Expect Further Market Melt-Up After Pullback, Says Jeff deGraaf

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The long-awaited correction in the stock market finally took place this week with the S&P 500, Dow, and other major averages currently down over 3% from their late-January highs. Is this the top or the end of the bull market?

Financial Sense Newshour just had the honor of speaking with Jeff deGraaf, founder and chairman of Renaissance Macro Research, to discuss his outlook on the bull market and whether he thinks it's time to sell.

Jeff has been rated as one of Wall Street’s most influential macro-based analysts for over a decade, also ranked by Institutional Investor magazine as the #1 Technical Analyst for the last 11 years. To request a free trial of his research, click here. Here's what he had to say...

Overbought Conditions Not a Bull Stopper

Yes, the market is overbought, and the de facto assumption is that this must be bearish, deGraaf stated. However, if we look at the extreme overbought conditions since 1929, in each of those instances, we actually saw well-above-average returns over the next 12 months.

“Are we stretched, and were we on an unsustainable pace for the month of January?” deGraaf said. “Absolutely. Does it portend a weak 2018? We would say absolutely not, but we would add that a consolidation or digestion period that then moves higher toward the back half of this year, is certainly in the cards.”

Despite interest rates going up, credit conditions are still ample. The market is actually poised for a further melt-up, deGraaf added.

financial stress market tops
Sources: Bloomberg, Financial Sense® Wealth Management

Individual Investors Jumping In

While the run up in stocks has been primarily led by institutional investors, individuals are now piling in, deGraaf stated. This tends to be something at the tail end that’s momentum-based, and certainly favors indexing.

What’s interesting is, as we look at how momentum strategies have historically played out, we’re not anywhere near some of the extremes seen towards the tail end of an advance.

This migration towards indexing will push these things further as we go, deGraaf added.

“If you look at valuation today and you adjust it for credit, or specifically the cost of corporate credit, valuation is actually exactly where you’d expect it to be over the long run,” deGraaf said. “In our view, valuation even has further to go, presuming that credit stays relatively stable here.”

What Positive Factors Are Pushing Markets Forward?

Algorithmic trading is helping to keep volatility low, deGraaf stated. Volatility is a byproduct of credit conditions, so when credit conditions are extraordinarily easy, we tend to have a low volatility environment.

The last time we had volatility on average about where we are today was in 2005 and 2006, when ample liquidity created a low-volatility environment.

Also, tax cuts and the downward trend in the dollar are helping earnings, and other factors are playing into current positive conditions.

“Both of those things are certainly tailwinds,” deGraaf said. “They are facing off against the headwind of higher rates, but if you look historically, the larger impact in terms of the delta or the change from a month-to-month or quarter-to-quarter basis comes not so much from yields but from the dollar as it impacts earnings.”

Yield Curve Not a Concern Yet

Generally, higher rates are causing some concern. When it comes to the yield curve itself, some people worry about the spread between the 10- and 2-year Treasury yield. However, the spread isn’t what’s important, he said.

In other words, if the curve is inverted, that’s a bearish signal. If it’s not inverted, things tend to be fine and we don’t have to be worry how large that spread is, deGraaf stated, just as long as there’s a positive spread.

yield curve bull market
Sources: Bloomberg, Financial Sense® Wealth Management

The other thing deGraaf looks at is the difference between the Fed funds rate and the 2-year yield. That’s over 50 basis points here, and what that’s signaling to the Fed is that markets can withstand higher rates without choking this bull market off.

The other long-held assumption is that when interest rates go down, stocks go up, and conversely, when Interest rates go up, stocks go down.

“That dynamic actually shifted in the early 2000s in a statistically meaningful way where we can say today with some certainty … that when yields go up, stocks go up, and when yields go down, stocks go down,” deGraaf said. “I wouldn’t be too concerned about rising rates. Unless you invert the curve … we still think the conditions from an interest rate perspective will remain favorable for stocks.”

Further Meltup Possible Into Year End

Most of the conditions we see internally for the market are still quite favorable for a continuation of the equity bull.

One of the ways we define a meltup is when we see a market up 50% or more versus the previous 18-month period. That would put us roughly at 3400 on the S&P toward the end of June of this year, or close to 3600 by the end of the year.

Based on average expectations of alpha in commodities, deGraaf sees room for commodities to outperform.

commodities vs stocks
Sources: Bloomberg, Financial Sense® Wealth Management

He expects industrial metals to do best, followed by precious metals and energy.

“One of the reasons we think there is a high possibility of a meltup is that we do think that there has been with the advent of fracking and the shale boom this more elastic supply curve that has developed,” he said. “If that’s the case … this may therefore be keeping the inflation data lower and the Fed looser than it might otherwise be, providing the fuel for a meltup.”

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