this case. The Russell 2000 represents a little less than 8% of the overall stock market. It is definitely the tail in the tail wagging the dog analogy. It was vital in May to keep an eye on the Russell 2000, however. Small cap stocks were coming under extreme pressure. The selling reached an area where the average typically bounces on May 12. The fear at that time was that small caps would become so weak that selling would spread to other areas of the market and things would begin to unravel. The fact that buyers aggressively came in to buy small caps at this time was a major positive technical sign.

The NASDAQ was also at critical support at the time. Many had pointed to a potential head and shoulder top formation developing. Until they actually take place, potential chart patterns are just that—potential patterns. We need to be prepared for the fallout should they actually come to fruition but to predict they will happen is not the best route to take. The NASDAQ never completed that pattern and buyers came in and drove the NASDAQ back above resistance.

There is no doubt that the chart patterns in the small cap area of the market were quite alarming last month. When those charts reached support, they were clearly oversold. The percentage of stocks in the small cap universe that were hitting new 20 day highs or trading above their 50 day moving averages reached extremely low levels. When these levels have been hit in the past, we have seen a new leg higher in the market. The fact that buyers came in so aggressively at support was a good sign. There has been continued strength in the small cap arena since then and the small cap averages went above the resistance levels I gave last week.

Many have been concerned about fewer stocks driving the overall market higher. Breadth did weaken from March through mid-May. The percentage of large cap stocks in healthy technical condition has remained strong all year. Weakness has been more evident in momentum based areas of the market. We can quickly perform a test that will give us a read on the underlying strength of the market. There are nine major sector ETFs. We can measure them on a market weighted and equal weighted basis to get a quick overview on market breadth. Of these 18 ETFs, 15 hit new highs last week. This is a clear sign that breadth in the market is improving.

The S&P 1500 is a broad-based index that includes the S&P 500, the S&P MidCap 400, and the S&P Small-Cap 600. Large cap stocks have been strong throughout 2014; small caps exhibited substantial weakness from March through mid-May. The advance-decline line for this broad average reached a new high last week. The rally so far in June has been broad based.

The majority is ruling the market right now. Those in the bearish camp have pointed to the lack of new highs in the small cap averages as a sign of weakness. That focus on the trees has caused them to miss what is going on in the forest. If you look at the broader market, several broad market ETFs hit new highs last week. The S&P 500 and S&P 100 ETFs along with the Russell 1000, NASDAQ 100 and S&P MidCap averages hit new highs. Breadth improved substantially in last week’s advance. It is true that the Russell 2000 average did not break out to a new high, but the trend in that average is still clearly positive. The average broke out to a new high in early March before selling off sharply. Long-term support held above the prior low reached in February. So, after a breakout and a higher low, the bullish trend is still in force. The rally in small caps moved the Russell 2000 above near-term resistance and its 50 day moving average last Thursday and Friday. Many have pointed to weakening breadth as a major concern this year. Those fears should be greatly diminished after the broad based rally over the past few weeks.

We continue to keep track of how the consumer is doing. Employment numbers continue to improve. The consumer discretionary sector did not reach new highs. There have been concerns about this sector because it gives us a direct read on the state of the consumer. Several times we have spoken about the need to gauge the strength of the consumer. The consumer makes up 72% of our economy, so it is vital that we see strength persist in the consumer sector, which has not reached a new high but clearly broke above near-term resistance and is near its all-time high.

Volatility measures have fallen over the past several years. Investors are concerned that this is a sign of complacency. Many point to very easy central bank policy for the low levels of volatility today. The answer is not that simple. The Fed was doing QE in 2010 and 2011, which were years of extreme spikes in volatility. We think that volatility began to decline when commodity prices and inflation began to decline in 2011. Low volatility among commodity prices and oil is key here, which has helped create more stability across interest rates, monetary policy, and the U.S. economy.

Concern has been raised because the VIX is back to 2007 levels. It is too easy to say that the VIX being at 2007 levels is bad. But unless we can come up with some reasons why the VIX is at its current low levels, we cannot dismiss this concern.

So, why is the VIX so low? As you know, we focus heavily on the changes in the Leading Economic Indicators (LEIs). One of the key drivers of market volatility is the business cycle. Recent improving growth has reduced volatility. The reduction in volatility is a function of the change in the business cycle. Some view a low VIX as a sign of complacency in the market. Lower volatility can also be viewed as a leading indicator for stronger GDP ahead. When you track GDP forecasts with volatility measures, you see that sharp declines in volatility demonstrate that investors are discounting a stronger economy.

Is this just hope, or are there signs that the economy is improving? We added to cyclical names last summer when we saw the LEIs tick up. We are seeing some measures improve after the weak numbers from earlier in the year. Over the last several weeks, the percentage of LEI releases above expectations has been higher than at any point in five years. We see no signs of macro weakness as credit spreads continue to decline. When credit spreads widen, we are told that the bond market always gets it right. Problems in the bond market point to weakness in the stock market in the coming months. Continued strength in the bond market and tightening bond spreads point to an improving economy. The low VIX points to continued improvement in the economy.

The VIX is also low because overall economic volatility has declined. We have talked frequently about the impact of oil price volatility on the business cycle. In the spring of 2010, 2011, and 2012 we saw sharp declines in the market after large spikes in oil prices. Oil prices have moved sideways for three years now. This has had a major positive impact on decreasing market and economic volatility. One of the key factors that has led to big spikes in energy prices has been China’s investment boom. We expect this trend to reverse over the next decade as investment growth in China contracts. So, hopefully this addresses the VIX issue.

The textbooks tell us that a decline in Treasury yields often points to a slowdown in economic activity. I mentioned above that we see the LEIs picking up, so why aren’t we worried about low bond yields? We feel that the U.S. economy is structurally strong. Our economy is the strongest in the world currently. In the 1980s and 1990s, there was a massive decline in interest rates and energy price deflation during a period of rising equity prices. This has happened in the past and it is playing out now.

As growth slows in emerging markets, we have made the case that we can experience non-inflationary growth. Strong growth and rising inflation are two sources of upward pressure on yields during periods of inflationary growth like in the 2000s. In periods of noninflationary growth, inflation is not a catalyst for rising yields.

Europe is also putting pressure on U.S. yields. Weakness in Europe has played a key role in keeping U.S. Treasury yields down. There will likely be more action from the ECB in the coming weeks. These actions will place the euro under continued pressure. Investors will reallocate toward the U.S. dollar and U.S. Treasuries.

The strength of the U.S. economy and our currency has had a large impact on Treasury yields. We do not see lower yields as a sign of a weakening economy.

Declining gold prices also suggest that low yields are not about fear. Declining yields have made investors uncomfortable about the validity of the stronger U.S. growth story and some argue that lower yields suggest that disaster is around the corner. If that were to play out, we should see buyers of gold step in. Gold hit a recent low last week.

There are always going to be compelling arguments for both the bull and bear side of the debate. Hopefully, today’s missive helped you understand some investor concerns. Also, I hope it proved that there is still more right than wrong in the market and the economy. Until the facts change, the bulls continue to be in charge.

Source: This Must Explain Why The Market Can't Go Higher?! Maybe Not