Three Little Data Extracts and a Small Post-Christmas Suprise

Haven't posted anything in a while, namely because there wasn't much that was worthy of thought since August (and graduate school tends to be massively distracting at times). My general trading philosophy is to only purchase/liquidate at market extremes- only when the data shows a clear reversal of trend. I have not a clue as to how to profit from equity short-run (less than a 90 days hold period) buy/sell transactions during the in-between phases of a market cycle. Long-run investing is a different matter altogether.

Please see the above three-row chart. Today's market (S&P500) is characterized by moderately high investor sentiment levels, as made evident by the II Survey of 2.77 Bulls/Bears and the VIX sustaining >17% below its 50 day moving average. The CBOE equity Put/Call 10 day MA is holding below .54, which is normally indicative of pollyan-ish expectations of earnings growth rates. RSI is at 66, and show a strong negative divergence even as the SPX advances to new intermediate highs (ie. the index is overbought and the rally is losing steam).

Why does any of this matter? In 2004, 2005, and 2009 we saw a similar alignment of these four indicators at similar levels. In those three observation periods, the SPX pulled back roughly 5% over the next 64 trading days. Of note, in 2005 the market was at 1235 (today we are at 1254.60), and gained less than 1%, only to give up its advance to finish at 1200 three months subsequent. If history is any guide (yes I'm aware that three observations does not make for good market science- unfortunately the CBOE does not freely public Equity Put/Call ratios pre-2003), then investors/speculators should prepare themselves for a soon-delivered market correction phase.

Since the SP500 has made new highs, and established strong foundational resistance at the 1040 level, matched with extremely accomodative monetary policy, I do not expect a retreat to below 1100. Yes, the market is generally over-valued, but valuations determine long run price changes, not short run deviations. Also, the market may advance to 1300 in the coming weeks, but as stated herein- such an advance may proceed no further than 1300 without touching back on the 1200 level. My crystal ball has spoken.

64 Day Minimum: 1190
64 Day Maximum: 1300

How shall we then speculate? What shall we then fear?

Recently a friend picked my brain on a few of the prevalent issues of the day that are plaguing most capital market traders (at least one would hope they would be bothered by these issues). These are merely only passing thoughts – at the very least please use them as a guide in shaping your own philosophy pertaining to the future direction of the markets…

[Asked a general question about the broad maco-economic ‘picture’]

My general view is that we are in the midst of a "U" shaped recovery that usually follows a post debt bubble, credit-contraction induced recession. It is my view that the 2007-2009 recession is unlike any recession post WWII and therefore should be compared to the depression era of the 1930's and of selected decades in the 1800's. What we are dealing with now is a generational shift (boomers retiring) and a fundamental reshaping of our societies' appetite for debt and savings.


[Bottom line: do you believe the bottom is falling out and the market is going to go much, much lower?]

Odds of a deeper correction remain elevated: market is somewhat over-valued and not over-sold:

Consensus 2011 S&P 500 EPS estimate ($96.00) – at a 12x multiple this gives a fair value of the S&P at 1152. However, this general EPS estimate is based on the premise that sales growth will be robust and profit margins will expand or at least remain stable. Presently, S&P 500 profit margins remain near an all-time high and are likely an anomaly caused by one-time events related to inventory liquidation. Also leading indicators are flattening out and in the case of the ECRI leading index are actually toppling over. The ECRI leading growth index recently crossed below -10%, which in its over 30 year history has always signaled an ensuing recession (However I’m not convinced yet that the odds of a double dip are 100% as this indicator may be skewed by recent statistical volatility). If we assume that sales (as a function of GDP growth) remain at best stagnant (say H2 2010 GDP growth of below 1.5%) and that profit margins weaken, we can safely say that 2010 and 2011 EPS targets will not hold on the upside (ie. earnings will shock to the downside). In other words, 2011 earnings of $80 per share seems a more likely scenario. This would justify an S&P500 fair value of 960. (PE ratio of 12 times $80 2011 EPS). Of course maybe something far worse develops and the global economy goes down in a deflationary tailspin (or far better?).

Technical picture of the S&P500: momentum and breadth (% of index components above 50 day moving averages) indicators are not generating buy signals. Also, investor sentiment is to some extent pessimistic but certainly not excessively bearish. Ideally you would want to buy into the equity markets when negative emotions are ruling the day.

[Do you see deflation for the near and mid-term as the primary worry?]

Near & Mid-term: low inflation or deflation

2+ years: possibility of moderate/high inflation as the velocity of money recovers
A finance professor once defined for my class what deflation is: “Too few dollars chasing too many goods and services”. To me the convergence of continuing problems in housing (over-supply of listings and foreclosures, tight credit markets)), unemployment (rising unemployment claims, expanding unemployment rate), deleveraging (how long can a total debt to GDP ratio of 375% be sustained?) and a stagnant recovery (H2 2010 GDP growth below 1.5%) seem to satisfy the necessary conditional elements of deflation well. Adding further insult to injury are Ben Bernanke’s recent doubts about the recovery and his intentions of resuming quantitative easing (by buying long-term treasury bonds). Why would the Federal Reserve feel the need to take such dramatic measures if there was no imminent threat of price deflation?

