John Lynch Chief Investment Strategist, LPL Financial
Are we out of the woods yet? After the fastest correction from a record high in the history of the S&P 500 Index, stocks staged an impressive comeback last week. The S&P 500 put together its best week since 2013, rallying more than 5% off the lows to bring its session win streak to six. This week we consider what this means moving forward, including what higher interest rates and rising inflation might mean for stocks.
Whether we are out of the woods yet is a tough question to answer with any confidence, but when we weigh the evidence, it appears the odds are good that the worst is behind us.
The stock market’s strong fundamentals are supportive. U.S. economic growth is solid despite last week’s retail sales shortfall, which we attribute to temporary factors. Consumer and business confidence remain high, as personal spending and capital investment are both likely to get a boost from the new tax law. Inflation is rising, but remains relatively low when compared to historical averages. It also may not be as strong as the January Consumer Price Index (CPI) data initially suggested due to weather and other seasonal factors.
Earnings season has been excellent, with a 15% increase in S&P 500 earnings in the fourth quarter and an 8% revenue increase, both nicely above prior expectations. The new tax law hasn’t even kicked in yet, but analysts have increased their 2018 estimates for S&P 500 profits by $10 per share (nearly 7%) since January 1. Companies are just starting to announce how much in overseas cash they are repatriating back to the United States due to the new tax law. A good portion of that cash is expected to be directed to share repurchases, boosting earnings per share.
Positive Technical Evidence
From a technical perspective, here are some indicators supporting the view that the worst may be over:
Bullish trend intact. The S&P 500 broke back above its 50-day moving average (MA) on Thursday, February 15 (at 2721) and managed to close above the 200-day MA (2547 as of February 16) throughout its latest correction. The 200-day MA remains upward sloping, indicating a continued bullish technical trend.
Evidence of capitulation selling. On February 5, when the Dow Jones Industrial Average dropped 1175 points, or 4.6%, the number of S&P 500 stocks declining relative to those advancing was greater than 40:1, indicative of extreme panic selling. The low percentage of stocks above their 50-day MA, below 20% on February 8, is another indicator of extreme selling pressure.
Reversal from oversold levels. After entering oversold territory on February 8, based on the 14-day Relative Strength Index, the S&P 500 subsequently reversed and moved strongly higher while maintaining its bullish trend, a pattern that has historically proven to be a bullish technical signal.