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Is the Recent Rally of the US Stocks for Real?

Stock indexes have moved out of the range they were stuck in for over a year, but was this recent rally justifiable and will it resume?  In short, our answer is yes on both accounts, with some caveats of course!

The recent rally appears to us to be healthier than previous runs we’ve seen in recent history.  This move has been characterized by improved breadth, meaning a greater number of individual stocks participated in the rally. Ned Davis Research (NDR) notes that during the rally since June 27th advance/decline measures have reached levels not seen since 2009. Breadth doesn’t mean that the rally can’t fail or that it will necessarily continue for a certain amount of time, but it does indicate to us greater staying power as the gains are spread out among a broader range of companies.  Additionally, to us it is also encouraging to see what has the led the recent move higher in terms of sectors.

More cyclical sectors such as materials and technology, along with the economically sensitive financial sector, have been the leaders, while the more defensive groups such as consumer staples, telecom, and utilities have lagged.  In contrast to some previous moves higher when defensives led the way, having sectors more exposed to economic conditions take leadership positions indicates to us greater confidence among investors and more willingness to move out the risk spectrum. To further differentiate this recent move higher from previous ones is the apparent decoupling between oil, which entered bear market territory after the recent fall, and stock prices that we may be seeing, which is positive to us as lower oil prices should help to bolster consumers, and thus stock prices.

Of course, we don’t want investors to move out of their risk tolerance ranges and we continue to maintain a neutral outlook on stocks, expecting modest gains over time but with bouts of increased volatility and pullbacks.  Volatility has come down substantially, and to us and based on history, that doesn’t seem likely to last for an extended period.

Volatility has declined, but likely won’t stay this low

Risks remain.  First, similar rallies have typically lead to investor optimism reaching excessive levels, as it did recently according to the NDR Crowd Sentiment Poll, which raises the risks for a near-term pullback. Additionally, according to ISI Evercore Research, August has been the second worst performing month since 1998. On a more fundamental basis, valuations still appear modestly elevated to us amid uncertainties that include the impact of negative interest rate policy being conducted by central banks in countries that make up 30% of the global stock market. Finally, we are slightly concerned by the level of household net worth as a percentage of disposable income, which has reached a level at or above the last two asset bubbles (tech and housing). We’re not saying we’re in for the same kind of blowup that we saw after those two occurrences, but it does warrant attention.

Fed remains on hold, but keeps potential for a rate hike on the table

In the midst of this cacophony of data, as well as ongoing global uncertainties, the Federal Reserve chose to keep monetary policy unchanged, matching investor expectations. However, they did upgrade their assessment of the financial situation through their statement, and had enough positive things to say about the economy to put the possibility of a hike at some point in 2016 firmly back on the table. And that possibility, along with the uncertainty that is a hallmark of the Fed as of late, will likely contribute to the bouts of volatility mentioned above. And while we are going to try to refrain from talking about the U.S. election in every edition of this publication between now and November, we’d be remiss if we failed to give credit to the two most disliked candidates in U.S. history for adding to the potential for an increase in equity volatility.

Earnings respect

Getting back to earnings, during the second quarter reporting season, companies both in and outside the United States are generally exceeding analysts’ estimates. Of course, since earnings per share estimates largely came down over the course of the quarter, the pattern of most companies beating estimates as results have been reported is typical of most earnings seasons. More interestingly, when we step back from the seasonal pattern we can see that after about two years of declines a rising trend in earnings estimates appears to be emerging. This rising trend is evident not merely over the past three weeks of earnings reports, but over the past five months.

So what?

The recent rally has stalled a bit but we think the make up of recent gains bode well for the potential for a continuation. Earnings in the US have bested estimates but they are vulnerable to potential economic growth slowing.  There will be pullbacks and an increase in volatility in our view, with August being a typically tough month for stocks as of late, so investors should remain patient and stick with their long-term asset allocations.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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