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 A potentially bullish long-term pattern has developed in the basic materials sector.

Among the main beneficiaries of the post-election “Trump Trade” has been anything related to reflation, construction, etc. In that wheelhouse is the basic materials sector of the stock market. Using the Dow Jones U.S. Basic Materials Index as a measuring stick, the sector is up roughly 15% since the election. The rally has also brought the index up to a very noteworthy area on its chart: its all-time highs near the 356 level, set in 2008 and matched in 2014.

    Now, some folks may be concerned about a potential “triple top” in play here. That is possible. However, in our many decades of chart-watching, we have frankly not found much evidence of triple tops that actually panned out. Furthermore, those triple tops that turned out to be valid typically saw a fairly equal distance between the first 2 and second 2 peaks. In this case, the spread in the former is 6 years while the latter is just over 2.

Those spreads between the peaks lead us to an alternate – and bullish – potential interpretation of the chart pattern: a cup-&-handle. As a refresher, a cup-&-Handle pattern involves 2 parts:

The Cup (2008-2014, in this case): This phase includes an initial high on the left side of a chart followed by a relatively long, often-rounded retrenchment before a return to the initial high.

The Handle (2014-2017): This phase involves a shorter, shallower dip in the security and subsequent recovery to the prior highs.

The bullish theory is predicated on the idea that after taking a long time for a stock to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs.

Even if this interpretation is correct, there is certainly valid reason for caution in the immediate-term as prices are just now reaching their former peaks. It would not be unusual nor unhealthy to see a temporary retrenchment or consolidation before an attempted breakout takes place. Besides, as we say often, never anticipate a breakout.

That should be especially important advice in this case since we are dealing with a very long-term scenario. When and if the breakout does occur, investors should have ample time and profit potential with which to take advantage as the resultant rally following such a breakout could potentially last for years.

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More from Dana Lyons, JLFMI and My401kPro.

Lower Taxes Should Boost Profits

Markets typically need a catalyst to break out of a multiple-year trading range. One possible candidate is the significant shift in market expectations related to the reliance on monetary policy relative to fiscal policy.

Lower Taxes And Higher Rates

The financial markets have been highly dependent on global central bankers in recent years (monetary policy). After the U.S. election, markets began to anticipate the possible benefits of President-elect Trump’s platform. From Yahoo Finance:

“We estimate that President-elect Trump’s corporate tax plan could boost S&P 500 earnings by $180bn,” writes Barclays’ Jonathan Glionna. “We think the market is underappreciating the likely big boost to S&P EPS from a lower corporate tax rate and the boost to bank profits from rising yields (and lower pension expense) and the much higher chance now of a long lasting economic expansion that rivals the 10-year US record,” Bianco added.

Numerous Longer-Term Market Signals

This week’s stock market video covers a long-term breakout in an economically-sensitive sector (XLB), describes a shift that has resulted in stocks outperforming bonds in the past, and updates the status of numerous long-term signals that have accrued in recent months.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Goldman’s Take On Trump’s Tax Plan

Sentiment shifts need to be backed by fundamental shifts for market gains to continue. The odds are extremely high corporate taxes are going to be lowered under the Trump administration. Lower taxes will impact earnings; the only question is the magnitude of the impact. From Yahoo Finance:

In a note to clients shortly after the election, analysts at Goldman Sachs outlined a number of tax scenarios that could play out in a Trump administration. Among them is a reduction in the statutory tax rate from the current 39% to 25%, while companies keep their strategies to pay less effective tax. Under this scenario, an effective tax rate falling to 15% could see S&P 500 earnings rise 26% in 2017 compared to 2016.

Investment Implications – The Weight Of The Evidence

This week’s stock market video reviews numerous signals that favor longer-term bullish outcomes for stocks and economically-sensitive investments.

A number of key charts pertaining to the basic resources sector have scored important breakouts in recent days. 

As large-cap averages break into all-time high ground, a key question on many investors’ minds is does this move have legs -- or will it prove to be a bull trap? One factor that would certainly help give the move “legs” would be the continuation of the bounce in commodity and resource based equities. After getting absolutely pummeled in the deflationary spiral over the past few years, resource stocks have enjoyed a resurgence since the January-February lows. Then again, so has the entire equity market. So, is this rally in basic resource stocks merely a mean-reversion bounce, in line with overall market beta? Or is it something more substantial -- a legitimate reflationary move. While we still can’t say with certainty either way, evidence continues to pile up that we are witnessing more than simply a dead cat bounce.

