The U.S. stock market is set for a big move as it lumbers through the traditionally dull “dog days of summer” and traders assess the post Brexit rally world.  The big question is whether a continuation of the current rally can last as the poor earnings season continues and the pressure of the U.S. presidential election continue to mount?

Terrible Fundamentals and Geopolitical Strife Don’t Seem to Matter (Yet)

The world is a mess. There are multiple wars, terrorist attacks, and mobs are marching in the streets in multiple countries around the world on a daily basis.  The U.S. economy grew at a tepid 1.2% rate, according to the most recent GDP report while other economies are doing even worse. Interest rates have hit negative yields in many developed countries. And yet stocks are still attracting money as global central banks flood the banking system with more cash through increasing bond sales in Europe and ETF purchases in Japan.  It’s clear to see that at this point, the lure of easy money seems to be more persuasive to investors than the awful economic and geopolitical climate. 

Investors Are Being Selective

The S&P 500 (SPX) has been consolidating over the last two weeks but the money flow pattern suggests that investors are not net sellers of stock, at least not everywhere.  Instead, the charts suggest that investors are being choosy about where they put their money and that money is moving from one area of the market toward others.  Those areas that are receiving the flow of money are starting to do quite well.  This is what is known as a rotation pattern, where little new money is moving into the market, but money moves from one area to another.  This leads to a mixed bag of returns where market indexes could seem to be going nowhere but sector indexes paint a different picture.

The chart analysis confirms the premise of both a rotation market and that a big move is coming in the not too distant future.  First, the Bollinger Bands (Green lines above and below prices) are starting to constrict. This is a sign that volatility has decreased, which is usually what happens before the market makes a significant move.  But then the analysis gets a bit more hazy, as the Money Flow Index (MFI, upper panel) has been trending down, which is a negative.  At the same time, the On Balance Volume Indicator (OBV, bottom panel) and the Accumulation Distribution Line (ADI, lower panel) have both been trending higher. 

Where is the Money Rotating To?

Money can’t be moving out of the market and into the market at the same time.  So I looked inside the market at thirteen individual sectors and discovered that five of them are getting the bulk of the money.  What is most interesting is that traditional interest rate sensitive sectors such as financial services, housing and utilities are in neutral mode while the strength is spread out in four unrelated areas.  This is unusual given the current low interest rate dynamic in the U.S.  And while it’s not a certainty, the poor performance of the housing sector combined with the sideways action in the financial, and utility sector could be a signal that interest sensitive investors are starting to expect an interest rate increase from the Federal Reserve in September.    If history is a guide, an interest rate increase from the Fed in September could be the trigger to a significant correction in stocks.  Here is what’s most crucial: If the Fed doesn’t raise interest rates in September, it most likely won’t even think about this again until after the election.

Gold Rally Has Meaningful Historical Ramifications

Perhaps the most interesting finding is the action in the gold stocks (XAU index), which have a history of being among the last groups to rally in a bull market at its later stages.  The chart of the Philadelphia Gold and Silver Index (XAU) is clearly in a very steady up trend with the 20-day moving average providing excellent support since February.

Yet, there are some interesting warning signs on this chart.  First, note that prices are two standard deviations above the 200-day moving average (Red Solid Line seen in price panel of chart).   As this distance increases, especially above the two standard deviation point, the odds of a price reversal increase because of the tendency of markets to revert to their mean.  Complicating matters, the bull market in gold stocks has come a very long way since February, which increases the risk of a trend reversal.   History is clear; bull markets that ended in 1987, 1990, 1994, and 2008 were all preceded by a huge rally in gold stocks which ended abruptly and took the rest of the market with them.  There is no guarantee that history will repeat itself here, but it is worth noting as 1987, 1990, and 2008 were all major bear markets, while 1994 was a very protracted trading range market in the S&P 500.

Momentum Runs can Last Long Periods of Time

We are in a consolidation period for what has been a momentum driven market in the S&P 500.  Investors seem to be rotating out of several groups into new areas of the market.   Gold stocks are due for a breather and have a history of topping out before the rest of the market. Momentum markets have two characteristics.  They are amazing profit generators while the trend remains intact, and they all end badly.   One thing is clear. Lower interest rates have created momentum conditions where higher prices continue to bring in buyers.  This momentum dynamic has pushed this bull market much further than anyone could have expected and the current trend remains up but is showing signs that a correction may be approaching.   Caution,  sector and stock selectivity combined with awareness of the reality of any market are never bad companions when investing in stocks.