What's in this week's Report:
- Did Friday's Tech Drop Signal A Market Change?
- Why Bond Yields Are Important (A Plain-English Primer)
- Three Momentum Indicators to Watch
- Weekly Market Preview
- Weekly Economic Cheat Sheet
- ECB Decision Takeaways
- Macro Review: What the ECB & Comey Mean for Markets
- Oil Outlook: Can It Keep Falling?
Futures and global markets are modestly lower following another quiet weekend as the tech stock declines from last week weighed on foreign markets.
Economically, Japanese Machine Orders and PPI missed estimates (-3.1% vs. (E) 0.5% and 2.1% vs. (E) 2.2%) respectively, but those reports aren't moving markets.
Politically there were no market moving headlines over the weekend as the focus was on the "micro" economic (i.e. what the steep drop in tech means for markets).
Today there are no economic reports and no expected political headlines, so focus will remain squarely on tech and whether that sector can stabilize following last week's selling, or whether it continues (if it continues I'd expect it to weigh on stocks modestly unless banks explode higher again).
S&P 500 Futures
U.S. Dollar (DXY)
Wednesday is the key day this week, as early in the day we get the latest Chinese data, then later in the morning Retail Sales and CPI, and finally the Fed meeting in the afternoon.
The Fed meeting is clearly the focus this week, and not just regarding whether they hike rates, but also the guidance (it's a meeting with the "dots.")
Last Week (Needed Context as We Start a New Week)
Stocks hit fresh all-time highs again last week, as a late-week shift in the Treasury market helped fuel a rally in bank shares that led the markets higher. Still, the S&P 500 slid 0.30% on the week, and is now up 8.62% YTD.
Stocks began the week with quiet and sideways trade, as the previous week's rally was digested and investors looked ahead to the busy calendar for the back half of the week. Economic reports on inflation and the service sector were both in line, and did not materially affect equities. The S&P slipped 0.12%.
On Tuesday, the pullback in stocks accelerated relative to Monday's very quiet trade, but the S&P still only fell 0.28% on the day. News flows were light and stocks seemed to focus on falling Treasury yields, and a flattening curve.
Stocks bounced modestly Wednesday with the S&P gaining 0.16% on the session, as positive political developments (National Security Advisor Rogers and Director of National Intelligence Coats both pushed back on the idea that they were pressured by the president on the Russian investigation) offset a substantial slide in oil prices. Additionally, the release of Comey's statement that proved to be largely benign for the administration helped ease some concerns further.
Thursday was a day of digestion, and the unchanged status of the S&P at the end of the session underscored that as investors reviewed the ECB statement and the Comey testimony. The biggest development Thursday was the steepening shift in the Treasury market (longer-dated yields rose faster than shorter dated ones) that spurred a notable rally in the financials. That trend continued through the end of the week.
Friday, stocks opened higher as the European shares largely shrugged off the shocking UK election results that left the county with a "hung Parliament" as they continue to navigate the Brexit process. Again the most notable trend in the market was the bear-steepening Treasury market that continued to support financial sector outperformance.
Your Need to Know
The major questions from an internals standpoint last week are... Are We Witnessing A Rotation In Leadership? And If So, What Does That Mean for Markets?
Those two questions stem from the significant underperformance of tech this week. Nasdaq dropped more than 1%, its first really bad performance of the year. Semiconductors and super-cap internet (FDN) dropped 1.2% and 2%, respectively, last week, which included a big decline in semiconductors on Friday (down 4%). There was some bad news in the sector (TSMC's poor sales) but it wasn't enough to cause that type of collapse, so clearly we're seeing some profit taking.
Meanwhile, banks and small caps, two cyclical laggards, handily outperformed last week as the Russell 2000 rose 1% while the BKX (bank index) rose 5%.
The reason this potential rotation is important is because if it continues, that will be a positive internal sign for markets, as banks and small caps outperform in reflationary rallies, just like they did in late 2016.
