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Summary

  • The poor numbers in U.S. GDP in the 1st quarter of 2014 was an aberration.
  • The U.S. economy is expected to pick up in the remaining quarters of 2014.
  • Investors should consider taking long positions in the S&P and hedging their long-term debt positions.

On the album entitled "Uprising", Bob Marley & The Wailers, undeniably the greatest reggae group of all time, had as the first track, "Coming In From The Cold." An interpretation garnered was that in life, there are always obstacles that bring us down, but you have to emerge from those lows and know that there will be opportunities to succeed. I urge readers to listen to the song. Similarly, the U.S. economy is "coming in from the cold." While first-quarter GDP was worse than expected, it was an aberration. Economic activity improved in the second quarter, and continues to improve. Also initial sector allocation signals of a pullback dissipated. As such, an S&P 500 index above 2,000 is expected within the next 3 months, approximately a 1% increase from current levels. Conversely, U.S. treasury prices are expected to decline over the same period. Fed policy indicates that Fed purchases will end by October this year and the Fed will raise rates by mid-2015. Investors attempting to front-run the Fed will exit and probably short their fixed income securities, as the U.S. 10-year yield is expected to rise to 2.8% within 3 months. Investors that are prepared to take advantage of this outlook should consider the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) to take a position in the S&P 500 Index and the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT) to take advantage of a rise in long-term U.S. yields.

Economic Activity

The U.S. had harsh winter conditions for the first quarter of 2014. After several revisions, U.S. GDP grew by 1.5% year-over-year. The U.S. economy's reduction in growth was the most since the depths of the last recession, as consumer spending cooled. The downward revision was also the largest since records began in 1976. These revisions were as a result of a slowdown in healthcare spending. Consumer spending was also weak, the weakest in 5 years. However in the second quarter of 2014, there has been a reversal. U.S. GDP rebounded with a 2.4% increase year-over-year as a result of consumer spending and business investment. Clearly, the U.S. economy was listening to the above mentioned song. The chart below shows the U.S. GDP.

Chart 1: U.S. GDP Growth (% yoy)

(click to enlarge)

Clearly the figures in the first quarter were an aberration, as the majority of economic data since the first quarter has improved. Following a 224,000 increase in June, July payrolls rose 288,000. The U.S. unemployment rate stands at 6.1%, the lowest level since before the financial crisis. The unemployment rate is at the top end of the Fed's year-end forecast. In the Fed Chair's testimony to Congress, Janet Yellen cited first-quarter growth as an aberration and expects the U.S. economy to grow at a moderate pace for 2014. The chart below displays the U.S. unemployment rate.

Chart 2: U.S. Unemployment Rate (%)

(click to enlarge)

The momentum in job growth is just one of the many illustrations that the U.S. economy is emerging from its winter doldrums. Industrial production in the U.S. is at 4.3% year-over-year, the highest level since March 2012. Furthermore, the U.S. has seen the fastest pace in car sales in 8 years.

However, the U.S. housing market remains on fidgety ground. New home sales fell 8.1% to 406,000, the fewest since March. Nonetheless, there are some green shoots, as the increase in home sales in June 2014 exceeded the median forecast of 78 economists surveyed by Bloomberg. While the U.S. housing market is still experiencing chills, the U.S. economy can still rebound.

U.S. CPI has been the main impetus for investors to speculate on when the Fed will raise rates. Most see that the central bank will increase its benchmark rate by mid-2015. As such, investors may look for an early exit, may hedge, or take outright short positions on U.S. long-term debt. U.S. CPI rose 2.1% year-over-year in June 2014; the core CPI, which excludes volatile food and fuel costs, rose 1.9% year-over-year in June 2014. The chart below shows the U.S. CPI.

Chart 3: U.S. CPI (% yoy)

(click to enlarge)

Asset & Sector Rotations

When we compare the S&P 500 earnings yield (5.52%) versus the U.S. 10-year yield (2.51%), U.S. equities look very attractive. There is an approximate 300 basis point difference between the 2 asset classes. Thus, for bonds to be just as attractive as stocks, yields may have to increase by 300 basis points. However, a risk premium on stocks should be maintained, and so initial estimates are for a 50 basis point rise in yields within 3 months. This will be driven by the Fed unwinding their asset purchases, as well as investors speculating that the Fed will raise rates as inflation figures near their target rates.