Why do we say that? Well, as you may know, as active risk managers, we don’t spend any time opining about why the market is doing what it is. All we are concerned about is what IS happening in the market. And in the resource sector, a number of positive developments are taking place. For one, one of the key and most comprehensive indices in the area, the Dow Jones U.S. Basic Resources Index, has just scored an important technical breakout.

Specifically, the index has just overtaken its Down trendline extending from the sector’s peak in 2008 and connecting the peaks in 2011, 2014 and several touches from April to June of this year.

One other interesting facet of the chart of the Dow Jones U.S. Basic Resources Index catches our eye. During the January selloff, the index broke below its low from 2008. However, it was able to recover that level in short order and continue to move higher. This type of “false breakdown” can be as powerful in jump-starting a move to the upside as a breakdown can be to the downside.

We pointed out a similar false breakdown in the gold miner stocks back in January that served as a springboard to an epic rally since. It should thus be no surprise that the Dow Jones U.S. Basic Resources Index has a large number of mining stocks, and specifically, gold mining stocks, in it. And if the index is to follow the lead of the gold miner indices, there could be plenty more upside to go.

Since the Dow Jones U.S. Basic Resources Index is perhaps off the radar for most, we will show one more chart that may be more familiar and at least more accessible for investors. The SPDR S&P Metals & Mining ETF (ticker, XME), is one of the most popular mining/resource funds in the market. Its chart is also showing similar characteristics as the Dow Jones U.S. Basic Resources Index.

Note how XME has recently broken above its post-2011 Down trendline. This is an important development regarding the prospects for more upside in the ETF. Additionally, note also how XME suffered a similar false breakdown early this year. The bounce off the low has already seen the ETF more than double in price. Given the damage seen in the fund over the past 8 years, this bounce could just be the beginning of a larger bull market.

The same goes for the Dow Jones U.S. Basic Resources Index and the entire sector. After the deflationary spiral since 2008, this year’s rally could be nothing more than a mere mean reversion bounce. The potential upside to a legitimate, cyclical bull market would be many multiples of the bounce we’ve seen. Whether that type of a move is in the works or not, we cannot know for sure. We just need to gauge it one step at a time.

But the steps made by the sector this week have been important ones in broadening the possibility of such a cyclical bull market.

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More from Dana Lyons, JLFMI and My401kPro.

Fed’s About Face Helped Kick Off Reflation Trade

The Federal Reserve’s rapid reversal on interest rates in the first few weeks of 2016 helped launch the reflation trade. The reflation trade is also known as the weak-dollar trade; both refer to leadership from assets that tend to perform well during periods of rising inflation expectations and/or a weakening U.S. dollar. Reflation is also used to categorize the early stages of economic improvement after a period of weakness or contraction.

Another False Dawn Or Sustainable Leadership?

While there is no question weak-dollar assets have responded to the Fed over the past few months, the jury is still out on the question of sustainability. The chart below shows the performance of materials (XLB) relative to the S&P 500 (SPY). Notice how similar periods of leadership ended in disappointment (red arrows below). The reflation trade has worked its way back to a similar area (orange arrow).

Weak-Dollar Trade And The S&P 500

With valuations stretched and earnings falling into the tepid category, markets have been focusing on the liquidity supplied by central banks. The chart below shows the same XLB vs. SPY ratio, but this time from a zoomed-in perspective. Notice how the performance of the S&P 500 has mirrored the fate of the weak-dollar trade.

We Learn Something Either Way

Have there been reflation/weak-dollar trade head fakes in the recent past? Yes, a March 18, 2015 headline proclaimed “Avoid utilities as reflation trade picks up steam”. The chart below shows the 2015 rally in materials relative to the March 18 reflation headline.

The present day look of the XLB:SPY chart aligns with the “possible inflection point” theme we have been covering in recent weeks.

Fed Statement June 15

On July 31, we posted a piece suggesting that the basic materials sector was threatening a material breakdown. Our rationale was the proximity of the Dow Jones U.S. Basic Materials Index to a confluence of key Fibonacci Retracement levels. As we have mentioned before these levels reflect the market’s tendency to “retrace” market moves in similar increments. We have also mentioned before that, in our view, the strongest Fibonacci signals come when there is a confluence of various such levels in the same vicinity. This was, and is, the case on the chart of the materials index. Oh, and that “material” breakdown did come to pass.

