Note: the previous blog post (Market Outlook 2020) discussed the major political, geopolitical and economic issues currently influencing the market.
Instead of reiterating these topics, this comment will go directly to a discussion of market conditions and sectors.
Market Strategy Review
Note: the following summary covers the current status of the U.S. stock market, by reviewing a checklist of key indicators.
Price / Volume activity
The market uptrend that has unfolded over the past three months remains strong, with very few signs of institutional selling, until the notable decline on Friday, January 24th. Money flow indicators remain positive and there have been only a few distribution days in the past month. (Note: a distribution day is basically a day with a sharp selloff on big volume. Keeping track of such days is a technique developed by Investor’s Business Daily to monitor the market’s health. More than six or seven of these days within a month is a bearish sign for the market.)
Behavior of Leading Stocks
A review of leading stocks shows that most have relatively strong technical positions and are not showing signs of peaking. In fact some have just broken out to new highs, a bullish sign.
Breadth / Divergences
The Advance / Decline line has been in an uptrend and other breadth indicators have been generally positive. However, as these comments are being posted on 1/24/20 , some breadth indicators are down sharply for the day, indicating increased risk that a market pullback could be starting.
Overbought / Oversold
The market is overbought on a short-term basis, having risen steadily for the past 3 months. From its October 2019 lows to 1/17/20, the S&P 500 advanced by more than 16%.
Based on favorable seasonal tendencies, stocks could keep rising for another month or so, as money pours into the stock market following the strong gains that we saw in calendar year 2019.
However, given the market’s current overbought condition, the near-term outlook depends on news events. If the global macro news remains benign, the recent uptrend could continue. But any major worrisome geopolitical news, such as renewed conflict in the Middle East, or the news that has just emerged in the last few days regarding a deadly virus in China, could spark a round of profit-taking.
Thus there is a possibility that a 5% – 10% correction could unfold in the next few weeks or so. After a strong advance in January 2018, stocks plunged into a 10% correction in February 2018, with very little warning except for the fact that the market had become overbought.
Support / Resistance
As the market is near all-time highs (roughly 3,330 on the S&P 500), it faces no technical resistance levels, but its overbought condition is still worrisome.
The S&P 500 has support at various levels such as its 50-day moving average, which is now around 3195, and the 38% Fibonacci retracement of its recent move, which is around 3160. A pullback to these levels would be a 4% – 5% decline. In a sharp selloff (e.g. February 2018), the market could drop to its 200-day moving average, which is currently very close to the 3,000 level, a decline of roughly 10% (see chart below).
However, after the strong move of the past three months, any pullback is likely to be followed by another rally, because many investors will probably view the pullback as a chance to get into the market.
Figure 1 S&P 500 daily chart — late 2019 thru 1/24/20
Sentiment:
Investors Intelligence survey — Percentage of Bulls roughly 57%, Bears only 18% — not an extreme level, but shows a fairly high degree of optimism or complacency, which is bearish from a contrarian standpoint.
VIX — Over the past week, the VIX has risen from 12 to 14.6, which could be considered a worrisome development.
Put / Call ratio (Above 1.20 shows excessive pessimism, which is bullish. Below 0.60 shows excessive optimism, which is bearish.) Currently 1.01 – not showing enough pessimism for a bottom (implying the risk of more downside).
Conclusion: Asset Allocation
Based on the strong economy, low interest rates, and other factors, we consider the market to be in a long-term bull market, but overbought on a short-term basis. This leads to the conclusion that asset allocation should be at a fairly high level of 70%, as highlighted in the following diagram.
Sectors:
One valuable way to analyze sector rotation is to study trends in relative strength. Relative strength is one of the best technical indicators.
In general, we want to be overweighted in the sectors whose relative strength is in an uptrend, and underweighted in the sectors whose relative strength is in a downtrend.
Current Sector Trends in Relative Strength
Uptrends: Health Care, Technology
Figure 2 Technology sector – weekly chart — has been outperforming
(Note: the Relative Strength line at the top of these charts shows the performance of the sector relative to the S&P 500. When this line is rising, it means the sector is outperforming the market, and when the line is falling, it means the sector is underperforming.)
Downtrends: Basic Materials, Energy
Figure 3 Energy sector – weekly chart — has been underperforming
From a contrarian viewpoint, the charts shown above suggest that we should sell technology stocks and replace them with energy stocks. However, this analysis is oversimplified, because trends in relative strength can persist for a long time. Before committing to such a move, we would want to see more evidence of a major peak in technology stocks, along with evidence that energy stocks have formed a bottom.
Thus at this time we would be overweighted in the technology sector, and underweighted in the energy sector.
Observations on sectors and industry groups:
Basic materials: the sector has been lagging, with a few exceptions such as building materials and lumber.
Industrials: relative strength has been flat to down, with the exception of a few groups such as business services.
Energy: as shown above, the energy sector has been lagging for some time.
Consumer cyclicals: ETFs of this sector, such as XLY, are generally dominated by Amazon.com (AMZN) which has a market cap of over $900 billion. XLY has performed in-line with the market over the last two years, similar to the performance of AMZN. However, other stocks in the sector have been outperforming, such as Starbucks (SBUX) and Target (TGT).
Consumer staples: have generally lagged the market’s latest rally over the past few months
Health care: presents a mixed picture, as some industries have been strong, such as diagnostics and research, while others have been weak, such as generic drugs. Biotechnology has made a notable rally in the past few months.
Financials: have had generally flat relative strength (performing in-line with the market), but a few areas have been very strong such as credit services (Visa, Mastercard, etc.) which have just broken out to new highs and have very good chart patterns and good fundamentals.
Technology: contains several attractive areas. The technology ETFs such as XLK have been very strong, but this is a bit deceptive, as they have been heavily influenced by the extraordinary strength in giant names such as Apple (AAPL) and Microsoft (MSFT), while some areas of technology have actually been rather weak, such as communications equipment and computer systems.
Figure 4 AAPL’s relative strength line has become parabolic overbought
Based on this chart, if we own a large position in AAPL, this would be a good time to take some defensive action, such as selling covered calls on the stock, or placing a stop loss on a partial position to lock in some gains, while continuing to maintain another position as a long-term core holding. AAPL’s 50-day (10-week) moving average is currently around $290, and a pullback to that level would be perfectly normal.
My work shows that the most attractive groups within the technology sector are:
- Electronic gaming
- Health information services
- Semiconductor equipment
- Semiconductors
- Software — application
This is based on the following data:
Figure 5 Summary of Technical and Fundamental data for groups within the Technology sector (as of 1/17/20)
This data is from a weekly spreadsheet covering over 1,100 stocks and ETFs. It summarizes both technical and fundamental data. Bullish technical developments include breakouts to new highs, improving money flow, etc. Bearish developments include weak relative strength, weak money flow, etc.)
The fundamental data is from a proven quantitative stock selection model based on factors such as earnings growth and earnings estimate revisions. The columns above show the net total of bullish data minus bearish data.
This type of analysis often provides valuable insights into what is going on beneath the surface of the market.
For example we can see that the semiconductor equipment stocks have been forming a lot of bullish technical signals, and also have bullish fundamentals.
Then we can drill down to the level of individual stocks and find the best stocks within these groups. The next blog post will show specific stock picks from the strongest groups in the market, based on both fundamental and technical data.