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Pushing on a String

The recent decision by the Swiss National Bank to unleash its tether to the euro felt like a “Long-Term Capital” moment. The decision to peg the franc to the euro around three years ago seemed like a good idea . . . when the Euro was strengthening. The recent about-face without any clear warning rattled the Swiss stock market and foreign exchange traders around the world. To us the tether resembled more of a “We should have just adopted the euro,” rather than have a separate currency. Government policy is the mitigating factor when investors attempt to measure risk. The shock waves sent the Swiss equity market down over 15%. As the European Central Bank weighs a round of quantitative easing on an economy where most of the spending occurs at the government level rather than the consumer level, and with rates already at dangerous or deflationary levels, we wonder if this will aide in consumption or is the signal to say, “We will try anything twice.” Even the Swiss 10-year bond is screaming get out at all costs as the yield is at a negative 6 bps. For those of you who are fans of Star Trek, we truly are going “where no man has gone before.”

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The U.S. Equity markets continue to deliver “super-sized” volatility. The watchword, deflation, has certainly had a notable impact recently on sector performance amid rapid rotations. While there is some glimmer of hope in terms of sector leadership, we realize, at some point, that we too are pushing on a string. The Consumer Discretionary Sector continues to exhibit leadership and, with the decline in commodity prices, we believe the consumer feels somewhat better when filling their gas tank.. This form of tax cut is a welcome sign and often leads the market to new highs. It is not often that we find Consumer Discretionary stocks hitting price and RS highs and the start of a bear market. We have highlighted below a number of Consumer Discretionary stocks that are exhibiting leadership characteristics.

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Over the last several months we emphasized that if the Financials can hold up on an absolute basis the prospect of a market top are not likely. We have seen evidence over the last few weeks that the Financials are losing some of their footing, and the Sector appears to want to test every morsel of confidence we have had in the market being able to weather any earnings and economic news. A number of financial names such as JPM, BAC, and C have decisively taken out their respective 200-day MAs and certainly appear vulnerable. On the other hand names such as GS and MS continue to reside near their respective 200-day MAs and appear much more constructive on the long-term charts. Finally, the XLF is bouncing off the 200-day moving average and, as such, we have to watch and wait. Bottom line: the Financial Sector continues to be highly rotational, and what weakness there has been in the banks, has been largely offset by the insurers and REITs.

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The defensive side of the market such as Utilities, Staples, and Health Care continue to race out to the forefront in terms Sector leadership. This may be a function of market participants seeking yield within the Utilities and Staples Sectors. However, we believe that reduced energy costs and the ability to refinance large fixed costs at lower rates is a tailwind for many utilities. Against the current technical backdrop, we are moving to an overweight in Utilities Sector and a market weight in Staples. Health Care remains an overweight as the biotech group continues to remain leadership.

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Looking at precious metals, it appears that deflation and parabolic down-moves in currencies have enabled precious metals to garner more attention from investors looking for a safe haven. Gold is commonly viewed as a hedge against inflation; however, it has also done very well during periods of deflation. We believe that we have formed a bottom in the

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precious metals; as foreign currencies lose ground against the greenback, investors are seeking to own some dollar-denominated commodities that are not as abundant as energy.

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The weak euro is helping many of the European markets break out to new, all-time highs. We see this as a positive, but it also suggests that the world in a currency war. This volatility will continue to weigh on U.S. companies that derive much of their revenue from exports. Thus, the breakouts in European indices are suggestive of market share gains. We believe that if the Energy and Materials Sectors can bottom, it would be viewed by investors as a sign of equilibrium and a signal that deflation concerns are being tossed by the wayside.

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In conclusion, the U.S. equity markets are likely to consolidate at present levels if we continue to see “super- sized” moves in currencies. Stability is the key in markets for currencies and commodities, as volatility breeds fear. If the Consumer Discretionary Sector remains a leadership Sector and Financials continue to consolidate at these levels, we will remain optimistic. However, if the list of financial stocks hitting new 26-week and 52-week lows expands, then we would move toward the market-correction camp or view it as the potential start of a bear market.

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Sector Commentary:

Health Care Sector: Overweight. Health Care is leadership on all measures. It’s our best RSR-ranked Sector, both from an equal- and cap-weighted perspective. It boasts the greatest percentage of Groups and stocks ranked in the top-third of the market. It’s home to the market-leading Biotechs. And, with a relative strength trend breaking out above a twenty-three year base, it brags of the best “big picture” chart. Stick with this trend.

