MMI Says Stay Bullish
Our Major market Indicators turned bullish in the week ended August 8th, which coincided with the end of the market averages pullback (see our note on that date, when we upgraded to bullish). At that date the S&P 500 was 1931.59. The index closed the month on Friday August 29th at 2003.37, a gain of 3.7%, which by the way is a record high! This week the MMI index rose to 67.83, a clearly bullish signal. So we continue to maintain a bullish posture. As we enter September we find this comforting as we expect an onslaught of voices reminding us September has historically been the worst performing month of the calendar year.
We note the continued bad news in world affairs (multiple wars, ISIS, etc.) did not appear to have any effect on the domestic equity market.
Below, the weekly graph of our Major Market Indicators shows the improved reading in the most recent week, well above our 60 point benchmark for bullishness.
MARKET SENTIMENT INDICATORS: Bearish
Market sentiment indicators remain slightly in the bearish camp, with a small majority of our indicators below a bullish benchmark. We derive
positive implications from Put/Call ratio S&P 100. Likewise, the short interest ratio of days to cover remains high, an encouraging sign for us, at
4.90 and 4.55 days for the NYSE and NASDAQ respectively. Framing it with a contrarian perspective, we see it fuel for market gains if/when those
positions are unwound. Likewise, we find constructive, in a contrarian sense, the yield spread between intermediate grade bonds and high grade
On the negative side, the VIX/VXN implied volatilities are at 11.98/12.71, a level which does not by itself imply fuel for market gains based on a potential reversal of sentiment, The implied volatility would have to sit much higher to be a benefit in itself. The same reasoning applies to the ARMS index, which sat at 0.92 and 0.69 for the NYSE and NASDAQ respectively. We view the Arms Index (TRIN) in a contrarian sense; both indexes would need to rise to an oversold position for us to rate them as a bullish indicator. Last month the AAII Index stood at a dead even 1.0 ratio (31% bullish/31% bearish), but bullish sentiment has taken hold, with bulls out numbering bears 51.9% to 19.2%. The chart below from Citigroup indicates we are closer to a euphoric sentiment than panic; we would be constructive if the indicators were more skewed towards the panic side of the equation.
TECHNICAL INDICATORS: Bullish
One month ago our technical indicators were in the bearish camp. Presently, they are now scoring extremely bullish. The ratio of new 52 week highs to new lows rose to a ratio of 4.70:1. This is supported by volume figures. The ratio of weekly advancing vs. declining volume for the NYSE was 1.49, while the NASDAQ A/D volume was an even better 1.62 times. Both these amounts are bullish. The ten day ratio of moving average new highs vs. new lows was bullish for both markets; NYSE was at 1.63 and the NASDAQ at 1.74. Finally, last week’s ratio of advancing to declining stocks was strong at 2.05 for the NYSE. The NASDAQ reading was not quite bullish in our interpretation, standing at a 1.57 ratio of advancing to declining stocks.
The major indexes are all above their 200 day moving averages. Even the equal weight Russell 2000 ETF (EWRS) was above its 200 day moving average by 1.8%; despite the reputation the small cap universe has lagged large caps of late (which is true). Overall, the technical picture looks very strong.
LIQUIDITY INDICATORS: Bullish
August is stereotyped as the month bankers and CEOs take vacations. This past month was true to form, as capital transactions slowed down the past four weeks. The IPO machine ground to a halt, with the total market value of new companies coming public at under $3 billion. Secondary offerings also slowed, to around $1.6 billion. This low level of dilution in the marketplace for stocks contributed to bringing the MMI liquidity calculation back into the bullish camp. Also muted was the level of net insider selling, which we count at under $3 billion for the period.
Although IPOs slowed in the month, it should pick up after Labor Day, and late September will probably see the largest deal to ever hit the market – Alibaba. The Chinese e-commerce giant is expected to raise at least $20 billion.
After a few weeks of outflows, mutual funds and ETFs have returned to a solid positive trend of inflows, at over $7 billion between the two of them this past month. New cash takeovers announced bounced back strongly, thanks to recent deals including Roche buying Intermune and Burger King announcing the Tim Hortons acquisition, both of which are in the $8 billion (cash portion) range. Also, despite it being a slow season, around $16 billion of stock buyback announcements crossed the tape in the same period. Domestic equity focused hedge funds received modest inflows in July (the most recent month we have available).
Put it all together, and we count up a net increase of liquidity to the domestic market of approximately $38 billion for the past four weeks, which is bullish in our judgment.
VALUATION INDICATORS: Bearish
Our fair value target for the S&P 500 is 2286, up 14.1% from 2003.37, the close on August 29th. The target uses a 19.1x multiple applied to 2014’s estimated operating earnings of 119.77. Our fair value target multiple is arrived at using an intermediate grade bond yield rather than the ten year Treasury bond, due to the artificiality created by Quantitative Easing. The S&P 500 is trading at 17.65 times the trailing four quarters operating earnings. This is above the historical norm of 15.5 times operating earnings. Also, bear in mind that if the multiple does not expand, stock index prices can gain just on the earnings growth in the future.
