Holiday Euphoria May Lift The Market Even Higher

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The overall stock market has begun to stabilize as the post-Presidential election short-covering rally in financial, industrial, and material stocks begins to fizzle. Last Friday’s Bespoke Report (“Shuffle Up and Deal,” November 18, 2016) called the last two weeks “one of the biggest sector rotations in memory,” due to traders betting that “single party control of Washington will result in major deals on the issues businesses care most about, namely taxes and regulations.” Bespoke analyzed the S&P 500’s performance in the first eight trading days following the election and found that the 50 stocks (10%) with the highest short interest surged 8.13% while the 50 stocks with lowest short interest rose only 2.22%, reflecting the power of the recent short-covering rally. Meanwhile, the 50 smallest-capitalization stocks in the S&P 500 surged 8.78% vs. a 1.87% rise for the 50 biggest stocks in the index. Bespoke analysts also found that the 100 stocks with the lowest price-to-earnings ratios surged 8.22% vs. 1.30% for the 100 highest-P/E stocks.

The overall S&P has risen by just under 2% since November 8th. According to Bespoke, the best S&P sector since Election Day was Financials (+10.8%), followed by a distant second for Industrials (+5.1%). The worst-performing sectors were Utilities (-6.4%), Consumer Staples (-4.4%), and Real Estate (-3.6%).

Fortunately, the seasonally strongest time of year is now just beginning. Another report by the Bespoke Investment Group (“Thanksgiving Returns,” November 16, 2016) shows that in the last seven years of the current bull market, the S&P 500 has risen by an average 1.55% during the week following Thanksgiving and an average +3.68% for the five-week span from Thanksgiving to New Year’s Eve. Longer-term, in the 70 years from 1945 to 1915, the S&P 500 has averaged +1.98% from Thanksgiving to year’s end.

The federal government and our democracy is not a speedboat, it’s an ocean liner – as I discovered when I came into office. It took a lot of really hard work for us to make significant policy changes – even in our first two years, when we had larger majorities than Mr. Trump will enjoy when he comes into office.

– President Obama, in his press conference, November 14, 2016

Presidents can’t turn an economy on a dime, especially when they won’t take the oath for another two months, but the market and economic indicators certainly have turned up sharply in the last two weeks.

Last Tuesday, the Commerce Department announced that retail sales surged 0.8% in October and a revised 1% in September. Not only were retail sales stronger than economists’ consensus expectation, but the last two months represented the biggest two-month surge in retail sales since 2014! Excluding strong auto and gas station sales, which surged 1.1% and 2.2% respectively, October retail sales still rose an impressive 0.6%, as 11 of 13 sectors posted gains. This was truly a great sign that consumer spending is picking up, which means that economists will likely revise their third-quarter GDP estimates higher.

Then, on Thursday, the Commerce Department announced that new housing starts in October rose by 25.5% to an annual rate of 1.32 million, the strongest annual pace in nine years! Behind this stunning surge was a whopping 68.8% increase in multi-family starts. Construction activity was strong in all regions, especially in the Midwest and Northeast, where housing starts surged 44% in October.

Finally, I should add that with all this robust economic activity, inflation may finally be brewing. The Labor Department announced on Thursday that the Consumer Price Index (CPI) surged 0.4% in October, due largely to higher prices for electricity, gasoline, and housing costs. Excluding food and energy, the core CPI rose only 0.1% in October. In the past 12 months, the CPI has risen 1.6%, while the core CPI has risen 2.1%. Consumer prices have risen for six of the past seven months. With the 12-month core CPI near the Fed’s 2% inflation target, the momentum of consumer inflation essentially insures that the Fed will raise key interest rates 0.25% in December. Not surprisingly, Fed Chair Janet Yellen gave Congressional testimony on Thursday saying that the case for a Fed rate increase has “strengthened.”

Impact of the Dollar’s Recent 14-Year High

With mounting evidence from these indicators that U.S. GDP growth is accelerating, the U.S. dollar hit a 14-year high against a broad basket of currencies, so I expect that domestic, small-to-mid-sized stocks will have an advantage over multinational, large-capitalization companies. In addition, an early “January effect” typically starts around Thanksgiving, making small-to-mid capitalization stocks stronger between Thanksgiving and mid-April due to year-end pension funding and pension funding in the New Year.

The Chinese yuan last week hit its lowest level in eight years relative to the U.S. dollar. Immediately after the U.S. Presidential election, the Peoples’ Bank of China (PBOC) allowed the yuan to steadily weaken, possibly in anticipation of a confrontation with President-elect Trump, who has called China a “currency manipulator.” It appears that Chinese authorities are willing to let the yuan continue to slide relative to the U.S. dollar so that they have a competitive advantage when it comes time to negotiate any future trade deals with President Trump. In the meantime, China’s exports will likely be boosted by the weaker yuan, so I expect a big turnaround after six consecutive months of declining Chinese exports.

A strong U.S. dollar is also pushing commodity and import prices lower, so I fully expect that deflation will re-emerge in the upcoming months. Crude oil prices remain amazingly firm heading into the next OPEC meeting on November 30th. No matter what OPEC members say, I do not expect any production caps, since OPEC members have been ramping up their respective production, almost if they were trying to beat any production cap. Even if OPEC agrees to a production cap, OPEC members like Algeria, Iraq, Iran, and Nigeria have a history of cheating and ignoring any production caps. Furthermore, non-OPEC members are also boosting their crude oil production, which should help to put a lid on crude oil prices.

Speaking of crude oil production, there is a lot of excitement in the U.S. about new discoveries in the Permian Basin, especially the Wolfcamp formation, which is estimated to hold 20 billion barrels of crude oil within four layers of shale in West Texas. Literally half the drilling rigs in the U.S. are in the Permian Basin and, at current prices, the crude oil that is trapped between shale deposits is profitable to extract.

Furthermore, when the pipeline from North Dakota is completed, the U.S. will be well on its way to being energy independent. Without a pipeline, high transportation costs have curtailed North Dakota’s production. In the meantime, the American Petroleum Institute (API) and the Energy Information Administration (EIA) reported that U.S. crude oil inventories rose 3.65 million barrels and 5.3 million barrels, respectively, in the latest week. This glut many diminish a bit in the Spring when worldwide demand rises, but it appears that crude oil prices will remain relatively low at least through mid-February.

Happy Holidays!

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