By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC 

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Today’s Market Call is looking at markets in light of long-term perspectives. One important thing to begin with is that the S&P 500 is breaking out as we transition into fall. This is a very bullish sign for several reasons – First, fall is typically a volatile season. Historically, this is a time when there is a lot of selling off and higher unpredictability that happens in August, September, and sometimes October.

Upcoming Election and Increased Volatility

Another indicator is that we are approaching an unpredictable midterm election. A lot of people feel that the Democrats want to unwind Trump's initiatives and that they have an opportunity to potentially gain some traction in the November 6^th midterm elections.

It’s important to understand what a midterm is – simply, it’s an election in which representatives are elected in the middle of a presidential term. Right now, the US Senate has 51 Republicans and 49 Democrats, including two independents. There are 35 seats up in 2018, 26 of which are held by Democrats. There seems to be an opportunity in many people's mind that the Democrats can gain some control in Congress. However, considering how strong the economy is right now, I think the default way of thinking is that the Republicans will remain in control of Congress, but it is a close call.

The Debate Could Cause Increased Volatility

Typically, when the economy and markets are strong the incumbent remains in office. What we do expect, however, is more volatility to come in November because of this election.

We expect a spirited debate over the progress of Trump's term so far. Democrats will probably argue that Obama is responsible for the improved economy and employment growth was really due to him. There may be a fair amount Trump-bashing from the Left as they argue Trump is doing poorly because crime is up and the number of people who have health insurance is down and wage growth is still sluggish.

On the other hand, Republicans will say the stock market is at highs, unemployment is down, less people are on food stamps, recent GDP growth is above 4%, and that we are getting better trade deals. The Right will probably also stress that corporations are benefiting from lower taxes which could increase employment and investment in the United States.

Corporate Profits Boom and GDP Growth Up

U.S. corporate profits boomed in the second quarter, up 16.1%, according to the Commerce Department. Lower corporate tax rates were signed into law last year, which means taxes paid by US companies were down 33% from last year. The US economy grew at 4.2% in the second quarter, which is much higher than the average growth the prior administration had been seeing, so that will be a part of some debates. Unemployment is down and home prices are higher. With all that said, we want to reiterate that there's likely to be more volatility if the debates get spirited or something out of the ordinary happens.

Positive Breakout in Seasonal Weakness

The S&P 500 broke out into the approaching fall-season and into the uncertainty of elections. This could be viewed as a bullish sign into the remainder of the year.

Technology and Consumer Discretionary Stocks From a Longer Term Perspective

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Switching gears, we’re going to look at the sectors currently leading the market, which are Technology and Consumer Discretionary. These two sectors have been the darlings of Wall Street recently, but we want to look at it from a longer-term perspective.

First, the technology sector; what this chart shows is the tech sector going all the way back to the dot-com bubble that happened in March of 2000, when tech topped out at around 653. Below the price chart is the relative strength index compared to the S&P 500. You can see that we had a major top and relative performance in March 2000, and since that time, the technology sector has yet to surpass that high in relative performance compared to the general stock market since the dot-com bubble.

Some would argue this means that we're going to have better performance in this sector even over a longer period of time. Keep in mind, having a sector focus can be very dangerous, especially if one was focused on tech over this time.

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Continuing the theme, this chart compares the technology sector versus the consumer discretionary sector, with the same long-term time frame as the previous one. The consumer discretionary sector involves the industries that are affected by consumer spending that isn’t staple, or necessary. This sector is basically discretionary spending; things you buy when you’re feeling flush.

Looking at the relative strength chart at the bottom, you can see that consumer discretionary stocks have far outperformed technology since the dot-com bubble, so the moral of this story is that it's important to have diversification. It's important to have a strong portfolio process and to not get lost in the short-term details and lose track of what’s happening in the long-term.

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What is More Attractive – Tech and Consumer Stocks, or Emerging Markets?

The emerging markets show a very interesting development. Looking at the long-term, going back to October of 2007, there was a peak in the emerging markets ETF. Following that peak was a dramatic drop in November of 2008. Since that time, we've been in a massive, multiyear congestion zone with a significant high in May of 2011.

The bars on this chart are monthly, and if you look at this month's action, you can see that we're at the low end of that trend line and we've been getting significant support. There's been bullish monthly market action as the emerging market stocks bounce off the monthly lows.

At the lower end of the trend line, we have what technicians call a “hammer pattern” where the market sells off dramatically and then rallies off the lows. This was happening in the congestion zone, so it’s a bullish sign. We’ve been seeing the emerging markets underperforming, but now it’s possible that we could see some stabilization.

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Looking at the valuation and growth metrics, these columns show the comparison of the price to earnings, price to book, price to sales, price to cash flow, dividend yields, and the long-term earnings growth. This really highlights the difference between emerging markets on the left column, technology in the middle column, and consumer discretionary on the right column.

The point of this is that sometimes we get into these modes where the market is on a trend and it's important that you stay on that trend. The valuations are giving us a warning sign and we want to be careful with the current leadership. Even though it’s currently bullish, there are signs that we need to be careful.

In summary, the markets look bullish from a technical standpoint, but complacency is dangerous. Stocks are performing better than they generally do in the fall, but volatility should be expected around the November midterms. The default view is still that Republicans will keep control because the economy is currently strong and a different outcome is going to cause some disruption. Technology and Consumer Discretionary are still leaders, but the valuation there is a big warning sign. Emerging markets are stabilizing and could offer longer term profit potential due to valuation and long-term growth prospects. Trim & Trail your winners and introduce new positions in longer term attractive investments.

Sincerely,

Louis B Llanes, CFA CMT

Founder, Wealthnet Investments