Total domestic market capitalization is at $24.24 trillion. Excluding financial services, we calculate market capitalization is 3.3% greater than replacement cost of the asset base of non-farm, non-financial corporate businesses. By this metric, our calculation of Tobin’s q, stocks are slightly expensive. However, compared to GDP the market is at a 40% premium, which is significantly high. This past week the second estimate of GDP for the second quarter of 2014 was released. The initial estimate of +4.0% was increased to 4.2% in the revision.
Looked at on a forward basis, the S&P 500 is trading well above the 10-year average, as seen below.
Forward 12M P/E Ratio: 10-Year
The ratio of the S&P 500 earnings yield to the Single A corporate bond yield is high at 1.54 vs. the historical record, implying stocks could run
further, but bond yields have been so compromised by the Central Bank’s easing that this may be a misleading metric. This ratio stood at 1.17 in
February of 2007, and 1.15 in March of 2009.
Small cap stocks, using the T Rowe Price small-cap growth fund as a proxy, are not necessarily cheap yet, but their relative valuation has come
down in the past month, to 1.61 vs. 1.75 times the valuation of the S&P 500, closer to the top of its historical range of 1.2 to 2.0 times.
Overall, valuations remain above average, as pictured above, and the data points accrue to a bearish result. This is a conclusion which is echoed by others so often that it has become conventional wisdom.
EARNINGS MOMENTUM INDICATORS: Bullish
Approximately 99% of companies in the S&P 500 have reported, and second quarter 2014 earnings growth of 7.7% was well ahead of expectations of 5.1%. Positive earnings surprises exceeded negative surprises by at 3.1/1 ratio. Revenue growth came in at 4.4%. Double digit earnings growth was achieved in the Telecom Services, Health Care, Materials and Consumer Discretionary sectors.
Despite the impressive earnings “beat” in Q2, growth expectations have come down for the third quarter, now standing at a positive 6.5% compared to 8.9% as at June 30th. The revision ratio of upward to downward revisions stands at 0.36. Yet calendar year 2014’s growth expectation stands in at 7.4%, down from 7.8% a month ago but up from 7.4% at June 30. Expectations for 2015 are at 11.5% growth, down from 11.6% a month ago but up from 11.4% at June 30. These growth expectations are consistent with this week’s GDP release.
On a PEG ratio basis, the S&P 500 is trading at a PEG ratio of 2.2 (trailing operating earnings), well under the historic average of 2.58 times, a positive sign.
The following chart shows the sector level earnings surprises for the second quarter. Health care is not only one of the best growing sectors this quarter, but it’s held the most upside surprises upon earnings release. Telecom services, which carry the best growth this quarter, +20.3%, held a very low surprise factor.
MONETARY POLICY: Bullish
The Federal Reserve continues to taper buying new securities, but they are still buying more bonds at present. Current policy is to hold the overnight Fed funds rate down at zero to 25 basis points. We don’t believe the Fed funds rate target will change anytime soon. At the Jackson Hole conference in August, Janet Yellen quoted the most recent Fed statement, “that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase programs ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” This tells us the Fed’s current expectation is to finish the tapering as planned, and then sit and watch, because of the well-publicized slack in the labor market. Yellen went on to issue the caveat that if the labor market improves faster than anticipated, or if inflation rises more rapidly than anticipated, then the federal funds target rate would be increased faster than the Fed expects. Yellen spent most of the remainder of her speech discussing the mechanics of evaluating labor market slack.
We say all the above because just as George Orwell said “All animals are equal, but some animals are more equal than others”, many investors believe the Fed’s Quantitative Easing trumps all other market factors. Our MMI analysis is predicated on the assumption this is not so, but we want to address the potential timing of fed-funds rate increases in anticipation of the knee-jerk reaction which may accompany such increases.
Our excess liquidity indicator is bullish at 276 basis points. This is evidence the Fed is still in easy money mode, providing two-and-three-quarter percent more liquidity than the current nominal GDP growth rate. This figure takes into account the decreased velocity of money in recent periods.
The spread between one year T-bills (constant maturity) and 10 year T-bonds is 223 basis points, down from 245 one month ago. Although this is an attractive spread, the absolute level of the 10 year at 234 basis points implies very low inflation expectations. The 10 Year yield is down 22 basis points from 256 just one month ago. This certainly isn’t an inflation warning! At the other end of the quality spectrum, high yield bonds spreads contracted over the last month to 252 basis points from 287 basis points.
High yield spreads widened very quickly in the July/August sell-off, but have acted stronger subsequently. Still, junk bonds are not cheap.
The graph below depicts the annual percentage change in M2 money supply vs. the velocity of M2, on quarterly basis. Since the mid-1990s
velocity has been on a downward trajectory, and money supply growth has trended positively. Since GDP = Velocity X Money Supply, and since the
velocity has been decreasing, increased money supply has been the prescription for maintaining GDP growth. As long as the machine we call
the economy continues to sputter at lower and lower velocity, we expect the Fed to continue to make money available on easy terms, since
maintaining consistent economic growth is key to fulfilling one of its dual mandates – fostering maximum sustainable employment.
In summary, our MMI score is solidly in the bullish zone, at 67.83. The bullish components in the MMI are the technical, liquidity, earnings momentum, and monetary policy categories. In contrast, the valuation and investor sentiment categories tell a bearish story. At the present reading, we believe there is no reason to fear a “September curse”. We maintain a bullish posture.
Singular Research Analyst and Market Strategist