In The Week Ahead: The Good And The Bad News Heading Into Year End

John Kosar's picture

Monday, November 28, 2016 - 3:30pm

by John Kosar

The U.S. stock market posted its third consecutive weekly gain last week, led once again by the small-cap Russell 2000, which added 2.4% to bring its year-to-date gains to a whopping 18.6%. To put that in perspective, the next best performer is the Dow Jones Industrial Average with a 9.9% gain for the year.

Last week's advance was broad-based with all sectors of the S&P 500 except for health care (-0.3%) finishing in positive territory. It was led by materials (2.6%) and industrials (2.3%). For the year, energy (20.6%) and industrials (18.3%) have been the best performers, while real estate (-3.6%) and health care (-3.5%) are bringing up the rear.

According to Asbury Research's ETF-based metric, the biggest inflows on a percentage basis over the past week went into consumer discretionary, while the biggest outflows were from consumer staples. If this trend continues, it bodes well for upcoming relative outperformance of the consumer discretionary sector into early 2017.

New Highs And Unmet Targets Are Intermediate-Term Bullish
The benchmark S&P 500 broke overhead resistance at 2,194 last week, hitting new all-time highs. However, the bellwether Dow industrials, which rose 1.5% last week, are still 6.5% below my 20,400 upside target, which I first mentioned in May.

Seasonality is also a positive for the market between now and year end. The chart below shows that December is seasonally the second strongest month of the year in the S&P 500, based on data since 1957. On average, the index closes 1.46% higher for the month while posting a positive monthly close 73% of the time -- higher than any other month.

However, all of this post-election euphoria has made investors a little too complacent.

Investor Complacency Should Keep A Lid On The Rally Near Term
The Volatility S&P 500 (VIX) index, also known as the fear gauge, finished last week at 12.34, just above a multiyear complacent extreme of 12. The chart below shows previous tests of 12 have closely coincided with every near-term peak in the S&P 500 since April, most recently on Oct. 24.

So, while an unmet upside target in the Dow and December seasonality suggest the potential for more strength between now and year end, history warns that low volatility could keep a lid on the market's upside, at least until a pullback puts some fear in investors.

Another, more intermediate-term thing to consider is that, following a strong December, seasonality takes a turn for the worse in January and February. This means that the closer we get to year end, the more likely it is that we have seen a peak in the stock market for a while. As a recent example, you may recall that in 2015 the S&P 500 peaked on Dec. 29, and then proceeded to collapse by 13% into its February lows.

More Weakness For Gold Prices?
In the Nov. 14 Market Outlook, I pointed out an emerging bearish trend change and head-and-shoulders pattern in the SPDR Gold Shares (NYSE: GLD), warning gold prices could be headed all the way back down to their January lows.

Since then, GLD declined 3.8% into Friday's close, helping confirm the validity of the head-and-shoulders pattern, which has a downside target of $104.50. This is 7% below Friday's close and will remain valid as long as the 200-day moving average contains price as overhead resistance.

 

Moreover, correlation analysis suggests a further decline in gold prices is likely to coincide with a continuation of the recent rise in long-term interest rates, which I covered last week.

Lumber Prices Testing Overhead Resistance
Back in the Sept. 6 Market Outlook, I highlighted an emerging breakout in the iShares Global Timber & Forestry (Nasdaq: WOOD), saying it targeted an 18% run to $60. As I stated in that report, rising lumber prices would not only bode well for the housing sector, but also for the U.S. economy as housing prices have historically been positively correlated to the S&P 500.

Since then, WOOD has advanced roughly 4% and is now testing formidable overhead resistance at its $52.47 December 2015 high.

This overhead resistance is a big obstacle for WOOD that must be broken to clear the way for a rise to the next key level at $56. Initially, this resistance may trigger a corrective pullback, so Market Outlook readers holding a long position in WOOD per my September report should consider tightening their protective stops.

Putting It All Together 
The market cleared a major hurdle last week as the benchmark S&P 500 rose significantly above its previous all-time high at 2,194. The good news is that strong December seasonality could power the broader market even higher through year end.  

The potentially bad news is that volatility has collapsed, with the VIX once again near multiyear lows. This suggests the market is unlikely to make an upside run without at least a minor pullback first. Moreover, the next near-term market peak could segue into the historic pattern of seasonal weakness in January and February.

Bigger picture, the Dow's unmet upside target 7% above the market, along with declining gold prices and rising lumber prices, suggests more overall market strength into mid-2017, along with a strengthening U.S. economy and rising long-term interest rates.

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John Kosar does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.