That breakdown on the Dow Jones U.S. Basic Materials Index occurred at around the 300 level. Note how the following 4 Fibonacci Retracements drawn from key lows in 2009, 2011, 2012 and 2013 to the 2014 highs, aligned almost perfectly with each other in that level:

23.6% Fibonacci Retracement of the 2009-2014 Rally  ~301

38.2% Fibonacci Retracement of the 2011-2014 Rally  ~302

50% Fibonacci Retracement of the 2012-2014 Rally  ~300

61.8% Fibonacci Retracement of the 2013-2014 Rally  ~302

Additionally, the 1000-Day (or 200-Week) Simple Moving Average is right in the vicinity as well.

We noted in that July post that:

Should the Fibonacci Retracement cluster around 300 fail to hold the index up, here is the next set of Fibonacci levels that the index would be likely to test (near 266, or 11% lower):

In the August mini-crash, the Dow Jones U.S. Basic Materials Index hit a closing low of...266. After bouncing for a few weeks, the index is once again testing that level.

Here’s a close-up look at the recent action.

That set of Fibonacci and other significant levels around the 266 area are the following:

38.2% Fibonacci Retracement of the 2009-2014 Rally  ~265

61.8% Fibonacci Retracement of the 2011-2014 Rally  ~266

2013 Lows ~266

Additionally, the 500-Week Simple Moving Average is right in that vicinity as well.

Should the Dow Jones U.S. Basic Materials Index bounce off the 266 area, its first big challenge may come at the post-crash bounce highs near 286. After that, it would be the 300 area. The problem for this index is, every potential line or indicator of support on the way down is now going to act as resistance on the way up. So even if the 266 level holds for now, the index would still have its work cut out for the foreseeable future.

Should this 266 level give way, there is really no noticeable, solid support until the 2011 lows which would correspond with the 61.8% Fibonacci Retracement of the 2009-2014 bull market. That level is around 210, which would signify a loss of over 20% from current prices. That’s on an index that is already off 25% from its highs. Not good.

We ended the July post by saying:

...if the (300) level fails, the Dow Jones U.S. Basic Materials Index is likely to visit the next cluster of Fibonacci Retracement levels near 266. Would such a move be a byproduct of an acceleration of the global deflationary trend currently in place? Or would it be a catalyst for a broader market decline? That is yet to be determined. However, such a breakdown would not be welcomed news for a stock market that has already seen its share of bricks removed from the wall.

Well, that dire scenario played out, in the basic materials sector and in the broader market. A failure of the current key support area would signify a deepening of these problematic trends that have unfolded over the past month. And as bad as things have been this past month, a further acceleration could be devastating.

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More from Dana Lyons, JLFMI and My401kPro.

We take a break from the regularly scheduled poor breadth programming to bring you a chart of a sector...that just so happens to be one of the main contributors to the poor breadth phenomenon. After threatening for months last summer to break out above its all-time high set in 2008, the basic materials sector succumbed to the October weakness along with the rest of the market. However, unlike most of the market, the sector, as represented by the Dow Jones U.S. Basic Materials Index, never did make it back to its September highs as it was caught in the deflationary spiral in commodities at the time. It did begin the year in promising fashion, though. In February, we posted that the Equal-Weight Basic Materials ETF, RTM, actually hit an all-time high, as did the Materials SPDR, XLB, despite the commodities rout. That victory was short-lived, however, and there has been precious little to cheer about in the sector since.

Earlier this month, the DJ U.S. Basic Materials Index became the first sector to actually move to a 52-week low. This was a fairly extraordinary event considering the major averages were still near their 52-week highs. The fact that the sector accounts for only 3% of the S&P 500 helps explain that possibility. However, the sector’s collapse has certainly played a role in the severe weakening of the index’s internals. And currently, the sector finds itself teetering on a very key level of potential support.

We refer quite a bit to Fibonacci Retracement levels as they reflect the market’s tendency to “retrace” market moves in similar increments. We have also mentioned before that, in our view, the strongest Fibonacci signals come when there is a confluence of various such levels in the same vicinity. No chart illustrates this point better than the DJ U.S. Basic Materials Index.

Note how the 4 Fibonacci Retracements drawn from key lows in 2009, 2011, 2012 and 2013 to the 2014 highs, are aligned almost on top of one another. In fact, it makes it difficult to distinguish each of the lines. Here are the levels to which we are referring:

23.6% Fibonacci Retracement of the 2009-2014 Rally  ~301

38.2% Fibonacci Retracement of the 2011-2014 Rally  ~302

50% Fibonacci Retracement of the 2012-2014 Rally  ~300

61.8% Fibonacci Retracement of the 2013-2014 Rally  ~302

Additionally, the 1000-Day (or 200-Week) Simple Moving Average is right in the vicinity as well.

