U.S. Equities: Too Much Uncertainty, Proceed With Caution

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Includes: AAPL, FB, IBM, KMB, MSFT, PG, XHB, XLP
by: Michael Battat

Summary

There has been a flight to safety, often a sign of a looming recession.

Political uncertainty will continue to take a toll on Wall Street.

The dollar is too strong to give companies the chance to meet earnings expectations.

The amount of new housing starts, often an indicator for the broader economy, has slowed.

The S&P 500 will go to 1700.

Thus far, 2016 has not been the year of the investor. Despite last week's strong rally the S&P 500 is still down 5% for the year. According to the January adage, "As goes January goes the rest of the market." Past performance tells us that a precipitous fall in equities in the month of January is typically a harbinger of more pain ahead. Since 1950, every down January in the S&P 500 preceded a new or extended bear market or, in some cases, a flat market.

But we should take this saying with a grain of salt and not rely solely on past performance to dictate our future outlook. Instead, we must break down the current macro events to predict whether the saying will hold true. More, it is advantageous to take a technical perspective to confirm or deny our fundamental opinions about the future of U.S. equities. Often times a technical analysis can show more clearly the quantifiable changes in the nation's economy. If the technical and fundamental outlooks align - albeit in a bullish or bearish manner - it strengthens the underlying thesis. As my title suggests, I believe that the thesis is more bearish than bullish.

Flight To Safety

Many investors believe that a recession is imminent. In the last couple weeks of trading we have seen a great deal of capital flow into recession-resistant stocks. Defensive consumer staples names like Procter & Gamble (NYSE:PG) and Kimberly Clark (NYSE:KMB) have drastically outperformed the S&P. The ETF that tracks the consumer staples, the XLP, is up 0.53% year-to-date compared to the 5% drop in the S&P 500.

XLP Chart

XLP data by YCharts

Unfortunately, this flight to safety may have a lot of merit. The recent Fedspeak has been neither favorable nor unfavorable for investors. And that's the problem. The latest Fed statement produced little substance, giving investors no direction. While the market dropped on the comments from the meeting, there is no doubt that it would have fallen further if the Fed raised rates. We weren't then and aren't now ready for another rate hike.

However, in lieu of recent events -- to be touched upon shortly -- it would make sense for the Fed to give investors something to work with, good or bad. To me, this doesn't mean that they should have cut rates; it just means that the Fed should have said more than "we'll see and get back to you later." This only stirs the pot and creates more uncertainty, which is certainly not a recipe for a strong stock market.

Political Uncertainty

To touch upon the recent events to which I previously alluded, well, they're not helping the bull-case either. For starters, we have a great deal of political uncertainty that could only get more uncertain as we near the Iowa caucuses. One of Bernie Sanders' sticking points is to denounce Hillary Clinton via strong criticisms of Wall Street. This in-and-of-itself is a bearish catalyst. If Sanders walks out of Iowa on top, his propulsion toward the presidency -- or at the very least the Democratic candidacy -- would create more fear on Wall Street as his initiatives take one step closer to becoming reality.

The Superman Of All Currency

Another hurdle for U.S. equities is the U.S. dollar. It just refuses to go down. As we have seen from earnings reports from Big Blue (NYSE:IBM) and Apple (NASDAQ:AAPL), to name a few, the conversion of overseas revenue to the U.S. dollar has created top and bottom line misses. Even though these companies may be beating expectations on a constant currency basis, investors simply have not cared and choose only to see the reports through a non-currency-adjusted lens. ^DXY Chart

^DXY data by YCharts

Though there have been some fantastic earnings reports in the past week, namely Facebook (NASDAQ:FB) and Microsoft (NASDAQ:MSFT), the broader trend appears to be bearish. However, we are currently in the middle of the earnings season so it is unfair to extrapolate the reports from the front half to the back half. It would be wise to monitor these statements as they are released and see if the negative sentiment persists.

In my opinion, a longer term stance favors the bears regardless of what the upcoming earnings reports say. In other words, the upcoming earnings reports can be bullish, but it doesn't mean that the market is out of the woods. I think that Q2 and Q3 earnings will continue to be bearish unless the dollar begins to weaken. Even if it does, though, it may not be enough to create a strong bull-case.

