Stock Market Pullback In the Cards, Yet Bargains Remain

In a recent edition of Small-Cap Profit Confidential, I advised subscribers to exercise caution in regard to their stock market investments as my research indicated that stocks were likely to peak in the next few months, primarily in response to substantial increases in inflation rates and subsequent increases in interest rates.

However, I also told subscribers that there was a good chance that stock prices in general would continue to trend higher over the next few months in response to unsophisticated investors reacting positively to July’s favorable GDP report; to sharp increases in corporate profits that occurred over the past two quarters; and to the massive amounts of stock that publicly traded companies continue to repurchase.

Since the August edition through Thursday, Sept. 6, the Dow Jones Industrial Average advanced by 683 points (2.7%), and both the S&P 500 Total Return Index and the NASDAQ Composite Index broke out to new all-time highs, rising by 1.8% and 1.1%, respectively.

In spite of the recent increases in U.S. stock prices, my research continues to indicate that stocks soon will pull back considerably in response to rising inflation rates. Some examples of those increases are outlined below:

  • Consumer Price Index: Rose during July, the latest month for which data are available, to the highest year-over-year rate since February 2012.
  • GDP Implicit Price Deflator: Rose during the quarter ended June 30, 2018 to the highest year-over-year rate since December 31, 2007.
  • Producer Price Index: Rose during July to the highest year-over-year rate since November 2011.
  • Employment Cost Index: Rose during the quarter ended June 30 to the highest year-over-year rate since the second quarter of 2008.
  • Personal Consumption Expenditures Price Index: Rose during July to the highest year-over-year rate since March 2012.

The current reading on my proprietary Tactical Asset and Sector Allocation Model (and associated Buy-Sell Index), which is derived from the readings on 23 leading economic indicators, also suggests that U.S. stock prices will pull back considerably within the next few months.

That model registered a “sell” signal during the third week of May.

In contrast, the current reading on my Market Leaders Index — which is based on the price performance of stocks that have outperformed most other stocks since the major U.S. stock market indices bottomed on March 9, 2009 — rose to a new all-time high on August 31, 2018.

This suggests that U.S. stock prices in general will continue to trend higher over the next few weeks. That’s because stock prices in general tend to move in the same direction as the market’s better-performing (that is, leading) stocks.

Meanwhile, the latest reading on my Sector Relative Performance Model suggests that stocks will trade in a volatile sideways range over the next couple of months, as a tug-of-war appears to have developed between optimistic (bullish) and pessimistic (bearish) financial market participants.

Tug-of-war erupts

Specifically, stocks of companies that operate in two so-called “defensive” sectors of the U.S. economy — those in the telecommunications services and healthcare sectors — outperformed stocks of companies that operate in all of the other 10 major economic sectors over the six weeks ended August 31, 2018.

Stocks of companies that operate in cyclical sectors of the economy generated the third- and fourth- better performance, in terms of their relative price performance, over that same six weeks.

That type of relative performance reveals that approximately the same percentage of stock market participants are optimistic (bullish) as are pessimistic (bearish).

Such mixed readings on the economic and stock market indicators is very typical during the late-expansion stage of the economic cycle — and near peaks in the overall stock market.

It’s the result of well-trained analysts at institutional investment organizations (insurance companies, corporate pension plans and endowments) becoming concerned about the future direction of the economy and stocks while less knowledgeable individual investors react positively to recent economic developments, which tend to be favorable toward the end of economic expansions.

As a result of their conflicting sentiment during the latter stages of economic expansions, institutional investors tend to become more defensive in regard to investment allocations while individual investors tend to become more aggressive.

That’s exactly what happened during August.

Institutional investors became the most defensive in terms of their stock allocations since February 2017 while individual investors became the most optimistic regarding their stock investments since mid-June, according to data released by State Street Global Advisors and the American Association of Individual Investors.

Both the cumulative advance-decline line and the cumulative volume index for stocks on the New York Stock Exchange trended lower over the past several days, while the reading on my Overbought-Oversold Indicator is currently in overbought territory.

Now, please don’t think that I’m one of those doom-and-gloomers, some who is constantly predicting the economy will enter a severe recession and that stocks will fall sharply during the coming months. I’m not.

In fact, if stocks were to pull back considerably there’s a very good chance that I would advise subscribers to invest in several small-company growth stocks that I’m monitoring, as well as a few of the stocks that I advised subscribers to sell on July 20.

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