The Fed, not fundamentals, is driving the stock rally

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Published May 23, 2013

| Covestor

By Michael Arold

Going into May, US stocks are trading at all time high. The last two months have been quite unusual. As I wrote in my March report, negative sentiment and investor’s expectations for a pullback could further fuel the rally.

And it did. Quite surprising, however, has been recent outperformance of defensive sectors. Utilities, consumer staples and healthcare stocks usually outperform in declining markets. I underestimated the ability of these industries to push up US stocks.

One of the reasons was that small investors started to return to equities, but have been doing so in a conservative way. Demographic developments could be a factor, as the Wall Street Journal recently pointed out: Baby boomers are more likely to invest in income-generating stocks.

Overall, US equities continue to receive Fed support since the central bank pumps over $80 billion into the markets each month. In my opinion, the central bank’s so-called Permanent Open Market Operations are a major reason why markets refused to correct in recent months despite continuing breadth divergences in my opinion.

Take for example the the percentage of S&P 500 stocks trading above their 50 day moving average (DMA): on Feb 1, 90% of stocks traded higher than their average 50 day price while the S&P traded around 1,500. Three months later, the index flirts with 1,600 but only 70% of stocks are trading above the 50 DMA.

Similar divergences have historically led to a major correction at one point. Predicting its exact time is of course impossible. The rally could come to a stop next months or next quarter unless (and this is key) participation can broaden again. The composition of a rally is never constant. Underlying sector leadership can change.

There are some signs that market leadership has indeed started to rotate. The WSJ recently pointed out that evaluations of defensive stocks have become stretched while for example technology stocks are cheap when comparing current P/Es with historical averages.

From a technical standpoint, relative strength of tech names has picked up in the last two weeks. It is still to early to extrapolate a trend from a mean-reverting move, but I'm long various technology names.

Stock prices are driven by supply and demand, which is hugely influenced by emotions (as the reader can imagine, I'm not buying the concept that fundamentals are driving price.) Investor sentiment had turned extremely negative in April: the American Association of Individual Investors (AAII) bullish sentiment came in at 19% on April 11, a very low number.

My proprietary research has shown shown that equities traded higher 90% of the time after eight weeks during the last 10 years.  This data point suggests that "sell in May and go away" might not work this time.

The investments discussed are held in client accounts as of April 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.

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