But, to be clear, one week of profit taking in tech and some late-week dip buying in banks does not mean that leadership in the market is shifting, but it is notable. If it continues that will be an anecdotally bullish, and our interest is piqued.
The major macro events of last week came and went, and while there were a lot of headlines and bluster, none of them changed the current set up for stocks. The ECB was taken as very slightly dovish, but not so much that it's impacting global bond yields. The Comey testimony didn't reveal anything new and wasn't damning enough to further reduce the chances of tax cuts; and the UK election provided another surprise, but that's a domestic issue and it shouldn't impact the US economy or markets.
So, the set up for stocks remains the same. Stocks remain incredibly resilient in the face of multiple caution signals from other assets and sectors: Treasury yields, the yield curve, recent economic data and the performance of cyclical stocks (banks especially) all sitting near 2017 and multi-month lows.
There was some mild progress on that front last week as yields moved slightly higher (for no direct reason, it just looked like an oversold bounce), and bank stocks surged on some dip buying, higher yields and anticipation of greater capital returns following potentially less onerous stress tests.
But, for us to become more positive on stocks, we will need to see a lot more progress, and the "Four Numbers That Would Make me Bullish" still stand: Will Add This Later
Until that happens, we remain cautiously positive on stocks. From a broad exposure standpoint we maintain our "Hold" opinion on US stocks, and for new money we continue to prefer more targeted, tactical exposure: Europe (the ECB didn't hurt our medium/longer term bullish thesis), emerging markets (IEMG), healthcare (XLV, IHF, IBB) and tech (FDN—we could see a short-term dip, but it's too early to say the trend has changed definitively).
Bottom line, the outlook remains largely the same: Momentum in stocks remains strong, so you can't preemptively sell this market. But there was not any real improvement in fundamentals last week, and concerning discrepancies remain between stocks, bonds, and economic data.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
There were only a few economic releases last week and the Fed circuit was silent ahead of this week's Fed events. The headline of the ISM Non-Manufacturing PMI was largely in line with expectations at 56.9 for May, and the details matched as well. The one outlier was a sharp dip in the prices category, which fell to 49.2 from 57.6. It was the first sub-50 reading in 13 months. And while the one number by itself is not very alarming, pairing it with other soft price data of late, including the weak unit labor cost on Monday, inflation data is beginning to gain some attention. For now, it is just something to monitor and will not have a material effect on Fed policy yet.
Looking overseas, the EBC decision was the big event last week. As expected, rates were left unchanged and there were no changes in the QE program. The ECB changed their risk assessment to "balanced" and also removed the potential for lower interest rates going forward. Overall, the meeting was anti-climactic as a step was taken towards eventually ending QE, but no update on the timeframe was offered.
Important Economic Data This Week
Focus will be on central banks this week as the Fed takes center stage Wednesday, the BOE is Thursday and the BOJ is Friday. The Fed will obviously attract the most attention as a rate hike is expected, but the outlook for future policy has grown cloudier. The market will be looking for any clues as to the number of rate hikes remaining in 2017, or whether the committee's sentiment towards the economy has changed in recent months.
As far as economic data goes, the NFIB Small Business Optimism Index is the first report to watch early tomorrow morning before some more widely followed reports are released beginning Wednesday. CPI and Retail Sales will both be released pre-market ahead of the FOMC on Wednesday. Later in the week we get the first look at June data from the Philly Fed Business Outlook Survey and the Empire State Manufacturing Survey as well as Industrial Production data for May. The latter will be important to see if the recent bounce in manufacturing data has continued at all in Q2 or not. Lastly on Friday, Housing Starts data for May will provide the latest update on the housing market.
Overseas, there are some important releases to watch beginning on Tuesday night with Chinese Fixed Asset Investment, Industrial Production, and Retail Sales all due at 10:00 p.m. ET. There are several second-tiered reports that may move market modestly if there are any surprises, but the only other report overseas really worth watching is the Eurozone HICP (their CPI) to see if inflation is firming at all or actually rolling over as some individual European country reports have shown (German CPI was -0.2 vs. E: -0.1% in May).
