|Garzarelli Indicators||Up to 75% from 73%|
Stocks continue to surge due to Trump’s speech this week, strong consumer confidence, higher house prices, and declining employment claims. The odds of a March hike were only at 24.0 percent three weeks ago. Since then, economic stats such as retail sales, the CPI, existing house sales, unemployment claims, and the LEI have been good. The odds, therefore, of a March rate hike have increased to 90.0 percent. Also, N.Y. Fed President Dudley commented "the stock market is up, credit spreads are narrow and we have the expectation that fiscal policy will probably move in a more simulative direction.” Fed governor Brainard said “it will likely be appropriate soon to remove additional accommodation.”
Clients have asked what would cause us concern about the stock market. Higher interest rates creating an inverted yield curve, the economy reversing into recession, global economic turmoil, or a significant rise in oil prices and inflation would be cause for concern. Those events are unlikely soon, in our opinion.
A bear market will likely not occur until the Fed tightenings lead to an inverted yield curve, which is when short-term rates rise above long-term rates. Chart 1 shows that based on the spread between the current federal funds rate and the 10-year T-bond yield, we are far from an inverted yield curve. The federal funds rate is 0.66 percent and the 10-year Treasury bond yield is 2.48 percent. Therefore, it would take a long string of tightenings for short rates (over 182 basis points) to rise above long rates. This means it would be a long time from now before an inverted yield curve becomes a problem.
Our proprietary stock market indicator composite is at 74.5 percent. We remain bullish and fully invested in equities since our composite is above the 30.0 percent bearish signal. The Fed will likely raise rates this month and our studies have shown that stocks rise during Fed tightening cycles, and generally peak after the last tightening. The Fed is only in the initial stages of raising rates, so it will be some time before the end of the cycle occurs.
The number of bullish advisors (our contrarian indicator) rose to 63.1 percent (a 30-year high) from 61.2 percent. As a contrarian indicator, a level about 53.0 percent is a negative sign for stocks. We rank this indicator bearish.
As we mentioned before in our reports, stocks are around fair value based on our P/E model. However, when our overall stock market composite is bullish as it is currently, stocks can rise above fair value, sometimes by 20.0 to 50.0 percent. Our P/E model indicates a fair value P/E for the S&P 500 of 18X and along with our S&P 500 earnings estimate of 129.00, fair value for the S&P 500 is 2322.
The ratio of the junk bond yield to the 10-year T-bond yield (Chart 2) is ranked bullish. Junk bond have been falling and are down over 40 basis points in two weeks while the 10-year T-bond yield is up slightly. This is positive for stocks since the ratio has an inverse relationship with the S&P 500.
The Bloomberg financial conditions index (Chart 3) gives us indication of the health of the financial industry. It combines yield spreads and indices from U.S. money markets, equity markets, and bond markets into a normalized index. Since the index continues on an uptrend, we rank it bullish.
We look to the economic cycle research institute weekly leading index ECRI (Chart 4) for indication of changes in the economic cycle. We continue to rank it bullish since it rose again this week with a 10.2 percent growth rate. It has been on an uptrend since early last year, indicating a recession is not likely anytime soon.
Economic stats were largely favorable this week. Existing house prices rose +3.1 percent (m/m) in January and the Case-Shiller house price index rose +5.6 percent (y/y). New orders for durable goods rose 1.8 percent in January, and real GDP growth was unchanged at a 1.9 percent annual rate in the second estimate of the fourth quarter.
With the rise in stock prices, consumer net worth is on track to rise about +9.0 percent (y/y) in the first quarter. Consumer confidence rose +3.2 in February to a 16-year high and is 22.0 percent higher than last year, which supports discretionary spending. Consumer spending has been strong in the first quarter, supported by rising employment, disposable income, and household wealth. We expect first-quarter real consumer spending to grow 3.0 percent, stronger than the 1.6 percent growth in the first quarter of last year. Nominal wages and salaries rose a solid +4.5 percent (y/y) in January.
The U.S. manufacturing sector was held back by a strong dollar and excess inventories over the past few years but these stats indicate better times are ahead for manufacturing. The February ISM purchasing managers' index (PMI) rose to 57.7, up from 56.0 in January, the highest level since August 2014.
Table 1 lists all the sectors in the S&P 500 with their associated ETFs. For those interested, we also list the ETFs that seek a return that is 1x, 2x, and 3x the return of the index for a single day. They should be used for short-term trades only. The S&P weights are indicated for all the sectors as well as our recommended weights.
We underweight those sectors that we do not expect to have superior returns to the S&P 500. We believe the weighting for each issue should be based on one’s individual situation and preference.
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