It is encouraging to see that Q3 earnings season is looking a bit better than expected and is on track to produce positive earnings growth for the first time since Q1 2015 (that was six straight quarters of negative year-over-year growth!) – and on positive revenue growth, to boot. Entering earnings season, Wall Street’s mood had turned negative after an expectation earlier in the year that Q3 would be the big turnaround quarter, so the upside surprises so far have been most welcome.

On the other hand, stocks appear to be enduring something of a “stealth correction” or risk-off activity, which has been impacting small caps much more than the larges. After seven months of expansion (essentially from Feb 11 until Sept 22), market breadth has been shrinking over the past month, as news headlines take the stage away from fundamentals, which is not surprising given the impending election. I think we will see elevated volatility in advance of election day, but after rationalizing what it all means (no matter what result transpires), I expect the market to stabilize – at least until the December 14 FOMC meeting. From a technical standpoint, the proverbial spring remains tightly coiled for a significant move. But even if the initial move is down, I would consider it a buying opportunity, as I think investors will return to a focus on fundamentals, leading once again to healthier market breadth and diverse leadership, with higher prices in our future.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas. Overall, our sector rankings look relatively bullish, although the sector rotation model still suggests a neutral stance.

Market overview:

Year to date, the S&P 500 price index is up +4.3%, and the Russell 2000 small caps, after greatly outperforming coming off the February 11 recovery, is up +4.8%. But the big action has been overseas, particularly with emerging markets, with the iShares MSCI Emerging Markets ETF (EEM) at +14.7%. The best YTD performance globally is Brazil at +85% (priced in dollars, or +48% priced in reals), and the worst is Italy at -19%.

If it weren’t for the craziness of the election, I think US stocks would be up double digits YTD across all major indexes. Latest manufacturing data and GDP growth reports have been quite solid. Up until September 22, the Russell 2000 small caps had been greatly outperforming S&P 500 large caps this year (+11.6% versus +6.5% YTD). But since September 22, small caps have suddenly underperformed large caps such that the performance gap has closed to within a half percentage point (+4.8% for Russell 2000 versus +4.3% for S&P 500). Notably, although money flows into ETFs during October have continued the net positive trend overall, about 85% of the capital has gone into large caps, whereas smids previously had been getting the bulk of assets for the first nine months of the year.

Moreover, it is looking a lot like FANG all over again, as five stocks – Facebook (FB), Apple (AAPL), Amazon.com (AMZN), Microsoft (MSFT), and Exxon Mobil (XOM), in descending order of relative contribution – have accounted for about 33% of total gains in the S&P 500 this year. To reiterate, 1% of the companies has accounted for 33% of the index gains.

Compare this to last year, which was an extremely narrow and news-driven market in which the large caps, led entirely by FANG and a few other mega caps, greatly outperformed the small caps. The S&P 500 price index was down about -0.8%, while the Russell 2000 small caps were down for -5.3% 2015. But when you look at the breakdown of the S&P components, the Value Index lost -5.5% for the year, while the higher-risk Growth Index gained +3.9% – entirely due to FANG.

However, other than the past month, this year has shaped up quite differently than 2015. For 2016 YTD (through Friday, 10/28), the S&P 500 price index is +4.3%, while Value is outperforming Growth, +5.6% versus +2.9%. The P/E of the S&P 500 has become elevated compared to historical norms, at 24x trailing 12-month EPS and 18x forward 12-month EPS, and a rising rate environment would be expected to put a lid on further multiple expansion and favor value stocks, Value historically tends to perform well in an environment of rising rates and compressing earnings multiples, and indeed, so far this year the trend has reversed, at least so far, and may continue. 

Although most stocks traded the first nine months of the year based on fundamentals while market breadth expanded, some segments still have languished under the weight of news headlines and investor caution, holding down a number of fundamentally solid stocks with attractive valuations. Airlines, for example, still are making a lot of money and many of them sport single-digit forward PEs, but they along with many of the travel segment have been hindered by worries about Zika, terrorism, and higher fuel prices, creating general investor aversion. Also, Healthcare names have struggled despite regular drug breakthroughs and favorable demographics, and in fact, biotechs have been the laggards within the S&P 500. Bloomberg reported recently that, “Among the 10 biggest single-stock declines in the benchmark gauge this year, six are health care companies…The weakness is a departure from the past five years, when health-care’s 128% advance through 2015 ranked ahead of any other group.”

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