Zeller Kern’s Investment Monitor

Market Technicals vs Earnings

> May 16, 2018

By Steve Zeller

So far, the month of May appears to be a month of rebound for the equity markets. On May 3rd, the S&P 500 was at the 2629.60 level. As of the close last Friday, the S&P 500 has risen to 2727.72. However, the Index is at the same level as it was mid-February. Year to date as of last Friday's market close, the S&P 500 is up 2.72%, and the Dow Jones Industrial Average is up a paltry 1.26% (source: Morningstar, includes dividends).

Of course, the sector that has been carrying the water for the market has been technology. Year-to-date, the Morningstar Technology Index is up 10.87%. This has produced positive results within the Large Cap Growth, Mid Cap Growth, and Small Cap Growth sectors of the market. These sectors are heavily weighted in technology. Overall, the market continues to be extremely concentrated with the FAANG stocks continuing their charge. Apple closed at an all-time high on May 10th of last week, closing at $190.04 a share. Warren Buffet has been talking it up. Recently, he told CNBC that if he could, he’d own 100% of the company. This was after Berkshire Hathaway revealed that they have bought 75 million shares or at least $11 billion worth. That’s a nice luxury to buy into a stock, in a large magnitude, and then have enough influence on the investor that when you hype the stock, it reaches an all-time high. I wonder if he’ll ever quietly begin to sell it off.

Many are wondering if the market will head back up to its high posted back on January 26th, or will it continue to chug along in a sideways pattern? There does appear to be resistance at the current level of the market. We may move higher and even towards the previous high, but there is a higher probability that we will see an overall sideways pattern for a few more weeks, in our opinion. Additionally, it remains to be seen whether the market continues to build strength or go into another period of weakness and decline.

The reality is, regardless of the direction of the market, we are more likely entering into a period of increased volatility. The market dipped below the 200-day moving average twice this year during intraday trading, and we haven’t seen that kind of volatility for a while. This pattern leads to the discussion of risk for the market and the typical influences that could cause the market to experience more volatility and even an extended period of decline.

Brad McMillan, Chief Investment Strategist for Commonwealth Financial, recently posted his monthly update for May. In this issue, he discusses the subject of market risk and the outlook for it for the near future. He points out that market risk comes in three forms: recession risk, economic shock risk, and risk within the market itself.

Recession Risk – Recessions are strongly associated with market declines. 8 out of 10 bear markets have occurred during recessions. So far, there isn’t any sign of recession. Many things within the economy remain strong. However, we may have peaked and could be trending into a slowing. But April’s data was solid. According to Wolfstreet.com, employers added 164,000 jobs in April, seasonally adjusted, as per the Bureau of Labor Statistics. April was the 91st month in a row for gains, which is the longest period in the history of the data. That is a great accomplishment. For the 12 month period ended in April, employers added 2.27 million jobs, not seasonally adjusted.

From another perspective, the number of unemployed in April fell by 239,000 to 6.35 million. The chart below shows the sectors that provided the growth in April, and a second chart showing the sectors that added and slashed jobs over the past 12 months in thousands.

There has been talk about the retail sector brick and mortar jobs being slashed, but some retail sectors have added jobs. Clothing and accessories were hit the hardest. This is negatively impacting shopping malls and is clearly a casualty of Amazon. The other sectors that have slashed jobs are Health & Personal care, Electronics & Appliance, Sporting Goods, Hobby, Book and Music, and Department Stores. However, Building Materials & Garden Supply added a substantial number of jobs, as did Non-Store Retailers, and Motor Vehicle and Parts Dealers. But it is expected that the sectors in “red”, will continue to get hit over the coming months, along with store closing, bankruptcies and liquidations.

So overall, the employment data is not a worry for economic risk. But business confidence is dipping and it is showing up in the ISM Nonmanufacturing Composite Index. Although it remains up above 50 (anything above 50 is expansion), the index is showing signs of weakening.


However, if these numbers remain well above 50, it should continue to be a positive driving force. Overall, even though we expect the economy to remain strong in the coming months, we may be peaking or have peaked.

Economic Shock Risk - Within the discussion of Economic Shock Risk, there are two major systemic factors, as Brad McMillan points out – The price of oil and the price of money (interest rates). These two factors drive the markets and the economy and have proven to derail them. When the price of oil spikes, it can cause a disruption and can signal a recession and a bear market.

The recent rise in oil prices is not significant and doesn’t appear to be a threat in the near future. The Price of Money, or interest rates, have risen off of the post-crisis low, but is still out of the danger zone, which means the immediate risk remains low. But this is an area to keep watching, especially the Fed, Libor, and the 10-year Treasury yield. It is an area to keep an eye on.

Market Risk – The other factor to disrupt the market is the market itself. Two things are important, as Brad McMillan states, which is to recognize what factors signal high risk, and when those factors signal that risk has become an immediate, rather than a theoretical, concern. The factors include valuation levels, margin debt, and technical factors.

