Weekly Market Update
Sunday, March 29, 2020
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Congress passed the $2 trillion stimulus bill and this will help the markets stabilize and possibly find a bottom. The SPX (big caps) is down 25%, and the small caps are down 35% from the recent highs, and they have recently bounced. This was one of the fastest and most violent corrections we've seen since 1987.
Stocks sold-off in anticipation of a recession hitting the US, which will usually take the forward 4 quarter S&P500 P/E ratio down to 13x to 14x. With the SPX at 2540, the forward 4 quarter S&P500 P/E ratio sits at 15.8x, and this is using a reduced earnings number of $160 versus the $175 that we've been using for the last 6 months. (Forward earnings estimates are supplied by FactSet) There is a moderate probability that the SPX (and the other major indices) will retest the most recent low of 2350 as covid-19 infection rates continue to trend higher. However, over time, the market runs out of sellers and stocks won't sell-off as much with bad news; we might have already reached this point.
Q419 earnings season is complete where earnings growth came in at +0.9% for the 500 large-cap companies that reside in the S&P500 index. This was a good showing since growth was slightly positive. Unfortunately, analysts are going to reduce earnings projections, and we'll get more visibility in mid to late April when companies start to release Q120 earnings. Analysts will be listening closely to the CEO and CFO on each earnings conference call to see how covid-19 is impacting their businesses.
As of late February the economy was in good shape growing at +2.0%, inflation and interest rates were/are low, employment was strong, the US consumer was strong, the Fed was dovish, and corporate earnings growth was acceptable to investors coming in with flattish to slightly positive growth. Based on that data in late February there was no recession in sight through late 2020. However, with covid-19 shutting down most of the US, this will dramatically slow US and global growth and it will most likely push the US into a shallow recession for one or two quarters.
On the risk to the downside, two major support levels for the SPX were breached, but so far it looks like the SPX might have found a bottom at 2350. We'll need a couple more weeks of trade to see if 2350 will hold.
Regarding our Large Cap Growth stock service, we've been running scans identifying the highest quality companies that have been hit with a 25% or greater pullback. We are now starting to open positions. Some high quality companies are down as much as 40%. These companies reside in the top 20 percentile for earnings growth and for other fundamental metrics. These companies are on *SALE* and we believe most of these stocks will increase by 50% to 100% over the next 12 months. We only get a *SALE* like this once per decade, so we are starting to take advantage of the current market dynamics. For more info on the Large Cap Growth service, where we can also autotrade it where we do all of the buying and selling, please go to https://upsideoptions.net/large-cap-growth. If you have interest in the Large Cap Service it's recommended to set up your account, and the associated autotrade rule if you want to autotrade, as soon as possible as we are now adding positions.
Overall, it's going to take many more weeks for this market to stabilize and for volatility to decline, as a tremendous amount of technical damage has been caused by this sell-off.
Analysis
Below are the daily and weekly charts of the Dow Jones Industrial Average Index. The Dow has rebounded a little, and is down 27% from the covid-19 pandemic. This type of crash caused by an exogenous shock is impossible to predict. Just prior to the crash the breadth indicators were good, earnings were okay and beginning to strengthen, the jobs market was very good, consumer spending was strong, inflation and interest rates were/are low, and the stock market was enjoying some upside momentum from a seasonal tailwind that usually lasts through April. Stocks were expensive trading at 19.0x forward earnings, but stocks can remain expensive for a while, especially heading into March and April that are the seasonally strongest months of the year, barring any external shocks. A shock to the market was required to trigger a sell-off, and we definitely got one. We can see that the Dow is back near the Dec 2018 low of 21,790. The next milestone is to get through this week where new covid-19 infections are still rising rapidly, and to get through Friday's jobs report that will be shocking.
Below are the daily and weekly charts of the S&P 500 Index. We can see that the SPX has rebounded a little and is down 25% from the covid-19 pandemic. Stocks have been selling-off in anticipation of a recession hitting the US, which will usually take the forward 4 quarter S&P500 P/E ratio down to 13x to 14x. With the SPX at 2540, the forward 4 quarter S&P500 P/E ratio is 15.8x, and this is using a reduced earnings number of $160 versus the $175 that we've been using for the last 6 months. (Forward earnings estimates are supplied by FactSet) There is a moderate probability that the SPX will retest the low of 2350 as covid-19 infection rates continue to trend higher.
Below are the daily and weekly charts of the NASDAQ Composite Index representing 3300 stocks. We can see that this index is back above 7313 representing a major support level.
Below are the daily and weekly charts of the NYSE Composite index that represents 1900 stocks. This is a very ugly chart! We can see that this index broke below 10,778 and so far has found support at 8942. We'll need a couple weeks of trade to see what levels will hold.
