Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio & Technical Strategy.
Volatility has picked up to begin the month of August, and the S&P 500 had pulled back 6% at its closing low on Monday. Tactical indicators such as the VIX (Volatility index) and put/call ratio spiked, and S&P 500 internals additionally reached short term oversold levels before turning higher over the past few days. While up-volume was unimpressive in the first couple of days of the rally, Thursday's 1.9% gain came on strong 88% advancing volume, as the index was able to break above its 50 DMA (2833) and close on the highs of the day.
It will now be important for the index to hold above this level in the coming days. This will further raise the odds that sustainable upside momentum is building. In other words, we need more evidence to enhance confidence that this down move is complete. Bottoms are a process. Outside of the 50 DMA, technical resistance resides at 2954 and the old highs at 3025. On the downside, technical support includes the 2792 (200 DMA) to 2822 (Monday's low) range, followed by horizontal support at 2728 (6/3 low and 10% from the high).
Although our confidence is guarded that the market low for this move is in, we do not currently feel the down move will turn into a collapse similar to the 19.5% draw-down last fall. Last fall, interest rates were moving higher as the Fed was hiking interest rates in the face of trade tensions and a much shakier technical backdrop. Now, the Fed is easing, interest rates are moving lower (supportive to consumers), and the intermediate-term technical backdrop is much more supportive.
We also feel stocks offer attractive upside over the next 12 months. Valuation is not overly stretched despite the market near highs, given valuations tend to expand in low interest rate, low inflationary environments. The S&P 500 P/E is currently 17.4x which historically is attractive given core inflation is 2.1% and the US 10 year yield is at 1.7%. That puts the equity risk premium (earnings yield vs bond yield) at ~400bps, close to two standard deviations above its historical average since 1960. However, trade tensions and global uncertainty act as a headwind to multiple expansion.
We stick with our next 12-month base case S&P 500 target of 3108 (P/E of 18.5x on $168 earnings) but lower our odds to 65% (from 70%). In our view, trade tensions and yield curve movement will force the Fed to act; and too much is at stake for both the U.S. and China to push things to the point of economic hardship. However, we lower our bull case (3480) odds to 10% from 20%, as this requires success with trade; and we raise our bear case (2415) odds to 25% from 10%.
Globally, the U.S. remains our favored area from both a fundamental and technical standpoint. Through the pullback over the past week, U.S. relative performance has continued to improve and broke to new highs (vs the World). Within the U.S., we favor the Large Caps, particularly with more U.S.-centric businesses as these areas are generally putting up better fundamentals and more stable technical trends. For example in Q2, S&P 500 companies with over 50% of their revenues from the US have grown earnings 5% on average vs companies with over 50% of their revenues from overseas seeing an earnings contraction of -1% on average.
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