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We continue to have a cautious near-term view based on overbought tactical readings. Although we do expect a 4-7% correction, the fundamental backdrop demands buying it, just like every other correction this cycle:

• Inflation remains historically low in the middle of the 20-year range,
• The combination of a highly accommodative Fed and steep yield curve suggest solid credit backdrop well into 2018,
• The domestic and global economy as seen through PMIs continue to be on sound footing despite Brexit and Trump Fear,
• EPS and valuations are in an upward trajectory, and
• The domestic economy could see meaningful fiscal stimulus in the form of tax cuts and deregulation.

Duration doesn’t drive an economic and market cycle, credit does. While this cycle already appears long in the tooth, recessions are not driven by duration, but are caused when short-term interest rates rise enough to cause an inversion of the yield curve and significant stress in credit. We are nowhere near that point, even on three more quarter-point rate hikes this year. The only thing that should cause investors to adopt an intermediate-term defensive position is a recession, and since the early 1950’s, every single recession has been preceded by an inversion of the yield curve by a mean 15 months. The 3-month/5-year U.S. Treasury curve is still POSITIVE by 135 basis points. We have had global crisis after crisis, historically slow economic recovery domestically, and a global populist movement that has made monetary and fiscal policy unpredictable. If any cycle has proven it is not different this time, and you need a shutdown of credit in the domestic economy – it is the current one.

Our key tactical indicators remain in overbought extreme creating environment ripe for correction. It is important to remember that corrections are normally considered natural, normal and healthy – until they actually happen. Such overbought conditions in our four key indicators suggest the market is ripe for some degree of correction. Nearly 60% of Newsletter Writers are bullish, the VIX has moved back to 11, there are fewer stocks above their moving averages than prior highs, and our trusty 14-week stochastic indicator remains in extreme overbought. Although it appears we are playing cute with our recent tactical downgrade to neutral, we have found that you cannot get more offensively positioned on a pullback if you are already positioned that way.

Summary – looking to buy any fear-based weakness as it develops. Given the likelihood of a temporary pause in the upside given recent market ramp and subsequent high optimism, we recently adopted a tactical neutral market and sector view. We would look to become more aggressive as the market works off its overbought condition because: (1) our positive fundamental core thesis remains in place, (2) economic data and EPS continue to improve, and (3) nothing in our credit-based indicators suggest any significant and sustainable deterioration that would warrant a more defensive position. Although we are now market and sector neutral, we want to be positioned to capitalize on any fear-based weakness, and believe our SPX 2017 target of 2,340 may prove to be conservative.

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Every single client meeting includes conversations of what may derail the current bull market. After such a strong run off the post U.S. Presidential Election low, many fear a significant correction may be imminent based on (1) equity market post-election move too far too fast, (2) the likely 25 basis point rate hike at next week’s December FOMC meeting, (3) the spike in U.S. rates could choke off economic activity, and (4) expectations for a strong rally in the U.S. Dollar. Although there could be a correction at any time, we do not believe there is any evidence they could cause anything other than a very brief correction on the way to our 2017 S&P 500 (SPX) target of 2,340.

1. Hasn’t the market moved too far too fast? It seems incredible that just a month ago, the SPX was down 9 days in a row and the Presidential election was just ahead. One of the reasons we upgraded our market view at that time was how oversold it became in anticipation of the election despite improving global economic data. In fact, our trusty 14-week stochastic indicator dropped deeply into oversold territory by closing below 20. In just the last four weeks, this indicator has gone from below 20 to greater than 90. This degree of improvement in just four weeks has only happened twice before – both in the 1960s with at least a gain of 7% over the next six months (Figure 1). Although both instances saw a gain over the next year, the bulk of the gain following the signal was over the first six months.
2. Won’t a hike at December FOMC meeting cause a meltdown similar to the 12/2015 hike? We don’t think so. Prior to the 12/2015 rate hike, the global economy was decelerating, commodities were in a very clear downtrend, the MSCI Emerging Currency Index was under significant pressure, and there was fear of political upheaval. Heading into next week’s decision, the global PMIs are at their best levels of the past year (or more), the Continuous Commodity Index and Oil are poised to break to the upside, the MSCI Emerging Currency Index is well off early year lows, and the feared political upheaval took place with very little impact (Figure 2).
3. Won’t spike in interest rates shut down economic activity? Again we are skeptical of this fear given (a) likely fiscal stimulus from new Republican majority, (b) sharp steepening of the yield curve (Figure 3) that should further incentivize bank lending, and (c) growth accelerated to 4% and 5% Real GDP in the second and third quarters of 2014, respectively following the spike in rates from 2% to 3% in late 2013.

Won’t U.S. Dollar strength hurt the bull case? While it sounds like heresy, we do not expect the U.S. Dollar to see significant and sustainable strength over coming quarters, without a sharp reversal in the current trend of global economic activity. There is a clear inverse relationship between the U.S. Dollar Index (DXY) and the Continuous Commodities Index (CCI), especially during periods of pronounced DXY strength (Figure 4). Although many also believe much higher relative rates in the U.S. vs. key trading partners could cause a spike in the DXY, the very limited upside since March 2015 suggests otherwise.

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