Bullish, but Time to be Selective

There are still plenty of bullish economic and market developments to prevent me from becoming overly bearish right now, but I am seeing a few warning signs that tell me this market is getting a little long in the tooth. As such, sector allocation and overall stock picking becomes much more important as the ranks begin to thin out in terms of stocks still participating in this bull market.

Why I Remain Bullish

While it is easy to find things that are either wrong about the economy or stock market, there are some positive developments that are occurring that can’t be ignored. There is still $200B left in the Fed’s QE 2 program to hit the markets between now and June, small business optimism is picking up and so is small business hiring, and recession risk remains quite low.

Given that the small business community is THE job creation engine of the country, it is very encouraging to see the strongest job gains to date coming from small firms since the economic expansion began in 2009. Over the last three months small business firms are adding 100K to monthly payrolls while medium-sized firms are adding 104K and large multi-national firms continue to outsource employment given their tepid addition to national payroll growth.


Source: Bloomberg

Rather than give a long list of economic positives I’d rather show my recession probability model which has had an excellent track record and is a culmination of many indicators to create an overall recession probability model. Given the risk of a recession in the next 6-9 months is only 6.25%, clearly there are far more positive changes on the margin than negative.


Source: Bloomberg

With the above things in mind it makes much more sense that the stock market remains robust, which is itself a leading indicator of recessions. The S&P 500 peaked in October of 2007 while the last recession began two months later in December of the same year. Also, given current conditions, it is not surprising to see my S&P 500 Long Term Trend Model showing all of its components on a buy signal. Three out of the five components gave sell signals last summer as it looked like were forming a major market top, but Helicopter Ben Bernanke helped push up the stock market with his August 2010 Jackson Hole speech in which he hinted of a coming round two of quantitative easing and made the official announcement in November 2010. This helped push the markets up as the “Bernanke Put” was in place, reversing my trend model sell signals and suggesting investors to get back into the market.

Divergences Speak of Selectivity

While there are plenty of bullish developments, leading economic indicators are beginning to diverge and wave a red flag. At major turning points for the stock market we’ve seen the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) diverge with the S&P 500. In 2000 the S&P was hitting new highs but the WLI failed to match the S&P 500 and was warning of a major market peak. Conversely, the WLI bottomed well in advance of the S&P 500 during the 2000-2003 bear market and was hinting that the bear market was coming to a close. Yet again the WLI provided early warning of a coming market peak as it failed to confirm the new high seen in the S&P 500 in 2007. Currently, a divergence has been developing between the two again as new highs haven't been confirmed by the WLI. At a minimum this speaks of becoming more selective in the sectors to invest in as the potential of a market top in the next 12 months is a distinct possibility.


Source: Bloomberg

Another warning sign to watch out for is a lack of confirmation between new 52-week highs of individual stocks and the major exchanges. As you can see from the charts below, new highs have begun to grow fewer in number while the market has continued to appreciate. Simply put, this means the bull market is beginning to become more selective as fewer and fewer stocks are participating.


Source: Bloomberg

If a topping process is indeed taking place, the sectors that outperform the market the most near the end of a bull market are defensive sectors like health care, consumer staples, utilities, telecommunications, and also late-stage cyclicals like industrials and energy. Going forward, investors should become more selective in sector allocation as well as putting on their risk management hats. If I begin to see more bearish divergences within the stock market and economy and my S&P 500 Trend Following Model flashes sell signals I will turn even more cautious. However, I still believe inflation will heat up this year and commodity-focused portfolios with exposure to energy, basic materials, agriculture, and precious metals should do well. Consequently, inflation will mostly likely be a major cause of the next bear market as corporate margins get stretched. I’ll develop this point further in my next article, but keep your ears open to comments on profit margins this coming earnings season as oil, gas, and overall commodity prices continue to climb.

About the Author

Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()
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