SPY Signal Points to Short-Term Slump, Long-Term Gains

SPY's price/earnings ratio could stretch even higher as fourth-quarter reports roll in

Jan 15, 2018 at 6:57 PM
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After an incredible rally during the first week of January, many people arrived in the office last Monday fully prepared for a market breather. Monday provided a slight pause in the action, but the break did not last long. By the end of the week, all the major U.S. equity indexes were higher, and the momentum from the first week of 2018 cruised along into the second week without so much as a hiccup.

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Chart courtesy of StockCharts.com

It won't stand out on the chart above, but Wednesday morning marked what many thought would be a chink in the market's armor, as 10-year U.S. Treasury yields jumped to their highest level since March 2017 and U.S equity futures indicated a strong move lower for stocks. While equities sold off early in the day, we saw a slow climb out of the red during the next few hours -- and by the end of the day the market finished near breakeven. Piggybacking on the late-Wednesday momentum, equities surged on Thursday and Friday and finished the week at new all-time highs.

Given the incredible momentum that U.S. stocks are experiencing, it is surprising to no one that momentum oscillators like the 14-day Relative Strength Index (RSI) have reached overbought territory. This indicator measures the speed and change of price movements, and oscillates between 0 and 100. Traditionally, the RSI is considered overbought when it's above 70, and oversold when it's below 30.

On Wednesday, the RSI moved above 80 for the first time since Feb. 21, 2017. Looking back at data for the SPDR S&P 500 ETF (SPY - 277.92) since 1993, this has happened only eight times. Below are the results when it does occur, along with normal SPY price movement over the same time frames.

spy after rsi 80 cross

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Although it is a limited sample size, when RSI reaches this level, the SPY has historically underperformed over one-week and one-month time frames. The other big takeaway is that the SPY has outperformed over three-month, six-month, and 12-month time frames after RSI reaches 80 or higher. So over the short-term, perhaps we could see the market take a breather -- but this type of price action has historically indicated that the long-term trend is still healthy and has more upside.

The other statistic that is interesting is the standard deviation, which measures the volatility of returns from the study. Across all time frames, the standard deviation is lower when RSI reaches 80 or above. This is of more interest over the longer time frames, because the SPY achieves higher returns with a smaller standard deviation. More reward with less risk is always a positive.

One area of the market that took center stage last week were small-cap stocks. While large-cap growth stocks were the darling of 2017, small-caps made a nice statement to start 2018. The Russell 2000 Index (RUT - 1,591.97) has been struggling to surpass the 1,550-1,560 region since the end of November, and finally broke out from its ascending triangle pattern on Thursday. This is good news for this segment of the market, and could indicate some rotation to areas that underperformed last year.

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Chart courtesy of StockCharts.com

With the new year also comes a new earnings season. The fourth-quarter earnings reports are starting to trickle in, and over the next few weeks they'll really pick up. For the quarter, the estimated earnings growth rate for the S&P 500 Index (SPX - 2,786.24) is 10.5%, and all 11 sectors are expected to report earnings growth for the quarter. Estimated revenue growth for the quarter is 6.7%, as well. If the results come in at or above these expectations, it will mark the third time in the last four quarters that the index has reported double-digit earnings growth. Besides revenue and bottom-line growth, market participants will be eager to hear about company's tax savings from the new GOP plan, potential capital expenditures from these potential savings, and other comments on guidance and expectations.

Valuation ratios remain high, and may only be stretched as prices go higher. With the forward 12-month price/earnings ratio of the SPY at 18.4, it is now above its five-year and 10-year averages. This will have almost zero implications for the price action for this week, month, or even the year. While growth in earnings or a decline in price could help spur a reversion to the mean for this ratio, this type of reversion has historically played itself out over periods of five to 10 years.

There have also been talks that an increase in interest rates can ultimately affect discount rates that are used to value companies. In theory this is true, but we must still remember that interest rates are near a historically low level, and even movement to the upside will not put us at a high level for quite some time. It is also important to remember that U.S. Treasury interest rates may seem extremely low, but they continue to be much higher than a majority of the developed countries around the world. This, coupled with the overwhelmingly bullish sentiment toward higher rates, continues to keep me skeptical of the assumed belief that interest rates must go higher. Let's not forget that everyone assumed interest rates had to go higher in 2017, and long-term rates decreased.

As for this holiday-shortened week, a full slate of earnings reports will dominate the headlines. While a few big banks reported last Friday, Citigroup (C), Bank of America (BAC), Goldman Sachs (GS), and KeyCorp (KEY) will disclose their results this week. Other big-name companies scheduled to report include American Express (AXP), Alcoa (AA), IBM (IBM), and Fastenal (FAST). Economic news will be relatively light, with crude inventories released on Wednesday and housing starts and building permits released on Thursday.


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