Market Update – March 4, 2016

Major averages closed the week ended March 4 up 2%-3%. This marked the third consecutive week of gains. The S&P 500 gained 2.7%, but smaller stocks have led the way during this rebound. The S&P Mid-Cap 400 gained 4.4% and the S&P Small Cap 600 gained 4.2% on the week and have also outperformed the S&P 500 for the past three weeks.

$SPX $MID $SML (D) 160304

Last week’s leader among the large caps was energy, gaining 5.8%. All sectors participated, but so-called risk off sectors (i.e. telecommunications, utilities, staples and health care) underperformed.

S&P Industry Sector One-Week Performance 160304

Energy. The gains in the smaller cap stocks have been led by a rebound in energy stocks. Mid-cap and small-cap energy stocks are up 24%-30% over the past three weeks, more than twice the 11% or so gain in the comparable broader market averages. The rebound in energy stocks has been driven by a 40% rally in the price of WTI crude oil from the Feb. 11 low of $26.05.

$DJUSOS (D) 160304

The bounce back in the price of oil was also a key catalyst for the rally in the high yield bond market. Junk bonds issued by independent oil & gas producers plunged sharply in 2015, taking the high yield sector down with them. The rally in the price of oil has raised hopes that defaults among these issuers will be postponed or avoided.

Despite the rally, it is not clear that oil will hold its current price level. The chart below – a weekly chart of WTI crude – shows that oil has rallied back near the downward trend line that has been in place since the summer of 2014. While this has been a quick rebound, the pace of gains is almost certain to be unsustainable beyond the next several weeks without any clear improvement in fundamentals. Although there have been preliminary indications that major producers may soon agree to a freeze (if not outright cuts) in production, there have been no formal announcements. Even then, the financial markets may remain skeptical about the producers’ willingness to adhere to any production caps.

$WTIC (W) 160304

Since the rebound has come on the heels of an oversold market, crude is not yet overbought and could rally as high as $40 in the near-term.   By definition, however, it will remain in a downtrend until it breaks (and holds) above the trend line. Even so, crude has rallied back above the Jan. 28 intraday high of $34.82, its first higher high in nearly two years. In the days ahead, traders will be looking to see if it can hold its recent gains or complete a successful retest of the Feb. 11 low of $26.05.

Gold. One of the more interesting developments this year has been the rebound in both the price of gold and in gold mining stocks. Both began to take off right in January, as stocks were being pummeled. The market saw this as a flight-to-safety trade, even though Treasury bond yields continued to fall.

The rally in gold and gold stocks has continued in February, even as fears about the global economy have begun to subside. The DJ US Gold Mining Index, shown below, posted a gain of 33.5% in February, its biggest ever. While this marks a strong rebound since the near-historic intra-month low of 33.24 recorded in January, the index may run into resistance around the 60 level, which is where it traded for most of 2014 and 2015.

On Friday, both gold and the miners reached a nine-month intraday high before selling off on fairly heavy volume. Both still closed up on the week, but it remains to be seen if they can hold on to these recent gains, if concerns about the global economy continue to subside. I remain bullish longer-term, but I am looking for the miners to consolidate February’s gains before moving meaningfully higher.

$DJUSPM $GOLD (D) 160304

Market Trend. The third week of the stock market rally took place against a backdrop of mixed economic data. The National Association of Realtors reported that pending home sales declined 2.5% in January. The Institute of Supply Managements Purchasing Managers’ Index (PMI) for manufacturing improved to 49.5 in February from 48.2 in January, but still signaled a contraction. Meanwhile the non-manufacturing PMI slipped a notch from 53.5 to 53.4.

The Fed’s beige book indicated a continuing economic expansion, but reports around the country were mixed. Most districts reported further gains in consumer spending, but consumers are becoming more cautious. Manufacturing activity remains flat, due to the decline in oil & gas drilling activity and weakness in exports. A modest increase in factory orders in January, after two consecutive monthly declines, provides some hope of improvement in the manufacturing outlook.

On the labor front, the economy added 242,000 jobs in February, the labor participation rate improved slightly and the unemployment rate remained steady, but average weekly earnings and the workweek both declined slightly.

The stock market rallied despite the mixed data, suggesting that the third week of gains was driven more by technical factors, including the rebound in the price of oil.

With the stock market’s recent gains, January’s steep slide has clearly been broken, but the stock market’s longer-term downtrend (that began in May 2015) may still be at play. The recent rise in stock prices casts doubt on the bear case, but the burden of proof remains on the bulls.

Although energy stocks may still have some room to run; the sector will probably begin soon to consolidate its gains in the absence of new positive developments that improve the supply-demand outlook. Consequently, the burden of extending the stock market rally will probably be borne more heavily by other “risk-on” sectors, most notably financials, technology, industrials, consumer discretionary and materials. Market watchers also continue to look outside the U.S. and especially to China for (positive) signals on global economic growth.

I believe that the market will move higher in the weeks ahead, sparked by further improvement in the economic outlook, but I would not be surprised to see a pause after recent gains.

March 6, 2016

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036
(908) 448-2246

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