The 2 Things 2017's Top Stocks Have In Common

Major stock indexes have struggled to move past their December 13 pre-Fed closing prices

Senior Vice President of Research
Jan 9, 2017 at 8:33 AM
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"Dow Comes Within 0.37 Points Of 20,000 Milestone"
"Dow Just Shy of 20,000 Milestone"

    - CNBC television headlines, January 6, 2017

The good news: Multiple indexes made new all-time highs last week, including the S&P 500 Index (SPX - 2,276.98) -- which had ended the previous week by pulling back below the 2,248 level (10% above its 2015 close), and thereby failing to register a 10% gain for 2016.

More good news: An index we haven't discussed in this report, but which faced round-number resistance in December -- the Nasdaq-100 Index (NDX - 5,007.07) -- surpassed the 5,000 level on Friday. This is a mark that it failed to surpass at its March 2000 peak, coming only 184 points shy of touching it before the "tech wreck" began. The NDX is a measure of big-cap tech stocks, and is the basis for the well-known PowerShares QQQ Trust (QQQ - 121.93).

The "bad" news: While the Dow Jones Industrial Average (DJIA - 19,963.80) also hit a new all-time high, it was "close, but no cigar" with respect to touching the 20,000 mark for the first time ever. If you were tuned into CNBC on Friday afternoon, you know the Dow came within 0.37 point of 20,000, which was one of a couple of predominant "Breaking News" headlines flashing onscreen at the time.

"With equities around all-time highs, the pre-election caution that existed has given way to short-term optimism, increasing the risk that January 2017 is a repeat of January 2014, January 2015, and January 2016, when the SPX declined 3.6%, 3.1%, and 5.1%, respectively."  
    - Monday Morning Outlook, January 3, 2017

Shifting back to the good news, the first week of trading in 2017 -- which encompassed only four trading days, due to recognition of New Year's Day on Monday -- saw the SPX advance by 1.7%. The SPX's move higher is a notable change of pace from the previous three years, per the table immediately below, which displays the SPX's return in the first four days of trading in 2014, 2015, and 2016. In those years, the SPX declined into month's end after logging negative returns in the first four days of January. Now, bulls are hoping that the first four days of January 2017 are indicative of what will occur the rest of the month.

spx first four days return

"Moreover, we are seeing optimism come into the market, which usually occurs prior to a sell-off or trading range behavior."
    - Monday Morning Outlook, December 19, 2016

While the SPX, Dow, and technology indexes registered new highs, small-caps and mid-cap stocks -- as measured by the Russell 2000 Index (RUT - 1,367.28) and S&P MidCap 400 Index (MID - 1,682.07) did not rise to new peaks in the first week of 2017.

And while the SPX made a new high, Friday's 2,276.98 close is only 5 points higher than the closing price of 2,271.72 on Dec. 13 -- the day before the Federal Open Market Committee (FOMC) raised interest rates and bumped up its forecast for three rate increases this year. In other words, the SPX has been mostly range-bound for close to a month, as we anticipated might happen, amid a loss of leadership from the small-cap and mid-cap stocks that were major outperformers since the election.

However, the SPX did make a little progress on Friday to move out of its range. Per my observation on Twitter, and as displayed on the graph below, note that the SPX's weekly finish above its Dec. 13 close was actually a minor feat. Prior to this happening, there were eight previous attempts to take out and close above this level, all of which failed.

spx daily since nov 2016

But the RUT and MID ended below their respective Dec. 13 closing prices on Friday. In both cases, these indexes have been dancing around these levels, with the RUT graph below also providing a serviceable facsimile of how the MID has behaved around its own Dec. 13 close. Neither buyers nor sellers have been in control during the past few weeks, though there is a hint of a slight shift into larger-cap stocks -- perhaps asset reallocations that came with the start of a new year.

rut daily since nov 2016

Short covering may have been supportive of stocks last week, as the calendar flip to 2017 generates investment decisions driven by tax considerations. In other words, with President-elect Donald Trump due to be inaugurated on Jan. 20, investors may be anticipating imminent tax changes in their favor. Therefore, by unwinding profitable positions in 2017, they can postpone the tax bill to a potentially more favorable tax rate relative to 2016.

Our Senior Quantitative Analyst Rocky White found that in the first three trading days of 2017, the stocks with the biggest percentage gains exhibited two factors: 1) As a percentage of float, they were among the most highly shorted; and 2) the shorts were sitting on significant gains in the 2016 year.

Said another way, if a highly shorted stock declined significantly in 2016, it was likely more prone to a short-covering rally last week as traders looked to book profits in 2017 instead of 2016. And the higher the short interest, the more intense the short covering (see the table below).

stock returns in 2017 0106

The turn of the year can bring major short-term or longer-term pivot points among individual stocks and/or asset classes, whether it is due to tax implications or asset reallocations. Technically, stocks continue to look healthy, as they digest post-election gains. But the sentiment backdrop suggests they are more vulnerable than usual to negative headlines, so ensure that you are prepared for a setback, with Dow 20,000 continuing to loom overhead amid a loss of leadership in the small- and mid-cap spaces.

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