Again, a cluster like this increases the confidence in the validity of the level. It should support prices, at least temporarily. Also, considering this is the first touch of this major level, it should provide support , initially. Interestingly, the index blew through the level (around 300) earlier in the week before recovering it. One might consider this a false breakdown and a springboard to a significant rally. However, we’d simply view it as a test of the support level so far.

How far could the index bounce if this support holds? We are not big on setting targets, but the first level to test would certainly be near 315, which represents the breakdown point below the previous 52-week lows. That would be a 4-5% gain from here and would certainly set up a tough level of resistance for the index.

Should the Fibonacci Retracement cluster around 300 fail to hold the index up, here is the next set of Fibonacci levels that the index would be likely to test (near 266, or 11% lower):

38.2% Fibonacci Retracement of the 2009-2014 Rally  ~265

50% Fibonacci Retracement of the 2011-2014 Rally  ~268

61.8% Fibonacci Retracement of the 2012-2014 Rally  ~266

2013 Lows ~266

Additionally, the 500-Week Simple Moving Average is right in that vicinity as well.

One interesting observation regarding the early-year rally is that, as several readers pointed out, the falling fuel prices served as a tailwind for the chemical companies in the index as it lowered their input costs. That enabled the new highs in the Equal-Weight Index and the XLB. In the recent (or on-going) commodity slump, the basic materials sector has shown no such signs of a rally due to lower input costs. What that means, we are not sure. Perhaps the weakness in the sector’s underlying business is outweighing the benefits accrued via low energy costs. At least, that is how investors are voting.

As mentioned, considering the multiple Fibonacci lines in the area as well as this being the first touch of the area, it should hold, at least temporarily. However, if the level fails, the Dow Jones U.S. Basic Materials Index is likely to visit the next cluster of Fibonacci Retracement levels near 266. Would such a move be a byproduct of an acceleration of the global deflationary trend currently in place? Or would it be a catalyst for a broader market decline? That is yet to be determined. However, such a breakdown would not be welcomed news for a stock market that has already seen its share of bricks removed from the wall.

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More from Dana Lyons, JLFMI and My401kPro.

People often ask us why we rely on objective, quantitative models to identify investment opportunities as opposed to popular theory, forecasts or intuition. One reason is that it assists us in avoiding perception bias. That is, the objective models are able to see conditions as they are rather than how we think they must be given the circumstances. A case in point: with the rout in commodities over the past 6 months, common perception may be that materials stocks are struggling in sympathy. A bias-free quantitative model would tell you that is not the case. In fact, would you believe that a broad collection of materials stocks is actually at an all-time high? Believe it.

As of a few days ago, the Guggenheim Equal Weight Materials ETF (ticker, RTM) did indeed hit an all-time high. The RTM, as its name implies, weights each of its holdings essentially the same, rather than the typical cap-weighted method. This way, the movement of 1 or 2 stocks alone is not likely to dictate the direction of the fund. Rather, a majority of the stocks need to be moving in one direction in order to get the fund going that way. In this case, the majority of materials stocks are rallying soundly, thus placing the ETF at an all-time high, a quite unexpected development given the commodity declines.

The location of the level from which the RTM recently broke out is noteworthy for a few reasons. The prior high point lines up precisely with two key Fibonacci levels:

161.8% Fibonacci Extension of 2007-2009 Decline

38.2% Fibonacci Projection of 2009-2011 Rally

If the breakout is successful, the breaching of these key barriers may provide further, material (no pun intended) upside potential, starting perhaps with the 61.8% Fibonacci Projection of the 2009-2011 rally (near $97, or 11% higher).

Lastly, a look at the sentiment picture for the sector is quite telling. From the terrific www.SentimenTrader.com service, we see that sentiment appears to be perhaps stricken with perception bias. According to SentimenTrader's proprietary models, sentiment on the materials sector, specifically on the popular SPDR Material ETF, XLB, is only just emerging from an extreme bearish condition. Similar extreme bearish levels have led to bottoms in the XLB and powerful rallies. This suggests, perhaps, that there is plenty of room aboard the materials bandwagon before it gets "overbought" or "overcrowded".

So we have a broad materials sector ETF at all-time highs, breaking above key resistance levels. At the same time, we have near-extreme low sentiment toward the sector, thanks likely to subjective perception bias stemming from the bear market in commodities. This is why we use objective, quantitative models in our investment selection. These models can locate opportunities in areas that, due to human nature, we may never even look at. Provided it can hold above the key breakout area, the Equal-Weight Materials ETF, RTM, may represent just such an opportunity.

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"Earthworms" photo by United Nations Development Programme