Commodities, Currencies & Bonds
In Commodities, the segment was mixed, but traded with a bias to the downside last week as gold pulled back from 2017 highs as interest rates bounced. Oil futures plunged after bearish inventory data while copper rose on supply concerns. Natural gas stabilized above $3 amid hot weather reports. The commodity ETF, DBC, fell 0.69% on the week.
Beginning in the metals, copper finally showed some signs of stabilizing thanks to supply concerns in South America due to weather and another potential labor strike in Indonesia. Cited reasons aside, copper is beginning to trade better as futures rallied 2.64% last week and finished at a more-than-one-month high. The more favorable price action in the industrial metal is turning more supportive of the gains in stocks that are largely based on economic growth and infrastructure spending, something that the price of copper is a good proxy for.
For the third time this year, gold futures rallied to new highs, and then shortly thereafter came for sale in a significant way. Futures peaked at $1298.80/oz. on Tuesday before a bear-steepening move in the Treasury market in the back half of the week saw gold reverse to fall 0.99% on the week. Bear steepening is an inflationary dynamic in the Treasury market, and that is bad for gold as it suggests that real interest rates may begin to move higher as inflation picks up. Bottom line, the gold market is still broadly in an uptrend for 2017, but we have entered a near-term downtrend (for the third time this year) that will likely see futures pullback all the way into the low to mid $1200s barring any unforeseen developments.
In the energy market, a bearish set of headlines in the EIA report on Wednesday (oil and both major refined products saw larger than expected builds) caused WTI futures to fall sharply and end the week down 3.85%. Looking ahead, the trend in the energy market is bearish and in the absence of some kind of bullish development, prices will continue lower (there is a volume gap up to $47, however, and the risk of a short squeeze exists).
In the details of the EIA report, the early signs of a potential bullish catalyst emerged as Lower 48 production fell -20K b/d, the first drop since late January. If US production rolls over and begins to fall, that would be a supportive fundamental development, but it is too early to tell at this point. So, bottom line, we remain in a lower for longer oil market environment right now.
Looking at Currencies, it was an active week as traders focused on politics, elections, congressional testimony and a limited amount of economic data. The dollar gained 0.6% on the week, but only after falling to multi-month lows.
Going through the big events that affected the currency markets last week, the UK election shock caused a sizeable drop in the pound on Friday. The pound finished the week down 1.5% at a near two-month-low. The uncertainties created by the "hung Parliament" that resulted from the elections Thursday are a stiff headwind for the British currency near term. The reason is simply a complete lack of clarity regarding the next steps in the Brexit process and how the process will proceed. Near term, the weak currency is a good thing for UK stocks. Longer term, uncertainties about how the economy will weather the Brexit process will keep a lid on gains.
Elsewhere in Europe, the euro pulled back from multi-month highs as the ECB was received as slightly dovish, but supportive of the economic growth outlook. That is why the euro declined but Treasury yields rose. Looking ahead, if the euro rally rolls over here, that will be key to the dollar establishing a bottom for 2017 and beginning to rally again as a part of the Trump trade.
In Asia, the yen traded higher in the front half of the week on political and international market uncertainty as part of a risk-off move, but that move reversed direction on Wednesday and the Japanese currency finished the week essentially flat as money flows shifted back in to risk-on mode in the back half of the week. Looking ahead, the outlook for the USD/JPY remains neutral, but if the reflation trade resumes, the trend of dollar strength over the yen will reestablish itself as a dominant trend in the currency markets.
Turning to bonds, there was a notable shift in the Treasury market in the back half of last week, as long dated Treasury yields rose at a faster pace than shorter dated yields, resulting in a bear steepening. These conditions in the bond market are inflationary, and are near term consistent with the Trump/reflation trade resuming.
To be clear, the downtrends in yields have not been materially broken and uptrends have not yet clearly emerged, but the rotation of funds in the Treasury market did notably effect trading in stocks in the back half of the week, as financials surged Thursday and materially outperformed into the weekend.