Internally, biotechs are still le grand fromage. This leadership trend is carrying over from last year, and, we believe, plenty of upside potential still exists. After all, our mid-, small-, and micro-cap Groups are just beginning to emerge from multi-year relative strength bases. Charts we favor include: GILD, AMGN, BIIB, ALXN, INCY, PCYC, MDVN, ISIS, UTHR, OPK, CPHD, MYGN, ALNY, PCRX, CLVS, NKTR, ACOR, INSY, NVAX, TSRO, MACK, LGND, EBS, and SGMO.

Technology Sector: Overweight. Technology is a global leader, especially overseas. In the U.S., it continues to outperform, but leadership is spotty at the Group-level, making internal over- and underweights important.

Observing Groups, semiconductors continue to monopolize our attention. Our three semi Groups—large, mid, and small-cap—boast RSR rankings within the 1-10 range (i.e., top 33.3% of the market), with small caps leading the way. For large-cap investors, INTC’s chart is tough to beat. The stock is consolidating above the $35 support level, making it an attractive buy, but the bigger sell is the monthly chart. This larger timeframe continues to reveal a secular base. Additional names of interest include: TSM, TXN, BRCM, ADI, NVDA, ASX, FSL, MRVL, SPIL, ONNN, CY, MLNX (bottoming), CAVM, ISIL, QLGC, OVTI, MCRL, ISSI, and TSEM. Semiconductor Equipment names of interest: ASML, AMAT, LRCX, TSRA, MKSI, KLIC, and CCMP.

Utilities Sector: Overweight. Utilities continue to benefit from several tailwinds: (1) the fallout in energy prices, (2) a healthy level of market uncertainty, and (3) floor-hugging interest rates. Together, these trends have recently provided an updraft for the Sector’s relative strength trends. We’re beginning to see widespread RS inflections, but we think this speaks more to the first tailwind—a lack of yield in fixed income—than it does to investor uncertainty. Given these relative strength inflections, we are upgrading the Sector to overweight.

Individual charts are more uniform in Utilities than any other Sector: most are characterized by strong absolute trends and inflecting relative strength trends. Examples include: DUK, ED, PCG, NI, SO, NEE, XEL, etc. Bottoming patterns are rare. EXC is one exception.

Consumer Discretionary: Overweight (Upgraded). We are upgrading this Sector due to positive consumer sentiment, low gas price and interest rates, and the fact that the Sector remains unexploited to a large degree. While the homebuilders remain trendless, the complementary feeder Groups remain robust, which is indicative that the consumer may use the current environment for home-remodeling projects or a replacement cycle. The leisure areas of the Sector remain intact and are gaining traction (Leisure Products and Facilities, Cruises, Hotels, etc.). The Restaurants also are enjoying resurgence and seem to have plenty of room to run, especially the domestic-based. They started outperforming in the fourth quarter last year, and have gained momentum at the start of 2015. Lower commodity and gas prices are a huge catalyst for continued outperformance. Retailers are also, once again, on our radar screen. Consumer sentiment remains at new highs, for the obvious reasons stated above, but the retail area is not exploited. While many retail Groups are positive-trending in price, the RS lines have only recently inflected, signaling the significant upside potential. Our favorite stocks in the Sector include: TM, MHK, MIDD, BC, LULU, PERY, DECK, WWW, CHH, WYN, CCL, RHP, CMG, BWLD, WEN, JMBA, BOBE, DRI, ZUMZ, CRI, BWS, DSW, M, KSS, WMT, DG, and TUES. Financial Sector: Overweight. We are maintaining our Overweight recommendation despite the ragged start to earnings season. The banks remain an area of concern, given the drop in interest rates and fears of deflation. More and more topping patterns have developed, with some breakdowns the result. The banks in oil-producing states are of particular concern. But, as it true to its nature, the rapid rotations within the Sector continue to take place. The Insurance area continues to maintain its leadership status as do the REITs. As investors search for yield, yet stable performance, these areas are a natural place to capture jittery investment dollars. The Asset Managers and Investment Banks are correcting, and haven’t broken down yet, which is an important underpinning for the market. Perhaps the best Group remains our Electronic Exchange/Markets Group. Our favorite stocks include: BLK, STT, FII, LM, GS, MS, CME, CBOE, NDAQ, MKTX, PRI, AEL, PNX, HIG, ACE, CB, XL, CINF, RE, ENH, and pick your favorite REITs.

