Dog Days bright and clear
Indicate a happy year;
But when accompanied by rain,
For better times, our hopes are vain.
— Dog Days of Summer Folklore

Sirius is the brightest star seen from Earth in the constellation Canis Major, the Greater Dog, which is in the Southern Celestial Hemisphere or the Southern Sky. Being the most prominent star of the constellation, Sirius is called the Dog Star. People in Northern Hemisphere can see it, often flickering, in the southeast or south or southwest on evenings from winter to mid-spring. However, during summer it stays behind the Sun and appears in the east before sunrise. This period of morning-rise of the Dog Star is called the Dog Days of Summer and traditionally lasts for 40 days from July 3 to August 11. Some researchers say that lore behind it suggests another dog. Anyway, we will stick with our folklore as it goes better with our story.

Now to the rain during the Dog Days, since we are on a roll let’s go all the way and get into meteorology from astronomy, according to National Oceanic and Atmospheric Administration, the rainfall during July 2016, the last month with available data, in the continental United States was … drumroll please … near historical average. Oops, that does not tell us much about whether our hopes for better times would be in vain or not but let’s dig in.

The statewide picture of rain looks different. It tells us that the southeast and most of the south and the southwest United States got less than average rainfall and the Northwest and most of the Midwest got more than average and the rest of the country got about average. So according to the folklore the hopes for better times for some of the people of the Unites States will be in vain and for some not.

On a serious note, isn’t this how life works? For some people the hopes for better times produce results and for some don’t. The same is true for markets too. At any given time some parts of the financial markets would do better than other. So we should spend our efforts on figuring out which parts are doing better and which are poised for better performance in the future.

Monetary Environment: Will They or Won’t They

Ever since Federal Reserve started on the path of cutting Fed-Funds rate and Quantitative Easing, market has been speculating what will happen when Fed starts to normalize its policies. Many years have gone by without Fed policy normalization and this has only increased the nervousness in the market about the impending interest rate hike, which is again flaring up as the sixth FOMC meeting for 2016 on September 20-21 approaches near. Let’s see how much of this nervousness is warranted and how much is just devoid of facts.

On May 22, 2013, then Fed Chair Bernanke testified to Congress that, in light of positive economic news, Fed would start to reduce the pace of its bond purchases later in the year or start the so-called tapering of its bond buying program. Market immediately threw a Taper Tantrum. The yields on 30-year Treasury bonds rose from a close of 3.149% on May 21, 2013 to a high of 3.930% on August 22, 2013. S&P 500, on the other hand, did not do that badly and declined from a high of 1687.71 in May to a low of 1560.33 on June 24, 2013, a decline of only -7.5%.

Since then the Fed has stopped its bond buying program and the sky hasn’t fallen but the yields have. By the start of December 2015, yields on 30-year Treasury bonds had fallen to 2.990% and the S&P 500 had risen to 2080.41. Later that month FOMC, under Chair Janet Yellen, raised the Fed-Funds rate for the first time in eight years by 25 basis points. Once again the ‘higher-rates-are-here-crowd’ got jittery but the market shrugged it off. In eight months since that rate-hike, the S&P 500 has gained almost 125 points and the 30-year yields have lost almost 76 basis points.

During this time the U.S. economy has moved along, albeit at a slow pace, the inflation has stayed low and the unemployment has fallen to 4.9%. The moral of the story is that it pays to disregard the hype and fear but weigh the data and facts to form any opinion about the market. Many of the factors that have prevented Fed from raising rates till now still exist. Let’s analyze them.

Inflation is Tame

Fed’s favorite measure of inflation is personal consumption expenditures (PCE) but Fed also closely tracks many other measures including consumer price index (CPI) and producer price index (PPI). While evaluating inflation instead of considering one data point, it looks at average reading over a longer periods of time – ranging from few months to longer. It also tries to eliminate the price changes that are influenced by factors that may be transient. Finally, it examines core measures, which exclude volatile food and energy items.

What we find is that the inflation, though rising from very low levels, is still quite tame. July’s core PCE (Chart 1) is at 1.57%, core CPI is at 2.16% and the PPI is at -3.4%. The 12-month average of core PCE is 1.4%, core CPI is 2.1% and core PPI is 1.0%.

The inflation expectations gauge is also showing that there is no  imminent danger of inflation shooting up. The University of Michigan Inflation Expectation (Chart 2) reading for July is 2.7% and the latest 5-year, 5-year Forward Inflation Expectation rate is 1.6%.

