Fundamentals, technicals, and sentiment are back in synch for the bulls.
Improvement in pharma and energy spaces will bolster the market in Q4.
Expect the trading range environment to give way to a steady climb.
The pieces are finally in place for the major U.S. stock averages to break out of their holding patterns and commence a well-deserved climbing phase. In this report, we’ll look at a collection of indicators which support an optimistic outlook for the remainder of 2019.
Let’s begin this review with a look at the market’s fundamental backdrop. The latest earnings season has been a benign one for investors. Earnings have been stronger than anticipated by analysts as investors embrace more of a risk-on posture. To date over 40% S&P 500 companies have reported earnings, according to FactSet, with an impressive 80% of them reporting a positive earnings per share surprise. Also, 64% of S&P 500 companies have reported a positive revenue surprise, according to FactSet.
Positive earnings surprises have set the tone for some of the market’s biggest upside days during the latest reporting season. Most encouraging has been the positive earnings reports from pharmaceutical companies like Merck & Co. (MRK) and Pfizer Inc. (PFE), both of which are Dow 30 components. The upbeat earnings of both companies have increased investors’ hopes that the beaten-down pharmaceutical industry will be revived in the current quarter.
Keep in mind that much of the malaise experienced by the tech sector in recent months has been in large part due to the relative weakness of the drug stocks. A turnaround in this market segment would indeed be more good news for the bulls. It’s certainly helping that the number of pharma stocks making new 52-week lows has diminished, thanks to the October rally that many of them have experienced. Shown below is the Invesco Dynamic Pharmaceuticals ETF (PJP) which illustrates the turnaround attempt now underway in the drug stocks.
Another area which has shown improvement this month, and which bodes well for the rest of the year, is the energy sector. Of all the major market segments, the energy sector has arguably been the biggest laggard for much of 2019. Whenever there have been periods of exceptional broad market weakness this year, energy stocks tended to have the greatest presence on the NYSE new 52-week highs list. With the latest energy stock bounce, however, the new lows have significantly diminished and the market’s internal structure is much healthier.
Moreover, the NYSE Arca Oil Index (XOI), which is my favorite tracking index for the sector, has established a pattern of higher lows since bottoming in August. This bodes well for a turnaround of intermediate-term (3-6 month) proportions. And a healthier energy sector is a strong supporting factor for the rest of the broader equity market.
Leading the charge higher out of the multi-month trading range has been the bank stocks. Consensus-beating earnings reports from some major U.S. banks helped propel the PHLX/KBW Bank Index (BKX) to fresh highs in just the last few days. Leadership in the bank stocks also typically carries a bullish implication for the SPX and other major indices.
On a short-term basis, the market looks like it’s preparing for an upside breakout. The 4-week rate of change in the NYSE new highs and lows continues to accelerate higher (below). This is an indication that the market’s near-term path of least resistance is now up again, after being down for much of August and September.
By far the most constructive aspect of the market’s internal condition is the improvement in the 120-day rate of change in the highs and lows. This is my favorite measure of the market’s intermediate-term path of least resistance. For the last several months, this indicator was slumping and underlined the listless condition of the overall market. Now, however, this indicator has begun to turn upward again. This steady rise suggests that the bulls will have a much easier time pushing stock prices higher in Q4. Whenever this indicator is rising on a sustained basis, stocks tend to be more responsive to news that investors regard as positive.
Now let’s examine the market’s sentiment profile. In previous reports I’ve mentioned that bearish sentiment among investors – both retail and institutional – has been on the upswing of late. This can be seen in the growing number of somber warnings being sounded by market commentators in the financial press. Granted that a major motivation for publishing these headlines is to simply capture the reader’s interest, but the volume of dire forecasts of late merits closer scrutiny.
Indeed, there’s nothing like an old-school, alarm-ringing crash prediction to capture the interest of investors benumbed by multi-month S&P 500 trading range. There has been an explosion in bearish prognostications among market timers and fund managers alike as the major averages approach their previous highs. The recent spike in bearish sentiment is understandable considering that previous tests of the major highs this year have been met with selling pressure. But the sheer scale of cynicism generated by the latest market rally is unlike anything we’ve seen so far this year.
Consider an article which appeared in MarketWatch this week. The article reports that financial analyst Michael Pento, of Pento Portfolio Strategies, has made a rather provocative prognostication. According to the article, in an interview with USAWatchdog.com, Pento said that if the Federal Reserve stops supporting the economy through monetary stimulus an economic depression could ensue. Pento was reported to have said:
When this thing implodes, we are all screwed. On a global scale, we have never before created such a magnificent bubble. These central bankers are clueless, and they have proven that beyond a doubt. All they can do is to try to keep the bubble going.”
Most investors correctly anticipated that the Federal Reserve would lower its benchmark rate by 25 basis points at its October policy meeting. According to Pento, however, the Fed essentially has no choice but to loosen its monetary policy. Otherwise, “The plunge in the stock market would be huge and from a much higher level” and another Great Recession could ensue.
This prediction is but the latest in a rolling series of dire warnings concerning the equity market and the U.S. economy. From a contrarian’s perspective, it’s actually encouraging to hear this since it lets us know that there’s still plenty of short interest to fuel additional short-covering rallies. The intensified market-related fears we’ve been hearing in the media also tell us that the bull market’s “wall of worry” is still very much intact. Market bulls thus have every reason to be encouraged that the latest test of the old highs in the major indices will ultimately result in an upside breakout to higher highs.
With the market’s wall of worry still strong and corporate earnings still supportive, investors should anticipate a sanguine outlook for the rest of 2019. Improvements in the energy sector and pharmaceutical industry are also encouraging for the broad outlook given that these were the two biggest laggards during the summer months. Meanwhile, NYSE internal momentum as measured by the new 52-week highs-lows is strengthening on both a short-term and intermediate-term basis. In view of the variables we’ve reviewed here, investors should continue to lean bullish on stocks.
Disclosure: I am/we are long SPHQ. 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.