By Scott Martindale
President, Sabrient Systems LLC

Overall, it appears that the stock market continues to focus more on improving fundamentals than on the daily news. We continue to see improved market breadth, low volatility, lower sector correlations, and capital flows into higher quality companies with solid fundamentals, attractive valuations, good earnings quality, and strong market position. Small and mid-caps have been leading market segments, especially those from the Energy sector. Among large caps, Technology and Financial sectors have been strong during Q3, while defensive sectors Utilities and Telecom have pulled back across all market caps after showing inordinate strength for much of the year (although they still remain strong YTD).

All of this is bullish – and is illustrative of the healthy broadening of the market. Although some traders appear to be taking some chips off the table in deference to September’s notoriety as the worst performing month of the year, I think the path of least resistance for stocks is to the upside.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas.

I haven’t written in a few weeks. That can be a lot of time for the latest news to impact the character and direction of the market, right? So, what has changed since my last article? Well, not much, really. It seems the market isn’t quite so news-driven these days; instead it has been focusing on fundamentals and the overall improvement in prospects for the economy and corporate earnings. And these things are driving it ever higher.

Nicholas Wesley YeeBy Nicholas Wesley Yee, CPA
Director of Research at Gradient Analytics

When analyzing stocks, I am often amazed at the lack of understanding many sell-side analysts have in basic accounting concepts and their naivety to how easily managers can fabricate numbers.  In fact, when analysts ask about accounting discrepancies during earnings conference calls, they often refer to them as a “housekeeping item,” as if they are afraid to anger the revered CFO.  You really can’t blame them; analysts survive by building congenial relationships with Investor Relations and CFOs in order to ensure continued access.  If they were to get locked out of conference calls, their value to their sell-side firm would be greatly diminished.

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The market broke out to the upside, as I predicted it would -- although the breakout came a good bit sooner than I anticipated. My expectation was that stocks would remain within their long-standing trading range until a clear upside catalyst emerged, such as improving Q2 earnings reports and forward guidance. But investors aren’t waiting around. Clearly, they are positioning in advance of the emergence of such catalysts. For now, fear of missing liftoff is stronger than fear of getting caught in a selloff.

The market has provided a nerve-wracking amusement park ride for those with the stomach to hang in there. Of course, the Brexit vote caused a nasty selloff due to the uncertainty of what comes next and the long-term ramifications, but the ensuing recovery was just as swift. At the end of it all, stocks are right back where they have been, mired in the same long-standing trading range but apparently (in my opinion) more inclined to find some sort of upside catalyst.

After a nice little rally from mid-February until early June, investors started taking chips off the table, ostensibly in anticipation of Thursday’s Brexit vote. But Monday brought a fresh hint of optimism that Britain will vote to remain in the union, and the market responded with a healthy, broad-based rally. On balance, there appear to be good tailwinds for U.S. equities over the near term.

The stock market rally off the February lows initially was led by the usual combination of short-covering, oversold bottom-feeding, and speculation (on “junk"). But then market action started showing signs of improving market breadth and a rotation back into higher quality companies -- the types of companies with characteristics Sabrient typically seeks in our GARP (growth at a reasonable price) selection process. It is notable that price action for the S&P 500 was very similar during 2015 to what occurred in 2011.

After showing weakness last week and creating some bearish-looking technical formations, stocks took a turn for the better on Monday. Perhaps it was renowned value investor Warren Buffett breaking from his usual aversion to tech companies and investing $1 billion in Apple (AAPL) that gave bulls a much-needed shot of confidence. But then things went south again on Tuesday, and some commentators are surmising that the strength in some of the economic data makes investors think the Fed is more likely to raise rates, i.e., we may be back to a good-news-is-bad-news reactionary environment.

The stock market rally from the edge-of-the-cliff reversal on February 12 has continued, and an assault on the all-time highs from almost one year ago (on the S&P 500) now seems plausible. If it can hit new highs, the 7-year bull market is back in business. We are about halfway through earnings season, and after several years of record corporate earnings that were at least partly fueled by Fed policies that helped finance M&A and stock buybacks, some fear that profit margins have peaked.

Q2 is well underway for the economy, while Q1 corporate earnings reporting season kicks into high gear this week. Although investors have pretty much written off the quarter as a stinker, they are eagerly anticipating forward guidance for the back half of the year. With the major indexes and underlying valuations sitting at lofty heights, investors are evidently pricing in improving fundamentals ahead, particularly here at home in the U.S.

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