Finally, let’s take a look at the productivity measures (Chart 3), which are also not heating up. The median weekly real earning has risen from the lows of 2014, it is still lower that the 2009 high. The real output per hour of all persons is falling since 2015 Q1. The per capita real GDP is also falling.

What is clear is that the overall inflation is still tame and is not heating up for an immediate Fed action. The trend, though changing, hasn’t firmed up that it can withstand pressures from other sources that include falling commodity prices and the deflationary pressures from other geographical areas.

Odds Are Low For A Rate Increase In September

The FOMC will release its next statement at 2:00 PM on Sep 21, 2016 followed by the press conference at 2:30 PM. When the Fed raised rates in December 2015, it hinted that the year 2016 will see four interest rate hikes. Since that time market participants are forecasting when the rates will be hiked. One hypothesis put forward was that the rate-hike will be announced during the meeting that has the press conference too as Fed would like to answer questions regarding its action. This argument left only March, June, September and December meetings as suspects for rate-hike as they are the only ones with announced press-conference schedule.

Almost three-quarters into the year we still haven’t got our first hike. This has increased the chatter that the next one will be in September. Also adding to this speculation is that the unemployment rate has fallen to 4.9% and the fact that since November 2010, US has added to its Non-Farm Payroll every month. During the past 12-months, the economy added 2.4 millions new jobs and the 3-month average stands at 190K jobs.

The recent remarks by Fed Chair Janet Yellen in Jackson Hole and by Vice-Chair Stanley Fischer signaled a greater willingness to raise interest rates. This has increased the odds for a rate hike, but only marginally. As of September 2, the CME Group’s 30-Day Fed Fund futures prices put the odds for a 25 basis points increase to 21% down from 27% on August 31.

We also believe that Fed will not raise rates in September. In any case, the Fed monetary stance will stay easy for a foreseeable future. Other central banks around the world are also pursuing easy monetary policies. Many are implementing quantitative easing or negative interest rates. In this environment it is difficult to come up with a scenario where the U.S. Fed Fund rates could go very high.

Psychological

Bullish Vs. Bearish Advisors %

The bullish sentiment with Investors Intelligence Bullish Advisors % has moved up to 55.90%, which is at its highest level since mid-2015. The Bear Advisors % stands at 20.60%. When the percentage of bears crosses over the bulls, the market bottom is likely. Last time bears were over bulls was in March 2016.

AAII Investor Sentiment Survey

As of August 31 2016, 28.6% of members of AAII are bullish regarding markets direction for the next six months. compared to 31.5% of members who are bearish and 39.9%, who are neutral. Bullish and bearish percentages are below the historical averages of 38.5% and 30.5% respectively. The neutral percentage is above the historical average of 31.0%. The bullish sentiment is at the 8-week low.

Many people use this gauge as a contrarian indicator. That, however, works at the extreme readings, during other times it does give some signs for future direction of the market. We have found that the slope of the 4-week simple moving average of the bullish percentage gives a good sign for the slope of the S&P 500 4-weeks later. For this, we consider the direction and not the absolute value of the slope. In the most recent reading, the bullish percentage and its 4-week average have declined. After making 2016 high during the week of July 28, the 4-week average has mostly declined (Chart 4). This does not bode well for S&P 500, however, it just gives an indication regarding the direction and not the magnitude of the move.

CBOE Market Volatility

The daily CBOE Market Volatility Index, $VIX, monitors the level of fear in the market. When fear rules, it surges, which usually means that the major indices will hit bottom and rally higher soon. The $VIX has been declining and staying low after spiking in June during Brexit driven uncertainty. Its last close of 11.98 on September 2 2016 and its 20-day SMA of 13.03 are at historical low levels (However, $VIX can stay at a low level for an extended period). A reading of more than 20% above its 20-day moving average will confirm a positive reversal in the market.

Put-Call Ratio

A contrarian sentiment indicator that helps determine major and short-term market tops and bottoms is the Put/Call Volume Ratio, which compares the total number of puts traded with total number of calls traded. The current ratio stands at 0.93. A reading above 1.15 usually confirms a positive reversal in the S&P 500 or NASDAQ.

