U.S. Equities Triple Threat (NYSEARCA:FCG) (2024)

This past week saw U.S. equities pause following three solid weeks of "Trump rally." If traders were looking for an excuse to take profits, OPEC offered up a good one last week. Two years after Saudi Arabia coaxed its fellow OPEC members into letting market forces set the oil price (provoking the collapse in oil prices in 2014), the oil producers' cartel agreed last Wednesday to remove 1.2m barrels a day from global oil production. The unexpected oil production cut caught markets off-guard, sending West Texas over +12% higher for the week.

As we have written about in previous missives, the equity bull market after the post-crisis normalization period (roughly from 2013 until today), has been predicated not on stellar company earnings nor on robust economic growth, but rather on central bank interest rate policy and excessive liquidity. It's a reality we have had to deal with and invest accordingly. Unfortunately, extreme policies also create excesses, and investors have had to take on more risk in this cycle to find yield.

And investors will have to deal with the fall-out of the central bankers' bubble. Some may choose to sell risk assets at some point as the bubble bursts, while others will ride the next bear market all the way to the bottom. Your personal choice will depend on emotions, investment horizons, solvency, and current spending plans.

While excess liquidity and low interest rates have pushed equity prices well beyond the expectations of most market observers during this bull market, we must not lose sight of the fact that we are in "rare air" at current equity valuations. The recent rally on hopes that Trump will spur U.S. economic growth is likely exaggerated, and as Bill Gross correctly said last week, benefits from such fiscal stimulus likely would be temporary. More precisely, we feel that even if Trump proves to be the Wizard of Oz and jumpstarts a flagging 8-year-old economic expansion, the market has priced in much of this future growth.

Consider this: The Russell 2000 (NYSEARCA:IWM) gained +140% for the entire 2002-2007 bull market. This year, the Russell 2000 has rallied +42% (almost 1/3 of the entire previous bull market), and, for just the three weeks following the U.S. election, the index gained over +16%. We believe that the equity markets have raced ahead of the economy (as usual). We now need to hope that the economic growth priced in actually materializes.

However, should we in fact return to +3% annual U.S. GDP growth in 2017, don't expect equities to rally even more. Payment has been made in advance; now the service must be rendered. The true risk today is seeing lackluster economic growth of +1% to +2% going forward. Markets will have overpaid for growth under Trump. If an overpayment has been made, it will quickly be redistributed should growth expectations are not met. Caveat emptor. Be ever-mindful of the following graphic, which Dr. Williams frequently uses in his investment classes:

The economic/business cycle (in yellow) tends to lead the stock market cycle (in blue) by 9 to 12 months traditionally. Markets are always forward-looking. Although the current rally, on hopes for reacceleration of the economy in an environment with still too much liquidity sloshing around, may continue to grind higher, we would feel safe in assuming that the easy money has been made in equities.

Adding to the valuation concerns that we have voiced for some time, we potentially now have three market headwinds hitting U.S. equities. Looking back at recent market history, we have not found an occurrence when these three factors were simultaneously all negative for the equity market. Although there is no precedent for all three factors moving in the same direction for any significant period, we cannot imagine how equities can do well even in the short run in such an environment. These three market headwinds are :

• A strengthening dollar.
• Rising interest rates.
• Rising energy costs.

While the intermediate trends of all three variables are to the upside, it would be incompatible to see all three rise over the long term together. Nevertheless, our concern today is for the short-term ramifications for equities, which are pretty much priced for perfection today. We will look at each factor in turn.

Dollar

Since 2014, when the Federal Reserve ended monthly asset purchases, the dollar index (DXY) has been in an uptrend. Currency markets have indeed been pricing in the next Fed tightening cycle for over two years. On the chart below, the DXY (NYSEARCA:UUP) entered into a two-year horizontal trading range (100.5 on the upside; 93 on the downside). The fundamental explanation may simply be the Fed's long hesitation in carrying through with the long-anticipated tightening of monetary policy.

The recent break-out of the trading range to the upside, as currency markets anticipate more inflation under Trump (giving the Fed the green light to raise rates), should be bullish for the dollar. The dollar is a headwind for U.S. multinationals (companies in the S&P 500) which on average realize 50% of their sales overseas. A strong dollar both overprices U.S. exports to foreign buyers and reduces the dollar-equivalent of repatriated foreign currency revenue. It's no surprise that the domestically-oriented Russell 2000 companies have seen their stock prices jump +16% versus only + 5.5% for the S&P 500 stocks (NYSEARCA:SPY).

Interest Rates

If Trump is going to undertake massive fiscal spending, and cut taxes, the money will have to come from somewhere. And that somewhere is deficit-spending. Aside from the long-run negatives of piling on more national debt, the increase in federal borrowing will push rates higher. Markets have quickly begun pricing this in. Technically, the U.S. 10-year (NASDAQ:IEF) yield clearing broke an important trend line in November:

While 2.5% has served as support for 10-year T-Notes for now, we believe (should Trump convince Congress on his spending programme) that the U.S. 10-year yield will trade between 3% and 4% in 2017. With the Fed still dragging its feet on getting the short end of the yield curve higher, the U.S. yield curve will continue to steepen. It's no wonder that U.S. bank stocks are going berserk. Recall that banks make their best money on net interest margin when the yield curve is steep.

