Staying Cautiously Optimistic on the S&P 500

The market has been surprisingly robust with the S&P 500 flirting with new highs this week. Investors seem unconcerned by the recession or unemployment rates inside the U.S. and around the world.

Person on the phone points at charts on a computer screen.

Source: Shutterstock

There are competing explanations for this behavior, from the fact that yields are so low there are no viable alternatives to stocks to confidence that the effects of the pandemic are extremely temporary.

The first explanation makes a certain amount of sense. If investors could buy something else, then they would. There is a lot of evidence that even a mild change in interest rates could unexpectedly send stock prices higher.

For example, 10-year bond rates moved nine basis points (0.09%) on Tuesday, and gold dropped more than 5%. And, at the same time, the S&P 500 was up another 1% as capital flowed from precious metals into stocks.

However, the lack of an alternative isn’t really an argument in favor of fundamental value. That means that stocks are treading water near all-time-high valuations, which is inherently fragile.

According to Yardeni Research, the S&P 500 is currently trading with a forward price-earnings ratio of 22.6 times, which is roughly in the middle of the dot-com bubble’s average forward P/E ratio as well.

Taking a Closer Look at the S&P 500

One way to think about this is that investors are paying $22.60 for each $1.00 of earnings that they expect to materialize over the next year.

A chart graphine the price changes of the S&P 500 and and S&P 500 ETF from 2004 to 2020.

Source: Fig. 1 — S&P 500 (Blue) vs. S&P 500 EPS (Orange) — Chart Source: MacroTrends

This is not to say that new highs aren’t possible. Rather, we want to provide some perspective for why a conservatively bullish outlook is still justified. However, if the recent trend of economic data remains positive, we would recommend a much more aggressively bullish stance.

For example, on Friday, the Census Bureau will release their month-over-month retail sales data. Since the decline in March, retail sales are roughly where they were in January and December.

That is a good sign, but it doesn’t mean the losses have been covered. There is still a huge gap in spending this year that could be a drag on performance and employment this quarter.

Although we have recently lightened up our retail exposure by taking profits on our Target (NYSE:TGT) and Starbucks (NASDAQ:SBUX) short puts, we are anxious to jump back into that sector if the retail data is still heading higher.

As you can see in the following chart, expectations for retail sales are for an increase of 1.3% over June’s data. However, if consumption exceeds that level, we believe that will provide further support for prices. We plan to open more exposure to the consumer sector if that happens.

Graph showing the growth or contraction of retail sales from January through June 2020.

Source: Fig. 2 — Retail Sales — Chart Source: TradingEconomics

We don’t usually like to focus so much on a single metric, but in this case, consumer behavior will definitely make or break the rally.

Our focus on retail sales is also a matter of proximity to the announcement. Now that the monthly labor report is out, retail sales is the next big release that also coincides with important technical levels on the major indices.

As you can see in the following chart, the S&P 500 is approaching its prior highs, which also happens to be concurrent with the projection target level at the 161.8% retracement level. That analysis is anchored to the last minor drawdown in June.

The typical behavior at a technical level like this is usually a minor consolidation or resistance bounce, which should give us some nice opportunities to take advantage of new bullish trades.

A daily chart of the S&P 500 index from February through August 2020.

Source: Fig. 3 — Daily Chart of S&P 500 Index — Chart Source: TradingView

There has also been some legitimate concern that the market is being dragged higher based on a relatively small group of stocks like Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Apple (NASDAQ:AAPL). However, positive performance has been more wide spread than you might assume based on recent headlines.

For example, as you can see in the following chart, the percentage of stocks in the S&P 500 that are trading above their 200-day moving average is nearly 62%, which is fairly good at this stage in a recovery.

This means if the S&P 500 runs into resistance in the 3,400 range, we expect market breadth to be strong enough to establish support near 3,200.

This is very similar to the situation the index was in after setting new highs in June. At that time, the S&P 500 pulled back to support at 3,000 before heading higher again.

A chart showing S&P 500 Stocks Above their 200-Day Average through 2020.

Source: Fig. 4 — S&P 500 Stocks Above 200-Day Average — Chart Source: TradingView

There are other places we can look for evidence of a broader rally if we resist being distracted by some of the high-flying outliers. For example, a basic tenant of the “Dow Theory” of securities analysis is confirmation from other indices like transportation and small-caps.

As you can see in the following chart, the Dow Transportation index has also broken out toward its prior highs with the S&P 500, which provides very important confirmation of the rally.

It is important to note that a breakout in transportation stocks without an accompanying rally in oil is fairly rare and tells us a lot about the momentum in that sector.

chart showing the movement of the Dow Jones Transportation Average through 2020 to August.

Source: Fig. 5 — Daily Chart of Dow Jones Transportation Average Index — Chart Source: TradingView

Unfortunately, not all the technical evidence in the market is bullish. Like high valuations, there are still some prominent red and yellow flags in other asset charts.

For example, despite the drawdown this week, U.S. Treasury bonds — as represented by the iShares 20+ year Treasury Bond ETF (NASDAQ:TLT) — are still at extreme highs compared to where they started the year.

You can see both assets in the following chart, which are in demand right now as a hedge against a drawdown in the stock market.

Chart showing the price of gold and the price of the 20-plus-year tresuries ETF (TLT) over the last year.

Source: Fig. 6 — Comparison Chart of Gold & iShares 20+ year Treasury Bond ETF (TLT) — Chart Source: TradingView

The Bottom Line

All on their own, the fundamentals do not support stock prices at this level unless the rebound in consumer spending and industrial activity continues to be positive. The best short-term information we will get for that trend will be released on Friday.

Market breadth is still strong enough to give the market the benefit of the doubt — especially if fundamental trends remain strong. However, investors are still hedging against draw-downs in safe-haven assets like bonds and gold.

A bifurcated market like this is inherently fragile, so we remain very cautious in our outlook. Buying the dips and avoiding taking on new risks at highs will continue to be our short-term strategy at this point.

In addition, we think there is still a lot of value in maintaining some moderate bearish exposure in the portfolio to protect us against a surprising spike in infection rates or other bad economic news.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.

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