In my previous 3-Month Outlook On S&P 500 And U.S. 10-Year Yield - The Click Relationships, sector rotation exhibited chills, where Energy and Consumer Staples were leaders, signaling a top in the market. These signs have since dissipated, with leaders becoming laggards, as well as cyclical leaders emerging from the cold. The tables below show the periodic returns of the S&P groups, the top 3 leaders and laggards, as well as the favored, neutral and disliked sectors based on leadership over various time periods.

Table 1: Cerebro Sector Preference as on 25th July, 2014

Favored

Neutral

Disliked

Info. Tech

Consumer Discretionary

Utilities

Health Care

Energy

Industrials

Materials

Financials

Consumer Staples

Table 2: Periodic Sector Returns (%) as on 25th July, 2014

Sector

1 Mth. (%)

3 Mth. (%)

6 Mth. (%)

9 Mth. (%)

1 Yr. (%)

S&P 500 CONS. DISCRET. INDEX

0.35

5.3

5.23

3.08

12.68

S&P 500 CONS. STAPLES INDEX

-0.01

2.53

8.07

3.95

7.51

S&P 500 ENERGY INDEX

0.07

6.78

17.45

13.65

18.49

S&P 500 FINANCIALS INDEX

0.54

4.84

8.44

6.65

10.83

S&P 500 HEALTH CARE INDEX

1.07

7.81

11.09

11.67

21.66

S&P 500 INDUSTRIALS INDEX

-0.90

2.21

7.59

6.77

18.43

S&P 500 INFO TECH INDEX

4.15

11.75

13.76

18.6

29.12

S&P 500 MATERIALS INDEX

0.82

6.41

14.3

13.13

23.49

S&P 500 TELECOM SERV. INDEX

2.48

7.56

9.2

3.77

2.4

S&P 500 UTILITIES INDEX

-2.82

-1.51

11.61

10.76

8.25

Table 3: Periodic Leader and Laggards as on 25th July, 2014

1 Mth.

Top 3 Leaders

Top 3 Laggards

Info Tech

Utilities

Telecom

Industrials

Health Care

Cons. Staples

3 Mth.

Top 3 Leaders

Top 3 Laggards

Info Tech

Utilities

Health Care

Industrials

Telecom

Cons. Staples

6 Mth.

Top 3 Leaders

Top 3 Laggards

Energy

Cons. Dis.

Materials

Industrials

Info Tech

Cons Staples

9 Mth.

Top 3 Leaders

Top 3 Laggards

Info Tech

Cons Dis.

Energy

Telecom

Materials

Cons. Staples

1 Yr.

Top 3 Leaders

Top 3 Laggards

Info Tech

Telecom

Materials

Cons. Staples

Health Care

Utilities

One note of caution is the underperformance in Industrials, which show some cyclical weakness in market performance.

S&P P/E Valuations

The S&P 500 appears to be overvalued when compared to historical averages. The S&P 500 current quarterly P/E is at 18.02x (as at July 25th 2014), versus the 3-year average of 15.35x and the 5-year average of 15.72x. One reason for these levels are the borrowing costs of the S&P 500 companies. With borrowing costs low and earnings strong, investors are prepared to pay an above-average premium for the S&P 500 Index. An up-move in rates should see a subsequent decline in price and a reversion to the mean of the P/E.

The Technicals

The trading ranges of the S&P 500 appears to get smaller and smaller over the past few months, but the inner and outer channels remain to the upside. The declines on the Index remain corrective, but a decline below 1925 would warrant a signal to identify a change in trend. Momentum indicators are confirming with price movements, and once the channels are maintained, the S&P 500 can trade above 2000 within the next 3 months. The chart below shows the daily chart of the S&P 500.

Chart 4: The Daily Chart of the S&P 500

(click to enlarge)

The U.S. 10-year yield produced clearer chart patterns than the S&P 500. The U.S. 10-year yield completed the flag pattern by hitting a daily low of 2.40% at the end of May 2014, and appears to be in a double-bottom setup, with pivots around the 2.43% area. A confirmation of this signal will see the U.S. 10-year yield closing above 2.69%. If the momentum in the trend reversal strengthens, the U.S. 10-year yield can be above 2.80% within 3 months.

Chart 5: The U.S. 10-Year Yield Index (%)

(click to enlarge)

Coming In From the Cold

Things are heating up in the U.S. economy. Investors should continue with their long positions on U.S. equities using SPY and consider hedging their long-term U.S. fixed income positions with TBT.

Source: Coming In From The Cold: A 3-Month Outlook On The S&P 500 And U.S. 10-Year Yield