Thursday, May 2, 2019
- The NDX, CCMP, and SPX returned to new all-time highs.
- The 10yr – 2Yr spread could be reversing a two year flattening trend.
- Cyclicals outperformed defensives
- Financials led (+8.8%) on a rebound from oversold conditions and rising rates.
- The greenback appears to be at a critical technical juncture with a potential “perfect storm” of technicals brewing.
The bull market continued through April with all of the major U.S. equity indices extending their impressive Q1 gains at a healthy clip. Cyclicals outperformed defensive sectors, however market cap was less a discriminating factor as the various large and smaller cap indices came in across the performance spectrum.
The major U.S. equity indices have now rebounded between 22% and 32% off their December lows, and this past month the Nasdaq 100 (NDX), Nasdaq Composite (CCMP), and S&P 500 (SPX) returned to fresh all-time highs. Market breadth could be better but at the moment that remains one of a number of divergences worth watching but not an all-out red flag.
The “generals” led the way once again with the NDX and CCMP indices gaining 5.5% and 4.7%, while the large cap Dow Industrials-INDU (+2.6%) and Russell Microcap indices (+1.9%) brought up the rear. In the middle the S&P 400 Midcap Index (MID) and small cap Russell 2000 (RTY) rebounded with gains of 3.9% and 3.3% after finishing March in the red along with the Microcap index. The flagship SPX gained 3.9%.
Accordingly cyclicals outperformed defensives led by an impressive +8.8% rebound by the financial sector following a (2.7%) decline in March. Technology (+6.4%), Communications (+6.2%), and Discretionary (+5.7%) crushed it in April and their rebound off the December lows are nothing short of impressive. The defensive healthcare (2.7%) and REITs (0.7%) were the only sectors in the red, while energy finished flat despite a +5.5% gain in the commodity (WTI).
Technology, +6.4% in April and +27% YTD, has been a key driver for equities throughout 2019. Its 22% weighting in the S&P 500 understates the sector’s importance since the sector reclassifications last year. April, however, was not for the faint of heart as various events influenced the category’s direction. The on again/off again royalty dispute between Apple and Qualcomm was finally settled mid-month which brought a great deal of relief and buying interest to the sector. That was followed shortly by the ZOOM Video Communications IPO which was embraced by investors and by all measures, was a complete success. The Philadelphia Semiconductor Index hit all-time highs on 4/24 reaching 1604.57. The euphoria however was short lived as we entered earnings season where Xilinx and Intel were two early reporters that fell short of expectations. Combine that with some ongoing weakness in the Chinese economy and a very recent sales miss by Google and you had a slight pull back in the sector that prevented technology from finishing at the top of the heap. For the month of April, the Information Technology Index was +6.4%. Within the category, the Semi and Semi Equipment sector was +7.0% while Software and Services was just behind at +6.8% and the Technology Hardware and Equipment came in at +5.0%.
The rebound in the financial sector is due in part to oversold conditions following the late March FOMC whereby the Fed surprised markets by doubling down on its dovish pivot. The committee then reduced its rate hike expectations for the remainder of 2019 from two to zero, and also forecasted an end to the balance sheet reduction (QT) by September. That week the KBW BKX Index declined 8.3%, its largest weekly decline since January 2016, while the KBW Regional Bank Index (KRX) dropped 9.4%, its largest weekly decline since September 2011.
A more recent tailwind for financials has been the yield curve which in select parts is beginning to steepen off the Q4 lows. Specifically the 10yr - 2Yr spread spent most of the last two years flattening, but over the last four months through March it has been bottoming in the 10bps – 20bps range. In April the spread broke out from both its declining “price” channel as well as its four month range. If this is the early stages of an upside reversal, that should bode well for the banks going forward. That said the short end of the curve remains largely inverted.