High-Low Ratio

This is a IBD proprietary indicator that helps in determining rebounds from immediate corrections during bull markets. It presently at a level of 2.00. A short-term bottom usually occurs when it turns up for the first time after crossing below 0.5. During bear market this threshold level drops to 0.1.

Margin Debt

Another contrarian indicator that denotes the year-over-year change in margin debt, which can help flag major tops in bull market. When optimism is high this will exceed 55%, which means that investors are borrowing heavily during the late stages of bull market. The current level is -11.41%, which means that the investors have cut their margin debt from the year-ago level.

Fundamental

The second quarter earnings report-card for S&P 500 companies is mixed. The guidance for Q3 is also mixed. But one thing is clear that the fundamental picture is not deteriorating even though it is not percolating. Bottom line is that there is nothing on the horizon to make us fear about the near-term market performance from this angle.

According to Factset Earnings Insight, So far in Q2 2016, 70% of S&P 500 member companies have reported earnings above mean estimates and 53% have reported sales above mean estimates. Seven out of eleven S&P 500 sectors, led by Information Technology and Consumer Discretionary, had upside earnings surprises and have higher growth rate now compared to June 2016. Energy and materials were biggest contributors to earnings decline

The year-over-year earnings growth for Q2 2016 declined by -3.2%. This is the first time that for five consecutive quarters the year-over-earnings have declined since Q3 2008 through Q3 2009. On the plus side, at the end of June 2016, the estimated earnings decline for Q2 2016 was -5.2%. So the actual number is better than the estimate.

Going forward, out of 111 S&P 500 members with announced Q3 guidance, 78 or 70% have issued negative guidance for Q3 2016 and 33 have issued positive guidance. This percentage of negative guidance is lower than the 5-year average of 74%. During the first two months of Q3, analysts have reduced the aggregate EPS estimates by -2.5%, which is better than the 5-year average of -3.4% and the 10-year average of -3.8%

The forward 12-month PE ratio for the S&P 500 is 16.9, this is above 5-year average of 14.8 and the 10-year average of 14.3. The current ratio is highest since Dec 31 2004. Though S&P 500 declined for the next few months after Dec 2004 – with the largest decline of -6.2% to the lows – it was higher one year later.

Seasonal

The outlook for the month of September is bearish. Since 1970, September has been the worst performing month for major U.S indices followed by August. During this period, the average return for the month of September for S&P 500 is -0.7%, for Dow Jones Industrial Average -1.0% and for Dow Transportation Average -0.8%. NASDAQ Composite and Russell 2000 perform better but only marginally. Since 1973, the average September performance of NASDAQ Composite is -0.6% and for Russell 2000 (since 1987) is -0.2%.

September also retains its worst-performing reputation since 2000. Over the last sixteen years, the average September performance for S&P 500 is -1.3%, for Dow Jones Industrial Average -1.0%, for NASDAQ Composite -1.9% and for Russell 2000 -1.4%.

September also has the least probability of being an up month. S&P 500 has been positive only 43% of time in September since 2000 and Dow Jones Industrial Average 35%. NASDAQ Composite and Russell 2000 have better odds with 53% and 59% respectively.

All S&P 500 sectors perform badly in September. Bonds, on the other hand go up on an average. The table below shows how different sectors and bonds perform in September.

	Avg. Ret.	Up %			Avg. Ret.	Up %
XLY	-1.2%	38%		XLP	-0.01%	44%
XLB	-3.5%	44%		XLI	-1.7%	50%
XLF	-1.4%	56%		XLE	-1.7%	50%
XLK	-2.6%	50%		XLU	-0.3%	56%
XLV	-1.7%	44%		TLT	+1.1%	56%
30-year Treasury Bond	+0.4%	50%		10-Year Treasury Note	+0.4%	69%

Intermarket

Intermarket analysis looks at the relationship between stocks, bonds, commodities and currencies to identify the stage of the business cycle. This helps us determine the investing cycle and select the sectors that will give us higher returns and avoid sectors that will not.

In a normal inflationary environment, stocks and bonds move in the same direction. In this environment, bonds usually change direction before stocks. Also, during these times bonds and commodities move in opposite direction. The US dollar and commodities also move in opposite direction. During deflationary environment, stocks and bonds move in opposite direction. So do bonds and commodities, as they do during inflationary environment.

The current economic environment is not deflationary and it is also not inflationary, rather it is a very low inflation environment. How do we know that? Take a look at the attached 3-month intermarket chart on daily timeframe.