As we have been mentioning in previous issues, when looking at market valuations, we commonly refer to the Shiller P/E, which looks at the average earnings over the past 10 years – to be the most useful when determining overall risk. The Shiller P/E is at a historically high level equivalent to the levels in 1929, and has only experienced a higher level, that being in 1999.


The big take away from this chart is that valuations are very high, in fact the second highest, historically, and suggests that we are in a period of elevated risk. Even after the tax cuts and the better than expected earnings season, we still remain in risky territory. But you can’t look at the Shiller P/E alone because it is a lousy timing indicator. As it is pointed out in Brad McMillan’s article, we also have to look at the 10-month change in valuations. Looking at changes, rather than absolute levels gives a sense of the immediate risk. The interpretation is, when valuations roll over and decline, with the change dropping below zero over a 10-month or 200-day period, the market typically drops shortly thereafter. Even with the recent recovery, valuations have dropped toward the risk zone, and while the long-term trend in valuations remains at a positive level, risks are rising.

Margin Debt – Margin debt remains near record levels. Margin debt rose last month after a brief drop, and the current level is concerning and needs to be noted as it is causing a higher level of risk for the market. But this may not pose immediate risk. A more accurate determiner for that would be the changes in margin debt that occur in a spike pattern is more relevant. This typically precedes a bear market decline.

The annual change in margin debt as a percentage of market capitalization has ticked down in recent months, according to McMillan, moving below zero. So, the risk is not immediate, but debt levels remain high.

Technical Factors – In his article, Brad sights two metrics to track the overall trend of the market – One being the 200-day moving average, and the other being the 400–day moving average. When the market level breaks below the 200-day moving average and the 400-day moving average, it signals trouble ahead. As I mentioned earlier the market broke below the 200-day during trading hours, but has not yet broken through the 400-day moving average. But it does appear that risk is increasing.

So, the conclusion is that even though there doesn’t seem to be any signs that the risk of a bear market is immediate, it does appear that we are closer to one. That being said, we could see the market move higher, but probably not without a lot of volatility. The other factor to consider, that we discussed in previous issues is the “Elliott Wave” count. Based on observing the market from that perspective, the market has completed 5 waves and does argue that we have possibly seen the ultimate top of this market which occurred on January 26th. Furthermore, the length of time for this current cyclical “bull market” is into extended territory and historically hasn’t lasted much longer than where we are now. We’ll just have to see how this plays out.

The good news is that earnings remain strong. Earnings for the first quarter were notably positive, with S&P 500 earnings rising 24% and profit margins expanded to a new all-time high of 11.6%. Sales, overall, for the S&P 500 grew around 10% (with 84% of companies reporting). The good news also is that earnings are rising faster than the market itself, currently, and it may give the market the ability to move to a new high. Furthermore, with increased profit margins and cash positions, gives the ability for companies to buy back shares and potentially increase dividends.

But, on the other side of this, is the future of earnings. Where do we go from here? Has earnings entered into a peak period? And with earnings being forecasted for 9% for 2019, may be revised downward. Additionally, the rising cost of labor with full employment and rising interest costs, may produce headwinds for further jumps in profit margins.

Review of Last Week
Looking back on last week, we saw buyers return once again as the S&P 500 moved up 2.4%. While the NASDAQ continued to lead the way, most of the US indices managed to have a robust performance. The market had a slow start after the decision by Pres. Trump to pull out of the Iran nuclear agreement. There was a fair amount of bearish rhetoric surrounding the markets but there was no real downside experience other than lots of chatter.
On Wednesday, we saw the markets move up 0.97%. The results were similar on Thursday, up 0.94%. And Friday closed with another 0.17%, with the S&P finishing up 2.41% for the week. All of this happened in spite of the heightened tensions in the Middle East. Market participants shrugged off all negative news and paid attention to many of the positive reports that came out as the tech sector once again was able to lead the way.
Friday’s action traded in a sideways range, finishing just slightly higher on the session. The market digested some of the rally that occurred on Wednesday and Thursday which was the bulk of the gains last week. The configuration suggests that the markets are nearing some major resistance between the 2738/2743 levels. A failure to close above 2743 by Wednesday will set the tone for a retracement back toward the 2709/2688 levels.
Market sentiment has almost become euphoric as everyone is looking at the magical wedge trend line and expecting much higher prices. But the PPM’s are not confirming the strong momentum that many are touting. Also, the VIX is trading down to the 12.65 level. This is one of the lowest levels we’ve seen since they February selloff. It does appear that we are getting extremely overbought and are likely to see a pullback in the next 2 to 3 sessions. The intermediate charts continue to suggest that we are locked in the trading range even though we did see some upward momentum increase with the last two weeks of price movement. However, the 2767 level represents a major pivot point. Should the market remain below this level and close lower on Friday, this will set the tone for yet more sideways movement, moving back toward the 2688/2667 levels.

Best Wishes,

Zeller Kern Investment Committee