In intermarket action interest rates rebounded off their March lows. The 10-year yield gained 10bps to 2.50% while the 2-year was anchored, +0.006 net chg. to 2.66% from 2.6%, thus resulting in a widening spread. Crude oil (WTI) surged another 6.3% for its fourth consecutive month in the green. Crude’s outlook is a big wildcard given the geopolitical risks posed by Venezuela and Iran, as well as an upcoming OPEC meeting which will impact the supply side and pace of future production. Gold gave back a modest 0.7%.
The U.S. Dollar index (DXY) gained 0.2% for its third consecutive month in the green. The DXY finished April with a modest gain of 1.3% YTD, however in the last week of April it “broke out” from a 5.5 month range to fresh 52-week highs. The upside follow through was limited to one additional session before a quick reversal lower which ironically followed Friday’s better than expected Q1 GDP report, +3.2% vs. 2.3% (e). The critical question from here is whether or not last week’s upside breakout can soon resume, or conversely if it marked the high (“sell the news” on GDP) and a reversal and new trend lower is in store.
At risk of repeating ourselves in the daily MIDDAY UPDATEs, the greenback appears to be at a critical technical juncture vs. the euro giving the potential “perfect storm” of tehnicals that are brewing. Weekly CoT data shows the highest short position by non-commercials since late 2016. Rate differentials between 10-yr Treasuries and German Bunds are coming off 30+ year highs made last November and over the prior twelve months have formed a large “head & shoulders” pattern which could either be a continuation or reversal pattern. In addition much of the 2019 activity has been sideways, corrective price action. This consolidation has led to a sharp decline in FX volatility, and more importantly an extreme narrowing in the trading ranges. For i.e. the width of the weekly Bollinger Bands (weekly) in the EURUSD pair are coming off 40 year lows, while the Average True Range (weekly) itself just made a 23-year low. From compression comes expansion as price transitions from consolidation to trend. When this transition to trend firmly takes hold, the next direction could be accompanied by powerful, accelerating price action. Given the greenback’s role as the world’s reserve currency, this scenario could have a profound impact on sentiment and asset prices.
Heading into the current earnings season, analysts expected a 4.1% decline in Q1 earnings. So far however, earnings have been jumping over that lowered bar, with 80% of companies beating on bottom line results (vs. a 71% long run quarterly average). Earnings are on pace for a 1.7% YoY decline but this has been perceived as “better than expected”.
Revenues have been in-line with expectations and earnings outperformance is coming mainly from cost cutting. If Q2 can show a similar upside “surprise”, then the much-discussed earnings recession may be avoided. Still Q2 is currently forecast to have negative YoY comps (-0.6%) and profit margins are in focus since earnings are declining more than revenues.
Though it’s early in earnings season, the current net profit margin for the S&P 500 in Q1 so far is 10.9%, which would be the lowest since Q4’17 and the first YoY decline since Q4’16 (chart below).
If the financials can continue their current run, it should bode well for the broader market whose current leaders, technology and discretionary, appear to be due for a period of consolidation after rebounding +36% and +32% off their December lows. The smaller cap indices (MID, RTY, Microcap) rebounded nicely following their March decline, but unlike their large cap brethren the RTY and Microcap indices remain 9% and 14% below their 52-week highs. Ideally we would like to see the rotation into financials continue and for healthcare to get on board.
The financial and healthcare sectors have a 17.7% and 15% weighting in the Russell 2000 (RTY), nearly 1/3 of the index. The S&P 500 financials index is +17.4% YTD, and remains a little more than 3% off its 52-week highs. Meanwhile healthcare index, April’s worst performer with a decline of 2.7%, currently stands +3.2% YTD. Healthcare is the only sector that is NOT up double digits for 2019, after placing 1st in 2018, +4.7%, and +22% in 2017.
The Russell 2000 made its YTD high two months ago on February 25th at the ~1,600 level and has since been consolidating. After the pullback in March, it returned to this clearly defined resistance level in the last week of April. The repeated number of times price has tested this resistance, starting back in mid-October, only increases its importance. An upside breakout from here would confirm a transition from consolation to trend for the small caps and should improve the diverging breadth readings.
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