Bottom line, we have approached a tipping point in the bond market, and Treasuries will either confirm that the reflation trade is back on with rising yields and a steepening curve, something that hasn't happened since late 2016, or the yields will fade and the divergence between stocks and bonds will continue. And if the latter is the case, it would be tough to construct an argument for the S&P 500 moving through the 2450 level.
Special Reports and Editorial
Why Bond Yields Are Important (A Plain-English Primer)
For more than two months, I've been talking about the increasingly concerning macro signals being sent by the bond market. During that time, stocks have traded great, hitting new highs amidst minimal volatility.
So, it's logical to ask why I and many other analysts continue to point out these signs of non-confirmation of the rally from the bond market. After all, it hasn't caused a problem in stocks, yet. But, I guarantee it will cause a problem (and potentially a painful one) if bond yields keep falling… it's just a question of when.
Given that, I wanted to take a moment and explain more fully, and in plain English, why I'm watching the bond market so closely, and exactly what the bond market is saying about future economic growth and inflation.
First, I watch the bond market because it's a better predictor of future 1) economic growth, 2) inflation, and 3) interest rate levels, compared to stocks or most economists' estimates. Case in point, the bond market told us the financial crisis was coming when the yield curve inverted over a year before the turmoil, and well before Fed Chair Bernanke said subprime was "well contained."
The joke is that bonds are more accurate because the smartest people on Wall Street always end up on the fixed-income desks (it's why we call it the "smart market"). And while that may be true (and I can say that as I was an equities guy), in reality bonds are better forecasters of these variables because A) The bond market is much larger and more liquid then the stock market, and B) Stock prices, at their core, are just discounted estimates of corporate cash flows, and there are a lot of variables that go into those future cash flows that are very company specific.
Conversely, in the bond market, everything trades off a spread to Treasuries, and Treasuries price off expectations for 1) growth, 2) inflation and 3) future interest rate levels. Point being, there are less variables in the bond market, and the market is more liquid. That equals more efficiency.
Right now, that more efficient market is screaming that future economic growth and inflation will be disappointing, and that the Fed is going to hike rates, regardless.
The disappointing economic growth and inflation can be extrapolated from the decline in the 10- and 30-year Treasury yields. They fall because markets expect lower longer-term economic growth and inflation, which equates to a lower rise in interest rates over the longer term. After a brief bump in late '16, the 10- and 30-year yields are telling us that the slow-growth economy is here to stay (so around 2% GDP growth).
However, in the short term, 2-Year Treasury yields are the best bond proxy for bond market expectations for the Fed funds rate, and that keeps rising (the 2-Year Treasury yield has risen from 1.2% to 1.32%). So, what the long end of the curve is saying is that rates may not go as high as we thought at the start of 2017 because of poor growth and low inflation. However, the short end of the curve (2-year yields) is saying that, right now, the Fed will continue to hike rates.
More specifically, maybe Fed funds will be 1.5% in a year (so 2-year yields rise) but it'll only get to 3% over the next four years (so 10- and 30-year rates fall). I'm making those numbers up, but you get the point.
Why does this matter to stocks? Because the short term aside, neither you nor I want to be overweight stocks at 18X earnings in a slow-growth and rising rate environment.
Think of it this way: From 2015 to 2016, earnings growth was flat and stocks went nowhere and volatility was high. Then, last year, earnings growth started to be revised higher, and stocks have rallied.
If the bond market is right about economic growth prospects and interest rate hikes, then that will hit expected earnings growth, and stocks will fall.
From a "how to play it" standpoint, the blueprint is clear: Defensive, higher-yielding equities like consumer staples (XLP) and utilities (XLU) (two of the best-performing sectors in 2017), and international exposure (Europe via HEDJ, EUZ) and emerging markets (IEMG).
Conversely, this set up will be very bad for banks, and the current selling is just the beginning if yields correctly forecast slowing growth. Finally, while they've held up well, it's unlikely tech will be able to continue to rally longer term.