However, aside from the bank stocks [which we will continue to hold via the S&P bank tracker (NYSEARCA:KBE), as long as our models permit], high rates will be a headwind for U.S. equities for a few reasons. First, companies have been fond of borrowing at dirt cheap rates to repurchase shares. This activity will slow down with rates heading higher.

Second, higher borrowing costs increase business operating costs. The hurdle rate for new projects will increase, which will slow company investments. Finally, traditional bond holders who have sought yield in higher yielding dividend stocks will be drawn back into the fixed income space. If pension fund can get a 3% yield on a U.S. T-Note or a 3% yield on the S&P 500, there is no doubt where fund flows will be heading.

Crude Oil

Will oil prices be the last shoe to drop? It's hard for Wall Street to spin the positive angle on higher oil prices. Outside the oil names, which only comprise 6% of the S&P 500 today, higher oil prices will:

• Increase the cost of business for most firms.
• Siphon consumer spending away from retail and into the heating fuel/transportation budget.
• Stoke CPI and PCE inflation measures, again forcing the Fed's hand to raise rates.

Our opinion is that the rise in oil prices last week was for real. OPEC was clearly responsible for the drop in prices from $100/barrel in 2014. It looks as if OPEC will carry through with production cuts, which will have more than just a knee-jerk reaction in the oil pits. Technically, our chart of West Texas crude (NYSEARCA:USO) is looking very bullish on a longer-term horizon. The price of crude has been making higher bottoms since the low in Q1 2016.

Today the price is back up against major horizontal resistance around $52/barrel in an ascending triangle formation. We can even make out a rough "reverse head-and-shoulders" pattern (left shoulder in August 2015; head in January/February 2016; right shoulder August 2016, as shown by the blue marks).

The only major sector which is not higher from 2014 is energy, due obviously to the crash in oil prices. Symmetrically, the S&P 500 and Nasdaq rallied on falling oil prices while the energy sector fell. With rising oil prices, we can logically expect falling S&P 500 and Nasdaq stock prices and stable to higher energy company prices. Despite the sharp move higher last week, we advise aggressively rotating into the energy SPDR (NYSEARCA:XLE), the E&P names (NYSEARCA:XOP), the equipment and services names (NYSEARCA:XES), or the natural gas producers (NYSEARCA:FCG).

To conclude, we will give our two cents on gold (NYSEARCA:GLD), whose price is a function of movements in the dollar and inflation (a potential by-product of rising crude prices). Long term we are bullish on gold as an alternative store of value to devalued national currencies as well as a hedge to the inflationary pressures built up after years of Fed, European Central Bank, and Bank of Japan quantitative easing. We temporarily stepped aside in our gold trade as the Trump turnaround rally sent gold below the $1200/oz support level.

However we are seeing constructive signs in the gold miners. The NYSE Gold Miners index (NYSEARCA:GDX) did not make a new low last week, contrary to the price of physical gold, which touched $1160/oz. While the gold miners cannot rally with falling gold prices, we have reason to be constructive here. Sentiment is now very negative on gold and the miners, despite the long-term fundamental reasons to like gold.

The NYSE Gold Miner index chart is also looking attractive for a reversal up. The next chart shows the magnitude of the correction since the summer highs. We have retraced 61.8% of the move higher in 2016 in a nice 5-wave pattern. Yes, this is textbook stuff, but the gold miner trade has been reacting primarily to technicals this year.

The next two charts show some nice positive divergences on the RSI (top chart) and the stochastic (bottom chart). Note the bearish Death Cross on the top chart (50-day moving average cutting below the 200-day moving average, shown by the red circle). Although 50/200 crosses tend to come late in price movements, this obviously merits attention.

We will be buying the gold miner ETF as long as the price stays north of $20.00. We need to be ready for an upcoming bear trap, so we recommend not letting yourself be stopped out of a full position on a move below $20.00. A move above $22.50 on the GDX should accelerate the upside movement.

Conclusion

With U.S. equity markets priced for perfection, the triple threat of a strengthening dollar, rising interest rates, and higher crude prices should provide some fodder for the Bears. Retail, tech, and transportation stocks, sensitive to riding oil prices, should be sold in favour of the energy sectors mentioned above.

Bank stocks will continue to do well as long as the increase in interest rates remains orderly. We would be cautious on adding to bank stocks as traders will not forget to take some of the profits earned since the U.S. election. Finally, gold and the gold miners are poised to bottom, but given the downside momentum, this trade should be entered gradually until we see a trend reversal.

Williams Market Analytics, LLC