New Housing Starts

Lastly, the days of a strengthening housing market may be behind us. Recent data shows that new housing starts fell 2.5% in December of 2015. This came as a surprise to me as I thought that a warmer winter would prompt a longer building season -- I was wrong. But does one month of declining new housing starts mean that we have peaked? Not necessarily, but I think so. In 2015, home builders started work on 1.11 million new homes, which is the largest number since the Great Recession. This represents an 11% increase over 2014 housing starts.

To further answer my question I will turn to the technicals. As I mentioned in my opening paragraph, the technicals can often show a change in fundamentals more clearly than the fundamentals can themselves. And such is the case with the home building market.

If you solely looked at the 11% increase in new housing starts you would scoff at someone calling the peak. Similarly, if you only look at the 2.5% month-over-month decline you wouldn't have a bullish bone in your body. Looking at a long term chart of the homebuilders paints an unbiased picture of what's really happening. It is not so much the fundamental analysis, but the technical analysis, from which I have called the peak of the homebuilders. The XHB is an ETF that tracks the homebuilders, and I will use it to show the topping of this market.

Click to enlarge

For those who aren't too familiar with technical analysis, a head and shoulders pattern is one of the most reliable reversal patterns. It often takes shape over a long period of time and signals the transition from an uptrend to a downtrend. Above is a four year chart of XHB which shows the prior uptrend, the pattern taking shape, and my projected price of $18. I derived this price by measuring the height from the top of the head to the "neckline," or the line that serves as support for the pattern (superimposed as the red and green horizontal line). The difference in price is $9.5, which can then be projected downward from the neckline of $27.5 to yield a price target of $18. Coincidentally -- or not so coincidentally, as charts often work in this fashion -- $18 was also an area of resistance on XHB's way up, which will serve as support on the way down.

As you can see above, the chart pattern is appropriately named as it looks like a head and a pair of shoulders. Notice, though, that the XHB has not shaped the right shoulder. Does this mean that it isn't a true head and shoulders pattern? No, it just means that we may be early to this change in direction. If you saw The Big Short, then you know that even if something is in the cards -- in that case the collapse of the housing market -- it can take time to unfold. I think that's where we currently stand with the homebuilders.

The technicals show that the homebuilders are ripe for a great deal of pain in the coming years. They also say that in the medium term, which will likely create the right shoulder and complete the pattern, we are due for sideways action. But if you buy a stock with the hope that it will trade sideways, go buy bonds instead.

So why does potential topping in the homebuilders market even matter? New housing starts are often seen as an indicator for the overall economy. More specifically, new housing starts data is often extended to consumer goods -- such as home appliances -- and can signal a trend reversal in this industry and others, as well. If new home starts continue to sag, so will correlating industries. And if the Fed continues to raise rates, new home starts will almost certainly continue their decline as it becomes increasingly disadvantageous for people to build homes. Again we see how the Fed's uncertainty can create lasting implications.

In Short

There are too many hurdles that must be cleared before U.S. equities can be deemed investable. Don't be fooled by the recent market rally: I think we are still headed lower. A flight to safety, uncertainty about the presidential election, the unwaning strength of the U.S. dollar, and a likely peak in the homebuilding market has created an inequitable risk-reward ratio for investors. It is advantageous to sit on the sidelines until many of these uncertainties become more certain.

But how far will equities fall until we can wade through the rubble and start buying with confidence again? My projection is that the S&P 500 will fall to 1700, which is 12.3% lower than where we closed this past Friday (1940). There is no single fundamental metric that will be able to pinpoint the best time to buy the S&P 500; but this is why technical analysis is handy. Like the XHB, the S&P 500 has formed a head and shoulders pattern and rounded top. The difference between the neckline and head is about 200 points which, when projected downward from the neckline of about 1900, yields a price target of 1700. Again, not so coincidentally this is an area of resistance on the way up, likely making it support on the way down.

This does not mean that the S&P 500 has to go to 1700 before you buy U.S. equities again, but I do think that this analysis shows how 1700 is a legitimate possibility. I'll see you there.

Click to enlarge

Disclosure: I am/we are long PG, FB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.