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Consumer Staples Sector: Market Weight. We’re upgrading Consumer Staples to market weight, as the new high in the equal-weighted Sector’s RS trend beckons attention. Internally, selectivity is still key, as many Groups contain both attractive and unattractive constituents—a reason that market weight, and not overweight, is the appropriate rating. Convenience Stores are internal leadership. Unfortunately—or rather, inconveniently—they are overextended. Names like CASY, CST, and CORE are ripe for pullbacks. For small-cap value investors, keep an eye on TA, a constituent that recently broke out above a multi-year base. Drug Stores are situated at the top of our favorites list. The Group’s relative strength trend is inflecting higher following a test of 5-year support. Both RAD and WBA are attractive constituents on pullbacks. Our Grocery Retailer Groups are not far behind in terms of leadership. KR is a leading large cap, but WFM, recovering from last year’s breakdown, offers an attractive setup. Our Food Distributors Group is emerging from a multi-year relative strength bottom. Here we find charts like UNFI (on the verge of a base breakout), SPTN (breaking out), and SVU (approaching 52-week RS highs). Other areas of interest include Soft Drinks (PEP, MNST), Tobacco (RAI, MO), and Coffee (GMCR, SBUX).

Communications Sector: Market Weight. The Communications Sector continues to be a mixed bag. Media is considered the only real leadership in the Sector, but it has become a lot more selective. The Telecomm Services area is basically a non-starter, and the Internet-related Groups (with the exception of the Internet Service Providers) have all turned lower and are underperforming. Our favorite Group remains the Movie Theatres - the breadth remains healthy, as it has likely transformed into a real estate play. Our favorite stocks include: ETM, CMCSA, CHTR, DISH, LBTYK, CVC, MHFI, TRI, ENL, CHL, FTR, CCI, AMT, CNK, AMC, RGC, IMAX, EPR, AOL, and LOGM. Services Sector: Market Weight. This Sector remains mixed with about half the Groups outperforming and the other half severely underperforming. We continue to like the Data Processing/Consulting/IT Services groups/stocks and are recommending an overweighting of the area. Other areas that remain attractive include the Human Resources/Staffing and Advertising Groups (both traditional and digital). Various other attractive service-related Groups are: Waste Services, Uniforms/Facilities Mgt., miscellaneous Office Services, and Correctional Facilities. Our favorite stocks include: MA, FIS, ADS, JKHY, G, ACN, INFY, GIB, IGTE, CONE, VRTU, EPAM, NSP, GPX, LAMR, MDCA, KNL, SYKE, WM, RSG, ARMK, ABM, CXW, GEO, and CTCT. Transportation Sector: Market Weight. This Sector continues to exhibit strong RS and broke a 5-year RS downtrend in January of 2012. We have been bullish of the airline stocks since December of 2012 and continue to believe they are leadership in the Sector. Airline names that continue to exhibit bullish characteristics include: DAL, AAL, UAL, LCC, LUV, ALK, SAVE, ALGT, JBLU, HA, RJET, CEA and ZNH. Our Group, TR-05 Air Freight and Logistics, Large-Cap, does look attractive and names such as UPS and FDX should be accumulated on pullbacks. Many of the Truckers are also exhibiting major reversals and/or breakouts. We prefer names such as JBHT, KNX, SWFT, HTLD, WERN, ARCB, MRTN, CLDN, CVTI, PTSI and USAK. Materials Sector: Market Weight/Select Interest. This Sector remains mixed and stock selectivity is important. We continue to believe that the Forest Products, Diversified and our Paper/Packaging Group remain long term leaders, as many secular reversals presented themselves in June of 2009. Names such as IP, WY, LPX, BCC, PTBTQ, RKT, MWV, GPK, SON, CLW, WPP and UFPT remain attractive, but we would wait for pullbacks. There are a number of select chemical-related names that are attractive and include: DD, ASH, FMC, APD, IPHS, NEU, KWR and OMG. Another area of interest in this Sector includes the gold-related names. Many of the individual companies are experiencing reversals in price and RS and suggest further upside. Names we like in this space include: GG, ABX, NEM, AEM, EGO, KGC, RGLD, NG, IAG, AUQ, SA, RBY, PZG and RIC.

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Energy Sector: Underweight. This Sector has been hit hard by the pullback in commodity prices. We continue to believe that it will underperform, as RS remains weak and price patterns continue to stay in downtrends. Many individual stocks are making RSI divergences, and we expect a reflex rally to take place. The timing of a rally, however, is not easily determined. Manufacturing Sector: Moving to an Underweight. This Sector has lost its luster and RS continues to spiral downward. The areas that are attractive include Group MF-03 Aero-Defense with large-cap names such as BA, LMT, GD, RTN and NOC. Stock-picking is important in this Sector, and we would prefer to list the names that we find attractive, rather than seeking out Groups. Some individual names that are exhibiting leadership characteristics are: TXT, TDG, MMM, BEAV, HEI, SPR, COL, LLL, BHR, ROP, MAS, OC, AYI, APOG and GFF. We believe that much of the weakness is due to the strength in the U.S. dollar, and, thus, if we get a pullback in the dollar it would be beneficial for this Sector. David P. Nicoski, CMT Shelley D. Moen, CMT John M. Betz, CMT Charts courtesy Factset Data Systems, Inc. January 20, 2015