by Scott Martindale
President, Sabrient Systems LLC

After an “investor’s paradise” year in 2017 – buoyed by ultra-low levels of volatility, inflation, and interest rates, and fueled even more by the promise of fiscal stimulus (which came to fruition by year end) – 2018 was quite different. First, it endured a long overdue correction in February that reminded investors that volatility is not dead, and the market wasn’t quite the same thereafter, as investors’ attention focused on escalating trade wars and central bank monetary tightening, leading to a defensive risk-off rotation mid-year and ultimately to new lows, a “technical bear market” (in the Nasdaq and Russell 2000), and the worst year for stocks since the 2008 financial crisis. Then, it was confronted with the Brexit negotiations falling apart, Italy on the verge of public debt default, violent “yellow vest” protests in France, key economies like China and Germany reporting contractionary economic data, and bellwether companies like FedEx (FDX) and Apple (AAPL) giving gloomy sales forecasts that reflect poorly on the state of the global economy. The list of obstacles seems endless.

Moreover, US stocks weren’t the only asset class to take a beating last year. International equities fared even worse. Bonds, oil and commodities, most systematic strategies, and even cryptocurrencies all took a hit. A perfect scenario for gold to flourish, right? Wrong, gold did poorly, too. There was simply nowhere to hide. Deutsche Bank noted that 93% of global financial markets had negative returns in 2018, the worst such performance in the 117-year history of its data set. It was a bad year for market beta, as diversification didn’t offer any help.

Not surprisingly, all of this has weighed heavily upon investor sentiment, even though the US economy, corporate earnings, and consumer sentiment have remained quite strong, with no recession in sight and given low inflation and interest rates. So, despite the generally positive fundamental outlook, investors in aggregate chose to take a defensive risk-off posture, ultimately leading to a massive selloff – accentuated by the rise of passive investing and the dominance of algorithmic trading – that did huge technical damage to the chart and crushed investor sentiment.

But fear not. There may be a silver lining to all of this, as it has created a superb buying opportunity, and it may finally spell a return to a more selective stock-picker’s market, with lower correlations and higher performance dispersion. Moreover, my expectation for 2019 is for a de-escalation in the trade war with China, a more accommodative Fed, and for higher stock prices ahead. Forward valuations overall have become exceedingly attractive, especially in the cyclical sectors that typically flourish in a growing economy.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings remain bullish, while the sector rotation model remains in a defensive posture. Read on…

by Scott Martindale
President, Sabrient Systems LLC

Last week was the market’s worst since March. After Q3 had zero trading days with more than 1% move (up or down), our cup runeth over in Q4 with the stock rollercoaster so far offering up 22 days that saw a 1% move. Volatility seems rampant, but the CBOE Volatility Index (VIX) has not even eclipsed the 30 level during Q4 (whereas it hit 50 back in February). Even after Friday’s miserable day, the VIX closed at 23.23. Of course, the turbulence has been driven primarily by two big uncertainties: the trade dispute with China and the Federal Reserve’s interest rate policy, both of which have the potential to create substantial impacts on the global economy. As a result, investor psychology and the technical picture have negatively diverged from a still solid fundamental outlook.

For about a minute there, it seemed that both situations had been somewhat diffused, with Presidents Trump and Xi agreeing at the G20 summit to a temporary truce on further escalation in tariffs, while Fed chairman Powell made some comments about the fed funds rate being “just below” the elusive neutral rate. But investors’ cheers soon switched back to fears (soon to be tears?) with the latest round of news headlines (e.g., Huawei CFO arrest, Trump’s “Tariff Man” comment, Mueller indictments, and the imminent federal debt ceiling showdown). The uncertainty and fear-mongering led to a buyers’ strike that emboldened the short sellers, which in turn triggered forced selling in passive ETFs and automated liquidation in quant hedge funds, high-frequency trading (HFT) accounts, and leveraged institutional portfolios, which removed liquidity from the system (i.e., no bids), culminating in a retail investor panic. As it stands today, the charts look woefully weak and investor psychology has turned bearish, with selling into rallies rather than buying of dips.

Ever since June 11, when the trade war with China escalated from rhetoric to reality, stocks have seen a dramatic risk-off defensive rotation, with Healthcare, Utilities, Consumer Staples, and Telecom the only sectors in positive territory and the only ones outperforming the broad S&P 500 Index. It’s as if investors see the strong GDP prints, the +20% corporate earnings growth (of which about half is organic and half attributable to the tax cut), record profitability, and record levels of consumer confidence and small business optimism as being “as good as it gets,” i.e., just a fleeting final gasp in a late-stage economy, rather than the start of a long-awaited boom cycle fueled by unprecedented fiscal stimulus and a still-supportive (albeit not dovish) Federal Reserve. As a result, forward P/E on the S&P 500 is down a whopping -19% this year, which is huge – especially considering this year’s stellar earnings reports and solid forward guidance.

But has anything really changed substantially with regard to expectations for corporate earnings and interest rates (the two most important factors) to so severely impact valuations? Not that I can see. And Sabrient’s quantitative rankings imply that the economy and forward guidance remain quite strong, such that the market is simply responding to the proverbial Wall of Worry by offering up a nice buying opportunity, particularly in beaten down cyclical sectors and in solid dividend payers – although there might be some more pain first. Over the past 10 years of rising stock prices since the Financial Crisis, there have been eight corrections of roughly -10% (including nearly -20% in 2011), and this year’s correction has led to the fourth major drawdown for Sabrient’s Baker’s Dozen annual top picks list (1Q2009, mid-2011, 2H2015, and now). But selling at each of those previous times would have been the wrong thing to do, and this time seems no different.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings remain bullish, while the sector rotation model remains in a defensive posture due to the persistent market weakness. Read on...