Zeller Kern’s Investment Monitor

Is There Still Steam Left?

June 28, 2017

By Steve Zeller

The U.S. equity markets remain in an upward trend. Even though we have experienced some choppiness within the last few months with a possible short-term pullback, our current expectation is for further market highs to be realized before a major market top is in place.

As of the market close on Friday, the S&P 500 is up 9.98 % year to date, the Dow Jones Industrial Average is up 9.58%, while the NASDAQ Composite, thanks to the “FAANG” stocks (Face Book, Apple, Amazon, Netflix, and Google) and the tech frenzy, is up 16.39%. Other indexes such as the Russell 2000, the EAFE International index, are also remaining in positive territory, with the indexes being up 4.88% and 14.11% respectively. (Source: morningstar.com) The S&P 500 is currently at 2438.30, as of Friday’s market close, and currently we are still of the view that the index should penetrate the 2500 level and could move towards the 2640 level, before a top is complete.

As our readers know, we have pointed out that the current bull market cycle is over eight years in length, and we expect this cycle could possibly end within the next twelve months. We still think there are enough of the speculative animal spirits within investors to carry the market to new highs. However, as we have been saying in the last two issues of the Investment Monitor, many things are falling into place that indicates a market top is approaching. Market analysts such as John Hussman of the Hussman Funds makes some valid points to consider, mainly that the market is richly overvalued, market internals have turned unfavorable, and interest rates are off the “zero” mark. The zero interest rate conditions have fueled the speculative frenzy with assets, such as equities and real estate, and are now moving upward. Technically speaking, market internals are such that 40% of stocks within the S&P 500 are below their 200-day moving average, and market breadth, which is the number of stocks that are pushing the indexes higher are narrowing. But nevertheless, indexes can continue to move higher.

Furthermore, the Shiller P/E ratio is now at 30.10, as of Friday which is just about where it was in the late 1920’s.



The other question is how long can the economy continue to grow and at what rate?  Hopefully at a stronger pace than it has been during the last few years. This economy is being fueled partly by the second technology boom, which is what we refer to as the “app tech” boom, short for the application of technology, which is now underway. We know technology is booming, but it is the application of technology across the entire spectrum of the economy that is creating efficiencies, and yes, beginning to eliminate jobs and threaten certain professions. But of course, new jobs are created. Furthermore, as one visits cities across the country such as Austin, Nashville, Boston, San Diego, etc., it is quite obvious that the commercial construction activity is in a positive trend as one can witness numerous amounts of commercial high rise cranes in the air to assist in the building of high rise projects. Now granted, that is anecdotal evidence, but it sure is a sign of positive activity.

Real estate activity has spiked and residential real estate is gaining steam and approaching a frenzy in some instances. According to a recent report published by Mish Shedlock at Mishtalk.com, Median home prices surged 11.5% in May to $345,000. The year-over-year increase is 16.8%, which is nearly double the 8.9% gain in actual sales.  According to the report, home builders are reporting strength in the West and South, with sales of new homes jumping 13% to 162,000 in the West, while sales in the South jumped 6.2% to 360,000. However, sales in the Midwest and Northeast, which are small regions, fell sharply with double-digit declines, down 11% for the month in the Northeast to 33,000, and down 26% in the Midwest to 55,000. Although these reports can exhibit wild swings and revisions, it does indicate economic strength that is fueled by rising employment and low mortgage rates.

But the Mortgage News Daily reported recently, overall home sales were up 2.9% from April to a seasonally adjusted estimate of 610,000, breaking the 600,000 mark for only the fourth time since the housing crisis began. The median sales price in May was $345,800 and the average price was $406,400. To put it into perspective, prices a year earlier were $296,000 and $350,000 respectively. This beats the previous record of $332,700 and also represents a record increase in the year-over-year change of 16.8%, as was previously mentioned.

Mish Shedlock makes a great point in his article by pointing out that the slope of prices versus sales is very telling in that, most potential buyers cannot afford houses. So, even though home sales by volume is nowhere near it was in 2005/2006, individuals are getting themselves into debt and mortgages that they most likely won’t be able to handle in the long term.

Our thesis continues to be that what really threatens this growth cycle and financial market is the ability to sustain and support the amount of debt which is at absolute all-time high records. Even in other parts of the world such as China, corporate debt has now reached 166% of GDP, while household debt in China rose to 44% of GDP last year, according to a June 26th article, in the “Independent.” And as we have been warning our readers for the last several years, municipal debt default risks should begin to increase, which Puerto Rico has kicked off the festivities by defaulting on their general obligation bonds and now the State of Illinois the first state ever be at risk of defaulting.

But in the meantime, we still expect the market to set new highs in the coming months. This week’s economic reports include the Dallas Fed Manufacturing Survey and Durable Goods on Monday. On Tuesday, there is there Richmond Fed Manufacturing and the Redbook. Wednesday has Pending Home Sales and Thursday has Jobless Claims and GDP. And finally, on Friday is the release of Chicago PMI and Consumer Sentiment. When we have seen this type of economic data released in most recent weeks, there seems to be very little impact on the markets. It is likely that we are going to see a continuation of the summer rally, potentially moving us into an October to December top in the market.


Looking back on last week

After starting off on a strong note last Monday, the markets continued to drift in a sideways trading range as the S&P finished up on the week 0.21%. This would represent the second consecutive gain but it was very slim to say the least.
The NASDAQ exhibited relative strength on Monday as the technology and biotech stocks outperformed, bucking their recent bearish trends. Names like Apple and Biogen were leading the charge. Financials were also posting a solid performance and continued a bullish two-week run.

The market reversed its action, selling off on Tuesday as it removed most of Monday’s advance. The energy sector finished at the bottom of the leaderboard for the second day as crude oil continued to tumble amid excess supply concerns. However, besides the bearish tone in energy, the biotech stocks kept chugging along pushing the ETF IBB higher by 1.3%.

Wednesday’s action would be range bound as the healthcare and technology sectors held up under the weakness in the S&P 500 to keep the index from declining substantially.

On Thursday, the Senate rolled out their version of the health care reform bill, focusing on Medicaid expansion and rolling back the affordable care act’s more aggressive expansion. Meanwhile, crude oil continued to decline and dropped another 2.3% despite a fairly upbeat inventory report.

Friday’s action would be focused on the healthcare sector as it chopped in a sideways pattern for most of the session as financials, consumer staples and utilities weighed on the average. Crude oil did manage to trade slightly higher for the first time all week. While in the end equities managed to squeak out a moderate gain, the big loser for the week was the energy sector, down 4%.

On the interest rate front, market participants altered their rate hike expectations after comments from several FOMC voters including vice chair Fischer. The Fed Funds Futures now point to only a 50% probability for an increased in rates in December of this year.

Friday’s action moved in a very narrow, choppy range as the markets finished slightly higher at 2438.30 basis the S&P. The configuration continues to be moderately positive in spite of the lack of momentum on a short-term basis. Once again, all the action will be dominated by the intermediate and longer-term charts.

*Last week’s market recap provided by VPM Partners

Best Wishes,

Zeller Kern Investment Committee