Below is the daily chart of the QQQs that represent 100 of the largest mostly technology companies. So far, it looks like this index is finding support at 170. We'll need a couple weeks of trade to see if this level will hold.
Below is the S&P400 mid-cap index. This is another very ugly chart! We can see that this index already tested 1219 and bounced. We'll need a couple weeks of trade to see if this level will hold.
Below are the daily and weekly charts of the IWM ETF that tracks the Russell 2000 small-cap index. We can see that this index is down 35% and already tested 94, representing the 2016 low. We'll need a couple weeks of trade to see if 94 is the bottom.
Macro-Level, Fundamental View of US Economy's Underlying Health
Below are a selection of macroeconomic indicators to give us a big-picture, fundamental view of the health of the US economy. If/when the US economy begins to weaken per deteriorating macroeconomic indicators and corporate earnings, along with increasing stair-step volatility, this information will alert us to: 1) Incrementally reduce our downside exposure, and be more careful and wait for key economic data before opening additional bullish trades; 2) Alert us to increase exposure levels of bearish trades; 3) Tell us when it's time to move to the sidelines. Per exogenous shocks such as a virus pandemic where stocks can be down 30% in two weeks, this type of event is impossible to predict.
Initial Unemployment Claims, a weekly report that measures the rate of people being fired from their jobs, increased by 3.2 million to 3.28 million. When initial unemployment claims drop below 400k it's classified to be in the "recovery zone" and the economy will usually add +100k jobs monthly. When new claims are near 350k we'll usually see 150k+ new jobs monthly; when it's near 325k it usually represents strong job growth and a healthy economy that is expanding at a GDP growth rate of 3.5% to 4.0%, historically. When new claims drop below 290k, historically, the economy is usually overheating and inflation becomes a problem. The 2nd chart is the 4 week average going back to 2001 showing how this indicator behaves during good times and bad. Overall, as expected, this showed a massive increase in new claims, which was unprecedented in magnitude and velocity. Congress passed a $2 trillion bill that we hope will save many of these jobs.
Overall, the shutdown because of covid-19 will change all of the past economic data because US and global growth will slow considerably.
Earnings & Price/Earnings Multiple:
Q419 earnings season is complete where earnings growth came in at +0.9% for the 500 large-cap companies that reside in the S&P500 index. This was a good showing since growth was slightly positive this time. Over the last three quarters, investors have been okay with these slightly negative to flat earnings growth results. However, it's only a matter of time before analysts start to reduce earnings projections, and we'll get more visibility in mid to late April when companies start to release Q120 earnings. Analysts will be listening closely to the CEO and CFO on each earnings conference call to see how the coronavirus is impacting their businesses.
Q319 earnings season is complete. Earnings growth came in at -2.2%. This represents the 3rd consecutive quarter with negative earnings growth. Revenue growth came in at +3.1%. With this said, the stock market is okay with these results and investors have been moving cash back into stocks.
Q219 earnings season is complete. Earnings growth came in at -0.4%, and revenue growth came in at +4.0%. This represents the 2nd consecutive quarter with negative earnings growth.
Q119 earnings season is complete. Earnings growth came in at -0.4%, which was better than the -4.8% expected decline that was estimated by analysts. Revenue growth came in at +5.3%, which was good. With this said, corporate earnings are again expected to experience zero to slightly negative growth for Q2, and earnings growth is what ultimately drives stock prices.
Q418 earnings season is complete. Earnings growth came in at +13.1%, which is slower than in the last couple of quarters, but it's still a strong number; and revenue growth came in at +5.8%.
For Q318 earnings season the S&P500 companies reported earnings growth of +25.9%, and revenue growth at +9.3%, both which are excellent results and the strongest readings since Q3 2010.
For Q218 earnings season the S&P500 companies reported earnings growth of +24.5% and revenue growth of +9.8%, which represents very strong growth.
For Q118 earnings season the growth rate of the S&P500 companies came in at +24.6% and sales growth at +8.5%, which are excellent results and the strongest growth rates since Q3 2010.
Valuation: The current 12-month forward P/E ratio for the S&P500 is 15.8x, based on a price of 2540 (SPX) and a forward 12-month EPS estimate of $160. We lowered the forward earnings projection from $175 to $160 in anticipation of the covid-19 outbreak impacting company's earnings. Stocks are classified as inexpensive at a 15.8x multiple. Historical P/E averages for the S&P500 are the following: 10-year (15.0) and 5-year (16.7). Because interest rates are low, such as the 10 year treasury at 0.75%, P/E ratios could/should trade at higher levels, when the US is not heading into a potential recession. (A recession is definitely a possibility) Per past highs, one data point to ponder is that the S&P 500 forward P/E peaked at 21x forward earnings in March 2000, just before the dot.com crash and recession.