[Do you agree with the pros I’m reading that bonds are the way to go?]

[Do you see that as a trend for bonds for the immediate future?]

I would maintain holdings of medium to long term ([non-government] - the 10 year treasury at 2.57% is not a compelling long term yield) bonds in the interim if we agree with the idea that deflation or low inflation will persist for at least the next 12-18 months. It’s my intuitive sense that market participants in general are still holding on to the idea that inflation (and inflation expectations) will remain the dominant driving force of yields. What might lead to appreciation of longer-maturity (7+ years) bonds is the continued realization by market participants that the economic malaise will persist for years, thereby requiring the Fed to hold Funds rate at zero for an extended period. (Many traders calculate the intrinsic value of a bond based on the actual short term T-bill rate, expectations of the rate in future quarters, and other factors [default risk]). Currently, the market consensus estimates that the Fed will remain on hold until Q2 2011. Of course, market participants today are concerned that yields are already low and that trying to extract more gains from current levels is like trying to “pick up pennies in front of a steamroller” (cliché). It might be worthwhile/interesting to analyze bond trader sentiment in order to quantify the underlying behavioral framework of this market. Data points for sentiment might include Put/Call ratios, Volume/Price Momentum, investor surveys, and hedge/mutual fund allocations.

Chasing the Wind

What in the world is going on in the U.S. equity markets? Wish I could look into my crystall ball and tell you what I see, but have I neither such a device nor the courage to conjure up a knowledgable yet mis-guided explaination. However, I will share with you my thoughts that are both un-reliable and unsophisticated (OK I'm being too hard on myself; there just might be some value in this short article). My sincerest apologies for waiting so long to write another post. I was waiting for the drama to unfold before spoiling it for everyone (or frankly that I had nothing of value to share).

A.K.A. “Alphabet Soup”:
· Percentage of component stocks of the S&P500 above their 50 day MA: 5.21%
· Put/Call (Equity 20 MA): .66
· Put/Call (Index 20 MA):1.48
· Put/Call (Total 20 MA): 1.01
· ECRI Growth: -6.9%
· ECRI Coincident: +3.1%
· Shiller PE: 19.99
· Slope of Yield Curve (10 yr minus 3 month T-bill): 2.76
· 50 day MA about to cross under the 200 MA
· Beginnings of a “head and shoulders” formation- recent failed test of 1115 and a corresponding new low that exhibited stronger selling conviction
· % of S&P500 components with an RSI reading below 30: 15.3% (vs. a reading of 27% which typically marks market rallying points)
· Vix vs. its 50 and 20 day MA: at moderate levels, yet still not indicating an excess of pessimism
· Investor’s Intelligence Bull/Bear ratio: 1.32 (which is low, however a large number of “bullish” advisors/traders remain. Ideally I would like to see this number fall below 1 to prove that enthusiasm has been “washed out” of the street.)
· OEX put/call ratio: .76 (This ratio is often used as a metric to measure sentiment levels of sophisticated options traders. Many would say this is helpful in determining which side of the trade the “smart money” is on. In this case, the sophisticated investor remains constructively optimistic about a pending rally. However, readings below .5 typically signal a rapid reversal in market direction.)

Conclusion:
Due to a wide divergence in coincident and leading indicators, it is becoming increasingly likely that a dramatic slowdown in the broad economy is underway. The average American remains underemployed, over spent, and clueless about the once in a century structural changes to our system that are ensuing. The baby boomers’ are approaching retirement, debt levels are still astronomical, and fiscal and monetary policy is reaching its limits. In addition, Wall Street continues to gaze through the crystal ball of mean-reverting forecasting models that utilize only recent data (even data going back to 1950 is not sufficient; some prognosticators encourage analyzing the “Long Recession” of the late 1800’s). Complicating this ambivalence to sound analysis is the reality that the S&P500 remains overvalued on a historical business cycle adjusted as well as a traditional DCF basis (as espoused by the talented investor Jeremy Grantham). Furthermore, if you match the persisting unjustified bullishness of analysts and market participants with the over-valued and still-yet-to-be oversold nature of the S&P’s recent price action you will discover that “the party ain’t over yet”. I would wait for the drunks to spill out of club before trying to get back in for act II of the “recovery rally”.

September target: a failed test of 1220 (implying a strong rally from current levels and a persisting bear or sideways market [dead cat bounce or rubber-band effect]. I’ll post another update before September sharing my revised thoughts/flawed foresight)

July minimum target: 960 (a return to fair value on the standard and poor’s index)

Running to the other side of the sinking ship...

