Published December 30, 2016
Over the course of 2016 stock investors saw a dramatic shift in market leadership. As interest rates fell back in the first half of the year, so-called low volatility sectors led the market. These sectors tend to focus on higher dividends thus are beneficiaries of lower interest rate expectations. As markets entered the final quarter of the year and the Fed’s expected December interest rate hike became more of a certainty, leadership shifted toward sectors that are more cyclical along with those that benefit from a rising rate environment. This trend accelerated substantially after the election.
Chart 1: Stock market leadership shifts over the course of 2016
Not surprisingly, this change in leadership is a major theme going into 2017 as market prognosticators tend to expect current trends to continue. These trends are summarized in this outtake from Goldman Sachs’ 2017 Investment Outlook.
Chart 2: Expected trends for 2017
The ramp in inflation expectations is almost universally forecast at this point as wages have begun showing consistent signs of growth. The expectation for increased government spending along with decreased regulation – e.g. a generally more pro-business framework – is also widely forecast. These two trends have already been reflected in the sharp run-up in stock prices over the past few weeks post-election, however, with some market watchers thinking that additional gains may be hard to come by.
No one envisions a recession in the U.S. in any near term. As the table below shows, a recession is usually a necessary ingredient for a notable market decline. The two previous market drops that have been purely driven by excessive stock valuations have been sharp and swift as highlighted in yellow below. The current bull market run, if you assume it began in 2009, is now well beyond the average length in time. However, stock valuations, while not cheap, are also not nearly extreme. Valuations are just above average for U.S. stocks in a low inflation environment. Valuations for international stocks though are below their long-term averages, in some cases by quite a lot.
Chart 3: Recessions are a key driver of bear markets
The election result has accelerated views of a coming period of increased inflation and perhaps higher economic growth. Corporate earnings will be growing, and perhaps quickly so, as energy earnings turn up after a couple of difficult years. The question for stock investors is how much of this coming scenario is reality versus hype/expectation, and how much is already reflected in stock prices and the sharp move upward over the past few weeks. Finally, a wild card for markets in 2017 will be elections in Germany and France along with the substantive start of Brexit negotiations. If the populism that has reared up in the U.S. and England are shown also in France and Germany, we could see some shocks to markets in the coming year.
Of course, our models are agnostic to politics and market fundamentals. We look only to the movement of prices, volumes, and related market supply and demand metrics to drive our read on things. We expect our models will keep us mostly on the right side of the markets in the coming year as they have in years past.
Will the breakout hold?
Finally, we end the year with a chart of our favored Nasdaq 100 (QQQ) index. After spending 20 weeks trading in a tight 4.5 point range, the index recently joined the rest of the U.S. stock market in breaking higher. Will this breakout hold? If so, investors (and our Buy signals) will continue to smile into 2017.
Chart 4: The Nasdaq 100 Index hopes to continue upward
A light volume week of holiday stock trading saw investors holding off on new buys, perhaps expecting that there might be some profit-taking early in the new year as tax rates are expected to be lower. Stocks ticked +0.2% higher Tuesday after Monday’s holiday break. Strength in tech shares and retailers as consumer confidence read positively. All of the Christmas cheer was lost on Wednesday, however, with stocks slumping -0.8% in a broad-based retreat. Bearish oil inventory data was among the slim picking of news items Thursday with stocks holding flat on the day. Investors once more pushed the indexes down Friday with buyers seeming to be gone in the final trading day of the year.
Tech stocks paced Friday’s decline falling as much as -1% during the day perhaps driven by rumors of production cutbacks in Apple’s iPhone line.
Warm wishes and until next week.