Volatility: Below is the VIX fear gauge closing Friday at 65.5 where it has spiked from fear of the coronavirus and how it will slow US and global economic growth. Volatility will probably remain elevated over the next three to four weeks, or longer, as this pandemic persists.
Performance of the credit markets, known as the "smart money", which usually has a good track record of predicting the future direction of the stock market:
Below is a chart of the iShares high yield corporate bond ETF, HYG. High yield corporate bonds, also called junk bonds with a grade of BBB or lower, are a proxy for investor appetite for risk. When HYG declines it represents "credit stress" in the corporate debt markets and sends a "risk-off" signal that will eventually weigh on equities. When this index falls it's telling us that corporate bond investors are requiring higher interest rates on the bonds that companies are issuing. That is, investors believe there is more risk with companies defaulting on their debt, so they demand higher interest rates to compensate for the added risk. Currently, HYG has declined to 77, telling us that the high yield credit markets are getting stressed and that investors are demanding higher rates to compensate for higher levels of risk. Further on the negative, some analysts believe that high corporate debt levels will exacerbate the next recession when it eventually hits, which could be sometime this year.
Below is the iShares iBoxx Investment Grade Corporate Bond ETF - LQD, which represents investment grade corporate bonds with a quality rating of BB or higher. Investors have been moving cash into these "safer" corporate bonds to get higher yields for most of 2019. Currently, this index has pulled back hard but has bounced a little, telling us that corporate bond investors are feeling less comfortable with the risk of default for the companies that issue investment grade corporate debt, and they are now demanding higher rates of return to compensate for higher risk levels.
Below is the UUP that tracks the relative performance of the US dollar to a basket of currencies. In general, a strong dollar is a positive for US equities, as long as it doesn't get too strong. If it gets too strong it will impact the big-cap, multi-national companies because 35% of their revenue typically comes from outside the US, and a strong dollar makes their goods more expensive and less competitive outside the US. For emerging economies that have borrowed heavily in dollar denominated debt, a stronger dollar is a negative because it increases their interest expenses. Over the last couple of years, one reason the dollar has been strong was that investors from around the world were buying dollars to buy US treasuries to get a high yield, compared to negative yields offered by other countries such as Germany, Japan and Switzerland. Currently, the dollar is bouncing around violently and it will take many weeks for this to stabilize.
The yield on the 10 year treasury is at 0.75%, recently collapsing to an all time low as cash has been moving into bonds from fear of the coronavirus. It also fell because the Fed recently cut interest rates again in response to the coronavirus. Bonds/treasuries represent the "smart money" and it predicts a slowdown in the US economy over the next 6 to 9 months. Overall, cash has been flowing into bonds pushing down the yield, from fear of the coronavirus.
Posture of the Federal Reserve on Monetary Policy - The Fed made a 180 degree pivot in January 2019 and went back to a dovish stance where they decided to pause on raising short term interest rates. The Fed then lowered interest rates by 25 basis points in July, 25 basis points in September, and a final 25 basis points in October 2019. The Fed in late October sent the message that they were done lowering rates and are now data dependent. Currently, the Fed cut rates to zero in an emergency move, so they are out of ammunition. The market is betting that the Coronavirus will slow US and global growth.
The slope of the yield curve as measured by the interest rate of the 10 year treasury less the rate of the 2 year treasury steepened, which is a positive, but it's bouncing around from fear of the coronavirus. The bond market (the "smart money") has been predicting that the US economy will slow over the next 6 to 9 months since the yield curve has been flattish over the last 16 months. It will take many weeks for this to stabilize.
Performance of world markets, which ultimately affect US markets:
Below is the iShares 350 Index (IEV) representing 350 companies within 13 European countries - This ETF crashed over the last three weeks.
Below is EWG, an ETF that tracks a basket of large German stocks. This ETF crashed over the last three weeks. Germany is the largest economy in the Eurozone, so it's a leading indicator for most of Western Europe. The weakness over the last year was from an economic slowdown in Germany where their economy was growing near zero percent.
Below is EWU, an ETF that represents a basket of stocks in the United Kingdom. This ETF crashed over the last three weeks. The weakness over the last year has been from an economic slowdown in Europe, uncertainty around Brexit, and Trump's threat that they will impose tariffs on European products.
Below is the ACWX, an ETF that represents large companies within mostly developed markets around the globe, less the United States. This ETF crashed over the last three weeks, which is a negative for global equities.
