One Sector Could Race Higher as Market Continues to Stall
The major U.S. indices posted modest gains last week, led by the Russell 2000, which rose 1.1%. Last week’s rally puts the small-cap index up 10.2% for 2016, which is by far the best year-to-date performance for any of “the majors.”
The mid-July breakout in the Russell 2000 continues to target a move to 1,400 — almost 12% above Friday’s close — that will remain valid as long as the late-June, post-Brexit lows are not broken.
Last week’s broad-based advance was once again led by the financial sector. The only sectors of the S&P 500 to post losses were health care, energy and consumer discretionary.
Lack of Fear Keeping Stocks Afloat
I first warned Market Outlook readers that near-term downside risk exceeded upside potential in the July 18 report, and I have continued to beat that drum ever since. Seven weeks later, the benchmark S&P 500 is essentially unchanged, up less than 1% and apparently still stuck in neutral.
There are a number of reasons why the rally has stalled, including historically low volatility according to the Volatility S&P 500 Index (VIX) and formidable overhead resistance at the market-leading Nasdaq 100’s tech-bubble highs.
So why hasn’t a pullback or correction started yet?
There are two main reasons. First, we have not seen investor asset flows contract in key ETFs like the SPDR S&P 500 (NYSE: SPY). Second, we have not seen a meaningful increase in investor fear.
Regarding the latter, the lower panel of the chart below shows that since Aug. 24, the VIX has been mostly hovering just below its 50-day moving average. I use this moving average to determine whether investors are collectively fearful (above 50-day) or complacent (below 50-day).
Over the past several years, a sustained rise in the VIX — especially coming off a complacent extreme of 12 as is the case now — has indicated there was enough fear to trigger and fuel at least a multiweek pullback in the broader market. The last time this happened was during June, and as you can see above, it coincided with a countertrend decline in the S&P 500.
So, even though the market is unlikely to move meaningfully higher from here without a correction first, without a sustained rise above 13.50 in the VIX this week, the market’s sideways drift is likely to continue.
Tech Bellwether Outperforms
In the July 11 Market Outlook, I pointed out a buying opportunity in Texas Instruments (NASDAQ: TXN), saying it targeted a run to $75.50, which was almost 20% above the stock’s price at the time. Since then, the tech bellwether is up about 10% compared to just 2.4% for the S&P 500.
Although my $75.50 target remains valid, TXN has a long-term positive correlation to the S&P 500. Considering my expectations for a broader market correction between now and the end of the month, readers should consider tightening their stops to $68.30, which represents the Sept. 1 low, to protect their profits.
Bigger Picture Remains Bullish
Despite strong evidence that the market is unlikely to move much higher without a meaningful pullback first, the bigger picture still looks promising.
Texas Instruments’ $75.50 target sits 8.4% above Friday’s close, and the Dow Jones Industrial Average’s 20,400 upside target, which I first mentioned in the July 5 Market Outlook, is about 10% above Friday’s close.
The Dow’s upside target remains valid as long as the 17,063 June 27 Brexit low is not breached during the corrective decline I’m expecting. This means that the Dow could hypothetically drop as much as 7.7% from Friday’s close and not negate my overall positive bias.
Lumber is a Bright Spot for Investors
With the S&P 500 essentially stuck in neutral since late 2014, I have been spending more and more time looking for investment opportunities outside of U.S. equities, including in the commodity space. Currently, I’m seeing an opportunity emerging in lumber prices.
The iShares Global Timber & Forestry (NASDAQ: WOOD) recently broke above both its 52-week moving average, a major trend proxy, and its May 2015 downtrend line to confirm a bullish inverse head-and-shoulders pattern.
The pattern targets a run to $60 — 18.4% above Friday’s close — that will remain valid as long as the 52-day moving average at $46.82 loosely contains the ETF on the downside as underlying support.
Rising lumber prices bode well for the housing sector, as well as the overall U.S. economy, as housing prices have historically been positively correlated to the S&P 500.
Putting It All Together
Although it may be tempting to put some new money to work in the stock market after watching it drift sideways for most of the year, my research continues to suggest that patience is a virtue. The low volatility we have seen this summer historically precedes market pullbacks, not new highs.
Bigger picture, however, as long as the decline I’m expecting does not exceed the market’s late-June lows, I think it will present a buying opportunity heading into the new year.
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