On July 11 2016, 30-year U.S. Treasury bonds, $USB (Chart 8 – top frame), reached a high of 177.11. Since then bonds have been either moving downwards or sideways. During this time, Reuters/Jefferies CRB Commodity Index, $CRB (third frame), moved first down then up and then down again. The US dollar index, $USD (bottom frame), was rising for most of July. It fell in early-August before reversing course. While the bonds were in general downward trend, S&P 500 (second frame) was mostly moving sideways with slight upward pressure.

Since mid-August, commodities are moving down in tandem with bonds and not in opposite direction as they should do during normal inflationary environment. This leads us to believe that the current climate is not such.

Stocks

This is a time to be cautious in the market. The current trend of the major U.S. indices is up as we measure it using a combination of moving averages, trend lines and swing-high and swing-lows. However, this uptrend is under pressure at the moment.

Since making a double bottom on February 11 2016, S&P 500 has been on an upswing with price staying above its 50-day and 200-day EMA. Recently it has been struggling to stay above 20-day EMA. Since February, it has made one lower low after making a higher high (June 27 2016), but that breach was soon fixed and now it is at its higher level ever. The next critical swing low is 2147.58, the low on August 2, followed by 1991.68, the low on June 27. Other major U.S. indices are showing similar patterns, though the smaller cap Russell 2000 and the better technical pictures.

Still, this a time for caution. The blue chips have been generally feeling up pressure, they have been almost flat since mid-July. S&P 500 hasn’t closed above or below previous close by more than 1.0% since July 8 2016. During this time its daily range – from high to low – crossed that level only twice.

The lack of momentum at historically high level coupled with uncertain sentiment and seasonal factors signals that downturn in the near future (September/October) is possible. However, the fourth year of the Presidential Cycle sees the mildest downturn.

Market has been bullish from mid-year when the incumbent party wins the election. Currently, Democrat Hillary Clinton leads the Republican Donald Trump. If this hold then there is a high probability that market will do better going forward. The caution for mild downturn during September/October still holds.

Relative Strengths

Commodities

After making 2016 high in June, the commodities are again in decline. S&P GSCI Commodity Index Total Return ($GTX in StockCharts) made 2016 high in mid-June (Chart 9). It then declined till end-July, after that it rallied only to find resistance at the 61.8% Fibonacci retracement of 2350.37. It is presently below its 50-day and 200-day moving average but above a uptrend line from 2016 low of 1860.66 reached in January.

During the time that the commodity index was rising, it was still trailing S&P 500. When $GTX made a swing low of 2031.36 in early-April, the ratio $GTX/$SPX  (Chart 9 – bottom frame) made a low that was lower than the low in January. The same was true at the swing low of August. This tells us is that the relative strength is not with commodities.

However, not all commodity groups are doing badly. The base metals and precious metal commodities are doing better than the overall commodity sector and the agricultural commodities. Here are three commodity based ETFs that are doing better or as well as SPY.

DBB, the PowerShares DB Base Metals Fund (Chart 10) is in a uptrend since the beginning of 2016. Its ratio with SPY was rising during the first quarter. Since then it is mostly flat, especially since July. This means that DBB, is doing as well as SPY if not doing better.

SLV, the iShares Silver Trust ETF (Chart 11) is doing the best. Not only is it in a uptrend but its ratio with SPY is also in a uptrend, which means that SLV is outperforming SPY since the beginning of the year.

GLD, SPDR Gold Shares (Chart 12) has been on a uptrend since the start of the year. At the moment it is at the uptrend line. Its ratio with SPY is roughly sideways since April. It has outperformed SPY over past three-month though not over one-month period.

Fixed-Income

Some fixed market ETFs are also doing either better or as well as SPY. TLT, iShares 20-Year Treasury Bond ETF (Chart 13) made a double bottom in November and then started an upswing. It is still above the uptrend line from the January lows. Its ratio with SPY has been almost flat since March (more so since mid-July) with an up bias. It has outperformed SPY over the past three-month period but not over one-month period.

HYG, iShares High Yield Corporate Bond ETF, is on a uptrend since February (Chart 14). During most of this time its ratio with SPY was moving sideways, indicating that both were performing almost equally. It is outperforming SPY since the end-July.

