The stock market has advanced steadily through most of February. Many market commentators are calling it a melt-up because average daily price moves have been less than 1%. (In fact, the S&P 500 has not moved more than one percent in daily trading since December 7.) This latest rally, which began on February 9, has taken the S&P up 3.2%.
Despite the slow grind higher, stocks now look overextended, as shown in the relative strength indicator in the chart below, which crossed above the key 70 threshold on February 11. The S&P 500 is also 3.5% above its 50-day moving average and 8.6% above its 200-day moving average. That index has not been this far above the 200-day since right before the August 2014 sell-off.
Of course, the market does not have to sell-off because it is overextended. Last December, the S&P was more than 7% above its 200-day and subsequently traded sideways until late January. Sideways trading allows the market to catch its breath.
Still, there are other factors that suggest that investors should tread carefully. The lower portion of the chart above shows that the S&P MidCap 400 Index and especially the S&P SmallCap 600 Index have underperformed the S&P 500 since mid-December. Weaker performance in smaller capitalization stocks suggests that at least some investors are taking a more cautious approach to the market.
Likewise, the chart below shows that, for the most part, the so-called “risk-off” sectors – consumer staples, health care, telecommunication services and utilities – which mostly underperformed the market since the beginning of the year, have outperformed in recent weeks.
Furthermore, the U.S. Treasury yield curve has shifted down during the month of February, even though market participants have been expecting higher interest rates as a result of the anticipated improvement in economic growth and positive impact on business performance of tax, trade and regulatory reform.
Indeed, there was a 10 basis point decline across most of the yield curve last week, despite recent hawkish comments from Fed Chairman Janet Yellen and the release of FOMC minutes that indicated growing support for a more rapid pace of interest rate normalization. For example, the yield on the 10-year Treasury note declined 11 basis points from 2.42% on Feb. 17 to 2.31% on Feb. 24. and the 5-year yield fell 12 basis points to 1.80%.
Some of the market’s changing views may be driven by a sharp drop in the price of natural gas this year. Natural gas prices took off after the election and peaked on December 29 at $3.90 per million BTUs. Since then, however, it has been all downhill. That near-term contract closed Friday at $2.79. Much of the drop in natural gas prices is due in large part to the return of warmer winter weather.
Natural gas has declined even though the price of oil has remained flat (as shown in gold in the chart below). The price reversal has hurt the performance of oil & gas stocks so far this year. The S&P 500 energy sector slid 1.3% last week and is now down 5.6% year-to-date.
The S&P 500 Materials sector was roughly flat last week, but there was a divergence in performance within the sector. Chemical stocks, like Dow and DuPont faired relatively well, with gains of 3.7% and 3.0%, respectively. Yet, other materials stocks got hammered. Freeport McMoran fell 11% on the week. U.S. Steel was down 7%. Cliffs Natural Resources was down nearly 7%. Clearly, many of these decliners had risen sharply since the election; so an eventual correction was to be expected. But together with the decline in Treasury yields and the drop in natural gas prices, a picture may be emerging that suggests concern about the pace of growth of the economy and corporate earnings.
Investors took the market higher again last week, but they did so by buying stocks that are less exposed to the gyrations of the business cycle. Many market watchers have been expecting a pullback and maybe we will get one here; but even if the market does give back some of its recent gains, I believe that such a pullback will most likely prove to be temporary, unless some sort of geopolitical crisis surfaces.
February 26, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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