Will the Market Get What it Needs, or Simply What it Asked For?

According to FactSet, S&P 500 earnings are expected to increase 10.5% year-over-year, which is down from an 11.3% growth rate projected on September 30. The 0.6% reduction in the growth rate expectation over the quarter was the smallest reduction since 2010.

The smaller downward revisions to EPS estimates were broad-based across sectors, but the single biggest reason for the small decrease was the Energy sector which saw a +24.5% increase in estimated EPS over the quarter. That was the biggest increase since Q3 2005 (+25.4%).

This high level of positive EPS anticipation could reasonably be expected to bring with it the danger of disappointment, or of “sell the news” reflex action. But judging from the market’s first two weeks of trading, neither of these dangers have made their presence felt (yet). The market has roared ahead since the start of the year, reflecting the strong reported earnings; this past week alone, of the 21 companies reporting Q4 earnings, 16 beat expectations, one matched, and only 4 disappointed. We’ll have to wait and see if the market continues to celebrate earnings as earning season wears on.

In addition to rising equity values, this past week also saw Treasury rates and inflation expectations come alive. Rates have been moving higher since the second week of September, mostly at the shorter end of the curve, but the 10-year and the 30-year have been rising since the start of the new year (although the 30s yield was down this week) (chart below).

On Friday, the CPI came in a little higher than expected, and look at what happened to the 2-year yield (chart below).

It fell back to its upward sloping trend-line, but it says something about the “animal spirits” lurking in the market. There is a “Goldilocks” narrative that sees just the right amount of inflation developing (which we have been searching for the last ten years) and which is keeping stocks propped up. The expectation of inflation has been on the upswing since December (chart from Briefing.com below).

If more than ‘just the right amount’ of inflation shows up, the Fed will go overly “hawkish”, “good news becomes bad news”, and the market will get spooked. In other words, the market might just get what it wished for, but not what it needs.

Equities

Sentiment

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The NAAIM index 50 MA continues to roll-over while the SPX charges higher. This negative correlation is similar to what preceded the 2015 double-dip correction. The fact that the market has refused to correct a healthy 3–5%, could mean that in the near future the correlation will revert to the mean with a more substantial 10–15% correction in the S&P 500, like it did in 2015 (chart below).

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Technical
The long-term technical averages continue to demonstrate a late-stage bull market and no warning signs are evident. The 8-month moving average falling below the 12-month moving average would be a long-term bear signal. The ADX trend (black line) is close to bumping up against the down-sloping major trend (blue dashed line on chart below), and the bullish and bearish momentum (green and red lines, respectively) are both at extreme levels which could facilitate a correction (chart below).

Fundamentals
The 10-y minus 2-y differential increased slightly to 0.56, but continues to maintain a slope that would see an inversion in the second half of 2018. That would imply a recession could start sometime in 2019. However, there are no red flags at this time.

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Oil

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Oil futures positioning is also raising a big red flag for the oil price. The commitments of oil futures traders are at all-time extreme levels; The swap dealers (the true experts in this market) are net short an insane 605k contracts, while the speculators (managed money) are net long a historic 432k contracts. The managed money (other people’s money) are usually wrong at the pivot points, while the swap dealers are usually correct. The swap dealers are obviously expecting to buy back the oil at lower prices in the future (February).

Gold

Gold has been exhibiting fairly-odd behavior. Normally, gold has a strong positive correlation with TIP (the Treasury Inflation Protected Securities etf), but lately gold has diverged from TIP. The last time it did this was in mid-2016, shortly before it dropped $200 (chart below).

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The one market that gold is trading normally in is against the dollar (negative correlation), but the dollar itself is trading counter-intuitively against interest rates; instead of trading up as rates rise, which is usually the case, the dollar is getting crushed as rates are rising. It is not clear how much longer this can last, but since the dollar has dropped below support (chart below), it could go further before we get back to normal.

It remains possible that the dollar turns around and rallies from here, like it did in 1999. The chart below shows the similar patterns of gold and the dollar today and in 1999. To keep within this pattern, however, the turn-around has to happen soon.

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The commitments of futures traders in gold continue to move in a bullish direction; producers and swap dealers increased their net shorts by 20k and 24k, to 177k and 43k contracts, respectively, while the speculators increased their net long position by 48k, to 196k contracts. These levels, while not record highs, are still substantial and well above average, especially for the producers (chart below).

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Regards,

ANG Traders

Forty years of private equity trading, and still learning.

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