Will This Be a “Summer of Love” for Stocks?

I never made it to San Francisco’s Haight-Ashbury district 50 years ago, but I did spend a good amount of time in New York City and Boston, where the “Summer of Love” was also in full swing.

I have many fond memories of tooling around in the evenings that summer in my old, white convertible MGB, which seemed like a pretty cool car for a high school kid in those times. If memory serves correctly, the MGB did not have FM radio, but my girlfriend and I were more than happy to blast AM top-100 hits from Jefferson Airplane, The Doors, and Buffalo Springfield, just to mention a few.

Several seminal events in the development of the counterculture movement and evolution of rock music occurred in 1967. These included the “Human Be-In” at San Francisco’s Golden Gate Park (where Timothy Leary supposedly first declared, “turn on, tune in, drop out”), the Monterey Pop Festival (which brought many new stars to prominence, including Jimi Hendrix), the founding of Rolling Stone Magazine by Jann Wenner, and the national attention given to Bill Graham’s eclectic music venue, the Fillmore Auditorium.

But the “Summer of Love” was hardly just a fun-filled blast for young people wearing flowers in their hair. It had its share of turmoil, including the following:

  • Racial tensions throughout major U.S. cities.
  • A growing national drug abuse problem.
  • Controversies over foreign policy and deployment of U.S. troops.
  • Socioeconomic divisions coming to the forefront.
  • Relations with Russia making headlines.
  • An embattled presidency.

(Sounds just a little bit familiar.)

However, despite a tumultuous year on many fronts, U.S. equity markets finished 1967 with a gain of about 15%. Few things about the financial markets then would be recognizable to today’s investors. The Dow Jones Industrial Average resided below 1,000, the price of oil was just over $3 per barrel (about $22.50 inflation-adjusted), and the Federal Funds Rate was between 4% and 5%. Real GDP growth had been in the 6.5% area during 1965 and 1966, but it fell to 2.7% in 1967.

The Dow achieved an annual closing price above 1,000 for the first time in 1972, but it lost about 44% between 1973 and 1974 (closing out 1974 at 616). In fact, 1967 through 1981 was a “lost decade and a half” in the markets, with the Dow finishing 1981 3% below 1967’s closing level. This was due in no small part to the effects of recessions and sky-high interest rates during the period, accompanied by what some economists called “stagflation.”

Historical Federal Funds Rate 07/19/17

But that was then, and this is a new economic environment altogether. What is driving new records in U.S. equity markets, despite continued weaker-than-expected economic growth?

  • Markets proved once again last week that they are closely correlated to the perception of Fed interest-rate policy. Board Chair Janet Yellen’s largely dovish testimony before Congress led to the best weekly gain in two months, with the S&P up 1.4%, the Dow up 1%, and the NASDAQ soaring 2.4%. Ms. Yellen, according to a CNBC recap, reiterated that rate hikes would most likely be gradual.
  • Tony Dwyer of Canaccord Genuity, a well-known strategist often interviewed by Bloomberg, has spoken consistently for months on his “base case” for continued higher prices in equity markets: low and stable inflation, a slow normalization of interest rates, tailwinds from global economies, and a continued positive EPS trend over coming quarters.
  • Ray Dalio of giant hedge fund Bridgewater Associates, according to MarketWatch, sees “no major economic risks on the horizon for the next year or two.” However, he is far less positive over the long term, expressing worry about “the magnitude of the downturn” that will eventually come.
  • Analysts and strategists interviewed for Barron’s “Mid-Year Roundtable” were slightly less than optimistic, seeing some opportunity, but in a “bumpier road and modest advance, at best, through the end of 2017.” Said Brian Rogers, chairman of T. Rowe Price, “We’ve had a really good year in five months. … The S&P 500 is trading for roughly 18 times future earnings. A P/E multiple of that magnitude has historically suggested limited upside.”
  • Bespoke Investment Group, which provides exhaustive research of market trends, has noted that the S&P 500, Dow Transports, and small-cap Russell 2,000 all closed at 52-week highs last Friday. They wrote, “Since the Russell 2,000 came into existence in 1978, all three indices have simultaneously closed at new 52-week highs on just 2.3% of all trading days.”

S&P 500, Transports Russel 2.000 07/19/17

Bespoke adds,

“While the average forward returns following the ‘triple play’ of 52-week highs are indeed higher than the average forward returns for all periods, they’re only slightly higher. … Over the next month, the S&P has averaged a gain of 0.64% with positive returns 60% of the time, and over the next three months, the index has averaged a gain of 2.09% with positive returns 64% of the time. … While the new highs across the board are impressive and an indication that the market’s uptrend is solidly intact, based on prior returns after the same thing has happened in the past, it shouldn’t be viewed by itself as a buy signal.”

So, perhaps for some portion of the analyst community, it is sounding more like a summer of “some love” for stocks, despite the impressive start to the second half.

Weekly Edge: Risk Is Back On as All Factors Rise

Leadership among ETF sectors continues to suggest that market leadership is driven by a risk-on attitude by investors. All but one of our benchmark ETFs indicate more bullishness, based on an overall increase in momentum scores. Technology is the highest-ranked sector that had an increase in momentum score over the past week, from 12 to 27. Defensive and Energy sectors continue to lag due to both an overall decline in oil prices and an appetite for risk. With the exception of Financials, all sectors have improved for the week.

Sectors: The leading Sector Benchmark ETFs exhibited shifts last week. As mentioned, Technology improved the most the past week and now leads. Financials, which led the previous week, fell to fourth place and was the only sector to decrease momentum. The spread between the highest and lowest sectors increased from 46 to 48 this past week. Telecom improved last week, but the Energy sector improved more, pulling ahead of Telecom. These two sectors, however, continue to display negative momentum. Telecom decreased its negative momentum by 2, from -23 to -21. Energy decreased momentum to the negative side by 9, going from -23 to -14.

Unlike previous weeks, there is quite a bit of organization with regard to leadership. Cyclicals such as Technology, Materials, and Industrials are near the top, while defensive sectors such as Utilities, Consumer Staples, and Telecoms are near the bottom. The only exception is Energy, which is down with oil prices. While Energy is typically cyclical, a secular downward trend in prices is providing upside for the economy.

Factors: Momentum, Growth, and High Beta are the top factors among our Factor Benchmark ETFs. This suggests bullishness of investors along with the low performance of more defensive securities, such as Low Volatility, Dividend Growth, and Yield. The only bullish factor that may buck this trend is that small-size securities are not leading among factors. The overall increase of all factors (all factors have improved their momentum values this week) also suggests bullishness. This week, there are two factors with a momentum score greater than 20 (compared to one the previous week), and the sum of the top-three ranking scores is 70 (compared to 49 the previous week). Also adding to the increase in bullish sentiment is the rise in the sum of the bottom-three momentum scores, from 2 to 15.

Global: There were significant changes in rank and overall momentum levels among the Global Benchmark ETFs. The top-ranked regions now include China, Latin America, and Emerging Markets. This ranking continues to suggest that investors who long underweighted those regions are now directing new capital overseas to regions now believed to be economically and politically stable and growing. On the other hand, more developed regions, such as Japan, the U.S., and the U.K., are lagging, as investor sentiment continues to improve. Latin America appears to have increased the most, potentially signaling a decrease in the political uncertainty in that region. This ranking may not indicate a belief that the leading regions will have the best economies going forward, but that those economies have previously been undervalued due to investor anxiety. Overall, the trend for the week is an increase in appetite for risk and an overall increase in momentum.

2 Week Edge Chart 07/19/17

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