Top-Down Or Bottom-Up, Finding Diamonds In The Rough Takes Time

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(Friday Market Open) Equity index futures are pointing to a higher open as investors hope to build on Thursday’s afternoon rally. The Cboe Market Volatility Index (VIX) fell to 28.6 in premarket action as Asian markets rallied off favorable rate news.  

Potential Market Movers

The People’s Bank of China cut a key interest rate on Friday for the second time this year which sparked a rally in Chinese stocks. The Hong Kong Hang Seng rose 2.96%, while the Shanghai exchange rallied 1.6%, and the BSE Sensex climbed 2.91%. China’s neighbors also rose on the news with Japan’s Nikkei gaining 1.27% and Singapore increasing 1.56%.

One reason why stocks have struggled to bounce back is because many investors are deleveraging and liquidating positions. Rising rates and market uncertainty has made trading on margin more costly. According to FINRA, margin balances fell by about $50 billion from February to April. May numbers are likely to be released by Monday, which could reflect further decreases. The reduction of margin reflects a reduction in demand for shares.

Additionally, Melvin Capital Management LP plans to shutter its hedge funds and return money to its investors. Melvin had experienced large losses over the last 17 months and drew attention when it tried to short GameStop GME. According to Bloomberg, chief investment officer Gabe Plotkin has decided to close the doors. This is another flow of funds out the market.

Investors are weeding through several mixed earnings reports this morning:

• Deere & Co. DE beat on top- and bottom-line numbers and raised its earnings guidance but fell 4.26% in premarket trading anyway. Investors may be focused on the decline in operating margins.  
• Foot Locker FL beat on earnings despite missing on revenue. FL offered guidance at the “upper end” of the range leading to a 2.31% rally before the opening bell.
• Ross Stores ROST missed on earnings and revenue after the close on Thursday and plunged 23.19% in extended-hours trading.
• Decker’s DECK rallied nearly 16%after beating on earnings and revenue after yesterday’s close. The company reported record sales in UGG boots and raised guidance.
• Applied Materials AMAT also missed on top- and bottom-line numbers after yesterdays’ close. The semiconductor maker fell 2.47% in after-hours trading but trimmed its losses to 0.59% before the opening bell.
• Palo Alto Networks PANW beat on earnings and revenues yesterday evenings causing the stock to rally 10.23% in extended-hours trading.

Despite the premarket bullishness, the 10-year Treasury yield (TNX) fell 25 basis points ahead of the opening bell which suggests that some investors still want safe havens. Additionally, the U.S. Dollar Index ($DXY) also ticked higher. 

Reviewing the Market Minutes

After leading stocks lower over the last eight months, the Russell 2000 (RUT) led a bounce Thursday by rallying more than 1% though gave up most of its gains and closed just 0.08% higher. The Nasdaq Composite ($COMP) fell about 1% on the open but rallied 1.3% into positive territory before finishing 0.26% lower. Similarly, the S&P 500 (SPX) and the Dow Jones Industrial Average ($DJI) experienced similar upward swings before closing 0.58% and 0.75% lower respectively.  

Retailer performance was mixed despite companies issuing lower earnings guidance. Kohl’s KSS and The Children’s Place PLCE rallied 4.4% and 10.5% respectively. However, Bath & Body Works BBWI fell 6.8%. The culprits that started the sell-off continued to fall with Walmart WMT losing another 2.8% and Target TGT tumbling 5.1%.

Transportation stocks continued downhill with the Dow Jones Transportation Index ($DJT) plummeting another 1.84%. The group was hurt by Citigroup C analyst downgrades on railroads including Union Pacific UNP, CSX CSX, and Norfolk Southern NSC.

However, consumer staples were the worst-performing sector, continuing to struggle as inflationary pressures cut into profit margins. Technology was the next-worst sector, dragged down by Cisco (CSCO). CSCO fell 13.7% after missing on revenues and lowering their quarterly earnings guidance. 

Three Things to Watch

Staple Machine: One problem dealing with sectors is that they tend to be too broad and not every industry group within a sector reacts the same way to news. For example, the Personal Products Index represents the industry group by the same name in the consumer staples sector. It has been downtrending most of the last three months while the other groups moved mostly higher. Now, as the rest of the sector appears to be moving lower, personal products appear to be showing a little strength.

Additionally, the Tobacco Index fell with the sector, but at a smaller scale which demonstrates a degree of strength relative to the sector.

Using top-down methods to find potential investment candidates can sometimes require you to remove a few layers of grime.  

Risk On? The Russell 2000 (RUT) small-cap index is testing its 2018 and 2019 highs, which is likely to be a pivotal level of support. If the bulls can hold, the price level has the potential to stop the slide and build a base—a sideways trading range where large investors see value and start accumulating shares. When investors start accumulating riskier small-cap stocks, they’re said to be in “risk on” mode.

However, it’s debatable whether small-cap stocks are a good value. According to a report by Yardeni Research, the forward price-to-earnings ratio (P/E) for the Russell 2000 is 17.4 as of May 12. In 2020, its forward P/E was around 50 but the credit crisis bear market didn’t find a bottom until the ratio was around 12. The Russell 2000 Growth Index (RUO) reached P/Es in 2020 so high that the report capped the data at 60. As of May 18, the index’s ratio was 28.9. The Russell 2000 Value Index (RUJ) peaked around 28 but was at 13 in the report. At the 2008 market bottom, the RUO and the RUJ were both near 12 as well.

Trend Segments: A bull market trend is built on three broad phases: accumulation, public participation, and distribution. The accumulation phase often starts as a bear market is ending with the savviest investors buying while everyone else is selling. This type of accumulation is what builds basing patterns and helps launch a new bull market.

After the market has moved higher for some time, other investors jump in as well. Eventually, the general public will join, and the trend will continue to grow and expand.

The distribution phase begins as the bull market turns to irrational exuberance. When everyone is greedy, the savviest investors sell into the rallies. Eventually, stocks start falling when the number of sellers is greater than the number of buyers and the price has to fall to find new buyers.

While some investors may view small-caps as a good investment at these valuations, it’s difficult to tell if these are the savvy investors that can build a base. 

Notable Calendar Items

May 23: Earnings from Advance Auto Parts AAP  

May 24: New home sales and earnings from Intuit INTU, Best Buy BBY, Ralph Lauren RL, Toll Brothers TOL, and Nordstrom JWN

May 25: Durable goods, FOMC meeting minutes and earnings from NVIDIA NVDA, Splunk SPLK, Williams-Sonoma WSM, and Dick’s Sporting Goods DKS

May 26: Gross domestic product, pending home sales and earnings from Medtronic MDT, Dollar General DG, Snowflake SNOW, and Workday WDAY

May 27: PCE Price Index and earnings from Dell Tech DELL, Domo DOMO, and Hibbett Sports HIBB

Image sourced from Pixabay

TD Ameritrade® commentary for educational purposes only. Member SIPC.

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.