Saturday, November 22, 2014

US Equity Market Review For The Week of November 17-21

     One of the main points I've made over the last few weeks is the market is expensive by most valuation models.  This is hardly a revolutionary assertion; many traders have been looking to various metrics (PE, Forward PE, Dividend Yield) and making the same observation for the last few years.  What this means is the that, for the market to move higher in a meaningful way, we ultimately need fundamental change; something in the basic economic calculus has to be altered for the market to move higher. 

     And that's exactly what we got last week from two central banks.  Mario Draghi of the ECB has pledged to use central bank policy to increase inflation:

Mario Draghi strengthened his stimulus pledge for the euro area by saying the European Central Bank can’t hold back in its fight to revive the economy.

“We will do what we must to raise inflation and inflation expectations as fast as possible, as our price-stability mandate requires,” the ECB president said at a conference in Frankfurt today. Some inflation expectations “have been declining to levels that I would deem excessively low,” he said.

And on the other side of the globe is the PBOC lowering rates:

China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy, sending global shares, oil and metals prices higher.

The one-year lending rate was reduced by 0.4 percentage point to 5.6 percent, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, effective tomorrow, the People’s Bank of China said on its website today.

The net effect of this move on the US markets is clear from a daily chart of the SPYs:

The chart above clearly shows Friday's price movement as a gap higher, with the SPYs printing a solid candle on a nice increase in volume.  There are some technical drawbacks to the above chart, however.  The MACD and RSI are both already at strong levels, indicating prices are already at the top of a buying cycle.  While both of these indicators can stay pegged at higher levels while prices continue to move higher due to fundamental factors, they do bear watching.

     There are some other cautionary developments, however, in the 5-minute chart:

On Friday morning, prices gapped higher by over 1%.  But they moved lower in a disciplined manner until after lunch, when they slowly moved a bit higher into the close.  Some of this move is understandable; the market is already expensive, so an opening gap higher would probably be met with more valuation based selling.  However, in an ideal rally, prices would gap higher and then continue on that path. 
     This is hardly fatal.  And, when we look at the 30 minute chart, its importance diminishes:
After the sell-off about a month ago, prices made a continued move higher, forming a price arc.  For the last week and a half, prices have been consolidating right around the 204 level.  Friday's move was a push higher from this base, meaning the most likely interpretation is that we're looking at a new move higher, which is confirmed by the price action in other indexes:

The Russell 2000 (IWMs, top chart), transports (IYT, middle chart) and mid-caps (IJH, bottom chart) all confirmed the move higher.

     In addition to the international events driving the market higher, there is also the fundamental condition of the US economy.  Employment growth is strong and regional manufacturing numbers have been solid, corporate earnings are expanding.  The general consensus is that, in contrast to much of the developed world, the US is in good shape.  This means that, overall, the US equity market has the wind at its back -- at least for another week.