Bottom line, the signals in the bond market are important because they are telling us lower growth and inflation are coming, but with higher interest rates. That is a very bad set up for stocks at such stretched valuations, and that's why we're watching the bond market so closely.
The Comey Testimony
Former FBI Director Comey's testimony contained multiple headlines that media outlets seized on, but from a market standpoint, nothing new was revealed. The ongoing political soap opera aside, all markets have ever cared about was whether these various scandals made it less likely for Republicans to coalesce around a tax cut strategy. Comey's testimony was not damaging enough to cause further erosion of support for the president and his agenda from Republicans. As such, it wasn't a market negative despite the multiple, sensational headlines.
The ECB left rates unchanged, and made no changes to the QE program, as expected. The ECB met expectations Thursday, as they changed the risk assessment to "balanced," and also removed the potential for lower interest rates going forward.
Overall, it was an anticlimactic meeting as the committee took another step towards the eventual end of QE, but gave no indication that the end of QE or rate hikes would occur sooner than was currently expected. As a result, the market largely yawned at the decision.
The euro dipped slightly on the news, despite it being a technical "hawkish" shift, and that's because this result was already priced into the euro above 1.12. Thus, we saw a classic sell-the-news reaction.
Going forward, with the euro at current levels, whether the rally continues will depend more on US and EU economic data than anything else, as central bank policies for both the Fed and ECB are well known (the Fed should hike next week, and stick to the current guidance of three hikes for 2017).
From a bond standpoint, German bund yields dipped slightly following the statement, again a sell-the-news reaction. However, Treasury yields bounced slightly, mainly due to how short-term oversold they are. Bottom line, the ECB decision did not provide any surprises, and it will not cause Treasury yields to embark on a rally. Whether yields can rally from here will depend on economic data.
From an equity standpoint, I do not view this decision as negative for European stocks, and I remain bullish on European stocks via HEDJ and EZU. It'll take a material uptick in US economic data for the euro to begin to weaken materially vs. the dollar over the next few months, but even if that doesn't happen, the positive economic growth and continued QE should continue to put a tailwind behind EU stocks.
Three Momentum Indicators to Watch
Momentum, more so than anything else, is driving this rally in stocks. And while momentum is clearly a powerful force, it can also be fickle. When momentum dissipates, there are usually air pockets underneath the market (see August 2015).
The trick to outperforming, then, is knowing when momentum is waning, and we want to identify three momentum indicators we're watching to stay ahead of that move. Those momentum indicators are: Two tech sub-sectors (FDN and SOXX), the NYSE Advance/Decline Line, and Market Sentiment.
Starting with the latter, it's important to realize that momentum and sentiment, while related, are different. Momentum refers to a state of market psychology where higher prices themselves become the biggest bullish force, as underinvested people and portfolio managers chase stocks higher and aggressively buy any dip out of fear of underperforming. Unlike sentiment, strong momentum is not, by itself, a contrarian indicator (like overly bullish or bearish sentiment indicators).
That said, in today's market, a very bullish sentiment indicator could be a sign of an impending loss of momentum, as the bullish reading implies that everyone is "all in" on stocks, leaving a lack of capital to "chase" stocks higher.
Right now, despite new highs in stocks, there are few signs that sentiment is near the highs. In fact, sentiment remains remarkably depressed for how strong the market has been in 2017.
Momentum Indicator #1: Sentiment Indicators. The AAII Investors Sentiment Survey showed just 26.9% bulls vs. the historical average of 38.5%. The TMI Group Market Sentiment Index revealed just 49.8% bulls (the scale goes to 100) while the Citi Panic/Euphoria Model remains comfortably in "Neutral" range. Point being, if bullish sentiment is a sign of an impending loss of momentum in stocks, we've got a long way to go.
Momentum Indicator #2: FDN & SOXX. One of the reasons I look at sector trading every single day is because every rally is driven by a few sectors, or what I and others call "leadership" sectors. When these leadership sectors falter, that usually implies an impending loss of momentum.
