So here we are, a third of the way through 2016, and the S&P 500® Index is approaching its all-time high after rallying 16% in the past two months. The key question now is “What’s next?” Will the market keep pressing higher? Will it consolidate its gains and move sideways until the next catalyst emerges to push it upward or downward? Or is this a typical bear market rally, in which stock prices rise sharply before heading back down to the bottom of the range?
From where I sit, the stock market seems “overbought” after an extended period of substantial price gains without much pullback, so it may need time to consolidate its gains. While I don’t see an imminent reversal to the downside, it’s unlikely that all the ingredients are in place for the rally to continue much further. In other words, the S&P 500 may remain in a bull market purgatory of sorts, stuck in a trading range of 1,800 to 2,100 until the liquidity picture improves and earnings recover. More about earnings later.
In the meantime, I am watching several indicators that may reveal important clues about the market’s next big move.
|1.||Can crude oil remain above $35 per barrel?|
Since hitting a double bottom of $26 per barrel (West Texas Intermediate) in January and February, crude oil rallied above $35 (the previous trading high) in early March. Quite often in this type of pattern, the market then retests that previous breakout point (which now acts as support), and then the next direction reveals itself.
If the underlying trend is bullish, it will usually hold this support zone and resume its rally to new highs. On the other hand, if it was just a bear market rally, this new support zone will give way and it will return to the lows. For crude oil (WTI), that support level is $35. When it tested that level in early April, it not only held, it rallied to a 2016 high of $42 by the end of the week.1 That could be a bullish sign for energy and for risk assets in general.
Given the systemic nature of the recent decline in energy prices (because energy prices are so closely tied to earnings, credit, and emerging economies), what happens to crude oil prices is an important indicator for the markets in general. If they can remain above $35 per barrel, that it would likely be a positive signal.
|2.||The strength of the U.S. dollar, and Fed moves|
Like energy prices, the strength of the U.S. dollar is also related to energy prices and financial conditions.2 In fact, the direction of the dollar may be the most important indicator of where the market goes next, in my opinion.
The broad dollar peaked on January 20, the day the S&P 500 reached its first double-bottom low of the year (it retested that low on February 11). Since then, the dollar has declined 6%, while—in perfect inverse correlation—the S&P 500 has rallied 16% and crude oil has risen 50%.
The dollar has stayed down since mid-February, in no small part because the Fed has downplayed expectations of an imminent rate hike. This, in turn, has provided important support for the markets. Therefore, the interplay between Fed expectations and the dollar (and, therefore, financial conditions) is a key dynamic for the markets.
As of April 25, the probability of a June rate hike was 20%,3 while financial conditions have improved and risk markets have rallied. This suggests the market is taking it on faith that the central bank will not hike interest rates in June. If the Fed does hold rates steady, things should remain relatively calm in risk land. How long will this last? I don’t know, but at only 20%, the odds of a rate hike seem to have more upside than downside potential. And with financial conditions already greatly improved, maybe we can say the same for risk assets.
In any case, this interplay between the Fed and the markets will remain important to watch as we get closer to June. Basically, the markets are counting on the Fed to not hike rates in June. I guess you could say that less tightening is the new easing. In other words, if the Fed tightens less than what is priced into the market, it has the same effect as if it’s easing.
|3.||Divergences between S&P 500, the yen, and the 10-year Treasury yield|
Entering 2016, the Japanese yen had been weak and hitting new lows (in terms of dollars per yen). Since then, however, the yen has strengthened considerably (from 122 yen per dollar in January to 109 in April, a big move), while the S&P 500 has rallied near its all-time high. But a positive correlation between a strong yen and a strong dollar is unusual, because a strong yen is traditionally a “risk-off” signal. It’s unclear why we’re seeing this divergence, but risk has certainly been “on” (at least in the United States, because Japan’s Nikkei Stock Average remains about 25% below its 2015 highs).
A similar unusual correlation exists between the S&P 500 and the 10-year Treasury yield. These benchmarks historically have moved in tandem, because the “risk-on” trade is based on expectations of better economic activity. Yet while the S&P 500 has rallied sharply, the 10-year Treasury yield is only 1.79%, considerably below its 2015 high of 2.5%.
It’s uncertain whether it’s the strength in U.S. stocks that’s being mispriced or whether it’s the yen and/or the U.S. Treasury yield. But the trend bears watching. A continuation of this divergence potentially could signal that stocks are overpriced and due for a correction, or that Treasury yields are too low and headed higher.
|4.||Direction of global stocks|
You don’t have to be a technician to see that global equities were in a downtrend for much of the past year, as the chart of the MSCI All Country World Index (MSCI ACWI) shows. The index even reached bear market status in February for a brief time. A downtrend can be simply defined as a series of lower highs and lower lows, as the chart shows. It also shows a clear relationship between softening global growth (as represented by the Goldman Sachs Financial Conditions Index) and stock prices.
While global stocks have rallied nicely from their February lows, I think we need to see further evidence of this trend before concluding that the long decline for global stocks (or consolidation for the S&P 500) is coming to an end. For global stocks, the evidence could simply be a continued series of higher highs and higher lows on the daily chart. For the S&P 500, I think it would be a breakout above last year’s high of 2132.
|5.||Direction of earnings|
The consensus earnings-per-share (EPS) growth estimate for 2016 has fallen from +6.8% at the beginning of the year to a mere +2.3% currently. However, the 50% rally in crude oil prices and the 6% decline of the U.S. dollar may have created an unexpected tailwind for earnings estimates, just at a time when expectations have reached rock bottom. This sets up the potential for upside earnings surprises in the weeks ahead, which could fuel the market’s momentum.
It is especially interesting that the estimates have continued to come down since the dollar peak and crude bottom a few months ago. Of course, many companies “guide” below where they expect to deliver, and inevitably they beat their number. This happens almost every quarter, which is why there’s frequently a bounce in the estimate progression as earnings season unfolds.
Given how low the expectations are for Q1, it’s possible the earnings bounce may be even bigger than usual. But whether that will be enough to push the S&P 500 through its old highs remains to be seen. The market will likely need to see more than one quarter of “less bad” numbers for that to occur. In addition, the earnings cycle (which is five years long, on average) only just peaked a year ago, and the U.S. economy is experiencing a rise in late-cycle indicators. Earnings growth acceleration is typically an early-cycle phenomenon. Nevertheless, this cycle has been anything but normal, so anything is possible.
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