Couple of international bond ETFs are also doing well. EMB, iShares JP Morgan USD Emerging Market Bond ETF (Chart 15) and PCY, PowerShares Emerging Markets Sovereign Debt Portfolio (Chart 16) are showing trends and future potential similar to that of HYG.

Domestic

Not all sectors of S&P 500 are doing well but some are doing either better or as well as S&P 500. XLK, Technology Select Sector SPDR has been trending higher since February (Chart 17). During this time it has led SPY (more so since end-June). The trend looks to continue for some time.

We noted above that the base materials and metals are doing better so are XLI, Industrial Select Sector SPDR (Chart 18) and XLB, Materials Select Sectors SPDR (Chart 19). Also doing better are small-cap. IWM, iShares Russell 2000 ETF, is leading SPY since February and is doing better than others (Chart 20). Unlike S&P 500, Dow Jones Industrial Average and NASDAQ Composite Russell 2000 has not yet made a higher high than the 2015 high and hence has more room to run up.

International Equity

Emerging countries are leading the developed countries. We are noting four ETFs here. EEM, iShares MSCI Emerging Markets ETF, has been making higher highs and higher lows since mid-January (Chart 21). Since mid-May it is also leading SPY.

EPI, Wisdom Tree India Earnings Fund, has broken above a six -week congestion period (Chart 22). It has led SPY since June. The breakout in late-August bodes well for it. EWZ, iShares MSCI Brazil ETF has led SPY for most of the 2016 (Chart 23) and the trend looks to continue further.

EFA, iShares MSCI EAFE ETF, with exposure to companies in Europe, Australia, Asia and the Far East, is trying to break above a double top chart formation (Chart 24). Since July it is also leading SPY. If it overcomes the double top resistance then odds are good that it will go higher.

Notable Events / Reports

Many events and economic reports are due in September that could impact the markets either negatively or positively. The first debate of U.S. presidential campaign and many central bank meetings are on calendar along with many important economic reports.

Central Banks

ECB Governing Council meets on September 8 and its quantitative easing strategy is in focus. Many analysts expect that it may extend its asset purchase program from March to September 2017.

Bank of England is meeting on September 15. According to Bloomberg survey, there is only 6.3% chance that it will cut rate but its bond-purchase scheme faces implementation challenges.

Bank of Japan’s Policy meeting is on September 21 and it will announce the results of its comprehensive review of monetary policy. Expectations are rising that it would cut rates further or expand QE.

Federal Reserve Banks’ FOMC meeting is on September 21. The odds for Fed-Fund rate increase are falling but decision about it is still on the table.

Government Meetings

The G20 Summit will take place on September 4-5 in China and would focus on global growth and financial sector issues. Monetary policies around the world are having limited impact so the question remains whether the global powers will loosen up fiscal policy?

OPEC member countries will meet in Algeria from September 26 – 29. Of late it has failed to take leadership in establishing the direction of crude price. Analysts expect that it will maintain output at current levels.

Economic Reports

U.S. ISM Non-Manufacturing is due on September 6. A reading worse than estimated 55.4 will further reduce the Fed-Fund rate hike in September. Retail Sales and PPI data is due on September 15. The CPI data will come out on September 16 and Building Permits on September 20. These are major economic reports scheduled before FOMC meeting that may give hints about Fed’s decision on September 21.

Final Thought

Major U.S. indices are near all time high. The hiccups following Brexit referendum in the United Kingdom did not last for long. Good economic data, easy monetary policies and robust corporate earnings have buoyed the stock prices over the past few months. The lack of momentum and smaller daily ranges are giving the impression that, perhaps, the stocks are topping-out.

Historically, September has been weak month for markets. The trading volume in August is usually low on account of traders going on vacation. They end their vacation after Labor Day, which also coincides with opening of schools across most of the United States. One theory about stocks’ decline in September is that during off-time traders get to reconsider their opinions about market and then exit their losing positions and rebalance portfolios after they return.

Whatever the reason, the fact is that stocks’ average return in September is negative over many decades. In our opinion, the probability that stocks will decline too this year in September is better than 50%. But, it is also our view that in the longer term, and for the rest of the year, the investing climate favors the bulls and not the bears.

One feature of market is that not all sectors and asset classes move together. Relative strength analysis is one good tool to identify the sectors and asset classes with better odds for greater returns. If you analyze the data and study the chart patterns than you could find many securities that will help you withstand this weak period and, perhaps, improve the bottom line. We have listed the bullish case for some of them.