Fire in the Heavens

Market Stats as of 5/20/2010 (SP500 at 1081 as of 12:55 EST):

• Slow Stochastic: 42, %K below %D line (A BUY signal is issued by this indicator when the %K line is below 20 and crosses above the %D line)
  
• RSI: 37
  
• Advance/Decline Oscillator: approaching a “BUY” signal – still looks like the market selloff could continue for several more days
  
• Conference Board Leading Indicators: have declined slightly, looks as if it they have reached an unsustainable peak
  
• ECRI Leading: declined month over month; on a YoY basis has been losing momentum
  
• ECRI Coincident: growing at a very meager pace (does not reflect a rapid “V” shaped recovery)
  
• Shiller 10 Year PE: Above 21, still is describing a fairly to over-valued market environment
  
• Vix: 42, fear is in the air (this is an encouraging sign for contrarians looking to make some purchases)
  
• Investor’s Intelligence: 1.7, sentiment is becoming more realistic yet has not become exceptionally bearish
  
• 21 Day Put/Call Ratio Moving Average (Equities): approaching over-sold levels yet still not suggesting that sentiment is overly pessimistic.

Conclusion:

Weak Buy/Neutral at SP500 1080 based upon current weakness in technicals and more realism in sentiment measures (Vix at 42 is an encouraging sign). It might be wise to make small purchases (25% of cash) of undervalued high quality ETFs in the Energy and Health Services sectors (both of these industries have not rallied as much or become as over-valued as the general market). However, based upon the deteriorating fundamental picture (Stimulus unwinding, leading growth declining or stagnating, and EPS likely to print below expectations) I remain cautious and concerned about more selling pressure. If the SP500 index falls to 1020 in the next several days and is confirmed by sentiment indicators I would consider upgrading the “Weak Buy” signal to a “Mildly Moderate” one (Not "strong" due to the high 10 Year PE and other weak fundamental data points). If however the SP500 does not test the depths as I hope, I will still remain constructive about the long term outlook if sentiment becomes more "depressed and gloomy".

10 Day Target: 1020
September target: index to attempt another test at 1210

S&P 1100?

S&P 1100? Not an outlandish idea. My thoughts on the matter:

· Advance/Decline Oscillator: Issued sell signal 2 months ago (2 month lag typical, conclusion: correction imminent)

· Slow Stochastic Oscillator: At elevated levels, %K line below %D and recent cross under 80 line (technical sell signal)

· RSI: 58, recently topped out near 78 (sell signal)

· Shiller 10 Year PE: > 22, historical average is 16. According to historical data the expected annualized return for the S&P500 now stands at less than 5%

· 20 day average of the CBOE Equity Put/Call ratio: ~.47 (an extreme bearish contrarian statistical outlier)

· Investor’s Intelligence Bull/Bear ratio: 3.0 (high outlier- excessive market optimism)

· VIX: 19.9, rising above short term moving averages, symptomatic of market complacency

· Market Neutral Hedge Fund sentiment at high bullish levels:

It appears that when Market Neutral Strategy hedge funds are net sellers (< -50%) the market usually follows suit with a rally, and conversely when they are net long (> +50%) the market usually corrects. [This statistic may prove to be very helpful when deriving market timing strategies.] According to this chart we are facing the risk of a mild to moderate correction. (See chart below)

· 2010 and 2011 consensus Year over Year EPS earnings estimate growth rates both exceed 20%. This has never occurred in the history of the SP500 index. Therefore, market analysts’ forward valuation metrics are likely overly optimistic and off base. In other words, because earnings expectations are so high, companies will likely meet or disappoint in respect to earnings hurdle rates in future quarters.

Based upon these indicators I issue an imminent SELL rating on the S&P500 with an expected downward price correction of (-7%) from today’s levels. In summary, this conclusion is justified by the convergence of factors related to the over-valued, technically over-bought, and excessively optimistic nature of the current market environment.

Another Leg Down to 1050?

Case for 1050 on the S&P 500 within 30 days:

• Shiller PE now over 20 (historical average is approximately 16)
  
• Bull/Bear Ratio (Investor's Intelligence) elevated and trending lower (1.8)
• VIX below 18 (suggesting complacency and that volatility is likely to increase greatly in the medium term)
• RSI > 65 and Slow Stoch %K > 90 - Suggests that price momentum is near its short term upper limits
• NYSE Up/Down volume ratio near its upper overbought threshold
• SP500 grazing by its upper bollinger band (also bollinger bands are narrow suggesting an increase in volatility [a breakout in one direction]
• Yield curve likely to flatten somewhat over the next quarter (10 yr - 3 mo Treasury bonds) as the Federal Reserve becomes more hawkish with monetary policy. The wrapping up of ZIRP and excess stimulus may prove to be a pivotal catalyst that realigns expectations to more reasonable levels amongst the consensus of market participants.
  
• Expectations for 2010 and 2011 earnings are optimistic- Has the SP500 ever eked out a 20% year over year gain in earnings over two consecutive years? Even if we have a stellar year in 2010 earnings, expectations for 2011 may be a dead-weight on future price performance. This is a signal to me that the market may have "gotten ahead of itself"
• ECRI Leading growth slowing & ECRI Coincident quite weak
  

Summary

Given the above adverse elements I issue a moderate sell rating on the SP500. Overall, I see a risk of at least a 5% correction (with greater than 50% odds of -8.5%) over the next 30 trading days. However, it should be noted that I expect economic growth for 2010 to be trending higher and for SP500 earnings to gain at least 15% for the year.

Next 30 trading days target: 1050
End of year target: 1240