Since late 2016, semiconductors have been the biggest leadership sector in the markets. They rallied big during the Q4 '16 rally, and they are up big so far in 2017 (SOXX up 22%). While other sector leadership sifted from late '16 to '17 (banks and small caps to utilities, consumer staples and super-cap internet) semiconductors have continued to scream higher.
Similarly, as I and others have noted, nearly half of the 2017 S&P 500 rally can be attributed to just a few stocks: AAPL, AMZN, MSFT, FB, GOOGL. Those stocks are heavily weighted in the super-cap internet ETF FDN, and as such, that is a leadership sector in 2017.
So, these are two important sectors to watch as any possible breakdown will imply a loss of momentum. It happened in the spring of '14 when the then leadership sector biotech broke down and caused a pullback. It also happened before the pullback in August '15 when the "FANG" stocks (leaders at the time) topped out in July—a month before the stock market fell.
Right now, the uptrends in FDN and SOXX are in good shape, but we will be looking for a violation of those uptrends as a clue the market may be about to lose momentum.
Momentum Indicator #3: NYSE Advance/Decline Line. I'm not a huge fan of multiple measures of market breadth, but I do watch the advance/decline line, as it gives insight into buyer enthusiasm (i.e. the level of momentum). And, it's proven to be an accurate indicator in these types of markets (the A/D Line topped out in April, a month before the market topped in May 2015).
Right now, the A/D line just hit a new high. But, once again, we're looking for any signs of a trend break as a sign that momentum is waning. You'll never hear me say that fundamentals don't matter, because they do over the medium/longer term, and that's what most of us are focused on. Yet we're also judged in the short term by our clients and our competition, so getting both right is important.
Momentum in stocks remains higher still, but getting the break right, before our competition, will be the key to outperforming. The reason why is because with stocks this extended, a sharp, nasty and painful pullback is lurking somewhere out there. We're focused on making sure you avoid it, and we'll update you when any of these momentum indicators begin to break down.
EIA Analysis and Oil Update
Oil and the refined products plunged across the board early last week thanks to a unexpectedly bearish set of headlines in the weekly EIA data. Oil stockpiles surprisingly rose +1.6M bbls last week versus analysts estimates of -3.5M bbls, and the API report that showed a -4.6M bbl decline. The increase in stockpiles was the first in nine weeks. WTI fell 5.06%.
The energy sell-off actually started on Tuesday thanks to the +4.1M bbl build in gasoline supply according to the API. Analysts were expecting a -200K bbl draw. The RBOB figure in the EIA report was +3.3M yesterday morning, slightly less than the API, but being it was the first build in over a month it was enough to help contribute to the collapse in the complex. On balance, oil and product supply changes were bearish, as multi-week streaks of declines were broken. Recall that the string of oil draws was one of the two potentially supportive underlying influences on energy prices, but that trend has now decidedly weakened.
The other underlying bullish influence has been a slower pace in increasing US production since early April, and that trend actually accelerated last week. Lower 48 production fell -20K b/d, the first decline since late January. The decline was not; however, enough to spur any bullish speculation as it only dented the 2017 production growth by 3%. The output in the lower 48 remains up 574K barrels, or roughly half of the pledged OPEC supply cut lasting into Q1'18. Furthermore, in a monthly release the EIA said on Tuesday that they expect US production to rise to record levels of 10M b/d+ in 2018. So, the takeaway from the production data is that a single, 3% dent in the steady trend of rising production is not enough to offer the market support. And until output levels rollover in a more decided fashion, elevated US production will remain a bearish influence.
Bottom line, the oil market remains fixated on the highly elevated global stockpiles, and the increasing doubts surrounding the OPEC/NOPEC agreement and how effective it will be in bringing those supply levels back towards the five-year average.
Additionally, the dominant trend of rising US oil output remains very much intact, and that will continue to be a substantial headwind for the energy market for the months and quarters ahead if it persists. On the charts, the trend in oil prices has been bearish since March, and the path of least resistance is lower still from here.
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