Below is the EEM, an ETF that represents large companies within emerging markets around the globe. Some of the weakness in late 2018 was from a strong US dollar that was making interest payments higher for the countries that have dollar denominated debt. Also, a strong dollar puts downward price pressure on commodities, which negatively impacts emerging economies because many rely on commodity exports. Recently, this ETF crashed over the last three weeks. It won't rebound until we get through the coronavirus pandemic.
Below is the FXI that represents a basket of large-cap Chinese stocks. This ETF is back below the 200 day SMA and probably won't rebound until we get past the coronavirus pandemic fear. Most of the sell-off in late 2018 was from concerns around a weakening Chinese economy, and the trade war that was exacerbating the weakness in their economy. A big concern, in general, for China is if they will be forced to devalue their currency. Most likely the answer is "yes", since China's debt currently sits at 250% of GDP. ($30 trillion of debt for a $12 trillion economy) This level of debt is not sustainable and it will eventually collapse from its own weight, and probably cause the next global recession. But, it could take many years for this to eventually happen.
Below is the EWJ that represents a basket of Japanese stocks. This ETF crashed over the last three weeks, but has rebounded back above 49.
Performance of certain US sectors, which provides insight into the future direction of US markets (i.e. sector rotation analysis):
Below is the daily chart for the XLF that represents 81 US financial companies. Currently, this index fell below the Dec 2018 lows.
Below is the daily chart of the KBE, an equally weighted ETF comprising 60 US Banks, including both regional and diversified banks. Currently, this index fell below the Dec 2018 lows.
Below is the daily chart for the XLI that represents 62 industrial companies. Currently, this index is below the Dec 2018 lows.
Below is the daily chart for the XLY that represents 80 companies that are classified as consumer discretionary, or "risk-on" types of companies. Currently, this ETF is back down near the Dec 2018 lows.
Below is the daily chart of XLP, an ETF that represents 35 consumer staples suppliers, or "risk-off" defensive companies. Currently, this ETF tested the Dec 2018 lows.
Below is the daily chart for the XLV, comprising 55 healthcare companies where it's back down near the Dec 2018 lows. Healthcare stocks in general have a lot of policy risk, as the Democrats are making noise about expanded Medicare for all, eliminating private health care insurance companies, and efforts to lower drug prices. The healthcare insurance providers and pharmaceutical companies could be risky through the 2020 elections.
Below is the daily chart of the IYT for the transports (truck, rail, air) that are an important leading indicator for the general health of the US economy and usually needs to be strong to confirm/validate any broad rally in stocks. Currently, this index is below the Dec 2018 lows.
Below is the daily chart for the XLE that represents 41 energy/oil companies. This ETF has broken down through the Dec 2018 lows. It's pricing in a global recession from the coronavirus; it's also battling a supply/demand imbalance as Saudi Arabia and Russia try to agree on output quotas.
Below is the daily chart for the XLU that represents 30 electric, gas and alternative energy utility companies. Utilities are classified as a safe haven and cash will typically flow into utilities if investors believe that interest rates will stay low. Currently, this sector is pulling back hard as this sector got expensive. With the recent sell off there is no place to hide as this sector is usually defensive in nature.
Below is the daily chart for the IYR that represents a basket of real estate investment trusts, REITs. REITs are classified as a safe haven and cash will typically flow into REITs if investors believe that interest rates will stay low. Currently, this sector is pulling back hard as this sector got expensive, and as investors fear a recession. With the recent sell off there is no place to hide.
Below is the daily chart of the SMH that represents the semiconductor stocks, viewed as a leading indicator for economic growth. Currently, this ETF is back below the 200 day SMA.
Below is the daily chart for the RYT that is an equally weighted ETF that represents technology companies within the S&P500 index. Currently, this ETF pulled back hard where it was close in testing 131 before bouncing a little.
Biotechnology (XBI) is back up to $78. In general, the talk on capital hill by mostly the Democrats about high drug prices could keep these stocks on edge. With this said, the Republicans still control the Senate, so most likely no drug related legislation will make it through both houses. Regardless, there is policy risk around healthcare insurance providers and pharma stocks since the Democrats took control of the House. These stocks could be risky through the 2020 elections.
Materials (XLB) got hit hard. Emerging markets depend on commodities, and the virus will most likely impact worldwide commodity demand.
Below is the cumulative advance decline line of the S&P500 Index, which tends to be a good leading indicator. This indicator was taking out lower lows and tells us that it's going to take many weeks for this market to stabilize.
Below is the cumulative advance decline line of the NASDAQ Composite Index, which tends to be a good leading indicator. This indicator was taking out lower lows and tells us that it's going to take many weeks for this market to stabilize.
Below are the economic calendars for the next 1 week:
Week of March 30th: The unemployment report is released on Friday the 3rd and this is going to be a shocking number.
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