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Staying neutral in anticipation of opportunity. On December 19 we downgraded our market and sector view to neutral in anticipation of a digestive period in the markets. We continue to have a very positive fundamental intermediate-term view, but believe (1) the improved economic data, (2) fear of higher interest rates, (3) a less dovish Fed, (4) historically low volatility, and extreme overbought condition creates an environment ripe for a correction. With the likelihood of a recession so low and our positive fundamental core thesis in place, it isn’t whether we should be aggressive on any meaningful weakness, but when.
Our key tactical indicators tell us “when,” and it isn’t even close. Our four tactical indicators that would get us to be more aggressive vs. our current neutral market and sectors positioning remain in extreme overbought territory:
- The VIX jumps to 20 or higher. The VIX is currently at a historically low 13.59 (Figure 1).
- The percentage of S&P 500 (SPX) index components above their 10- and 50-day moving averages drops to 20% and 40%, respectively. While the percentage of stocks above the 10-dma has dropped near the required level at 20.4%, the percentage of stocks above the 50-dma is currently at 66% (Figure 2).
- Our trusty 14-week stochastic indicator drops to 30. This indicator can only register the required level on a weekly close, but the current reading remains in extreme overbought territory at 85 (Figure 3).
- Investor Intelligence percentage of bullish newsletter writers drops to below 35%. The most recent survey came in at 59.8%, suggesting recent weakness was not anywhere near enough to turn sentiment more pessimistic (Figure 4)
The key upside drivers remain in place. This cycle has made it abundantly clear that global events do not have the power to cause a sustainable economic retrenchment in the world’s largest economy. With an improving global economy, it’s hard to imagine a sustained negative economic environment is just around the corner with (a) historically easy Fed policy (even after a second hike and less dovish tone) as measured by the Real Fed Funds Rate; (b) a steep yield curve; (c) a demographic push in household formation from the millennials; (d) a new cycle high in consumer confidence; (e) generational lows in initial unemployment claims; (f) historically low household debt service ratios; (g) improved housing trends; and (h) recovery in the global growth outlook.
Summary – looking to buy any fear-based weakness as it develops. Given the likelihood of a temporary pause in the upside given post-election rally and 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 warrants 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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