Market Indicators & Strategy Report August 30, 2015

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Is the Sky Falling? MMI Says No.

Our Major Market Indicators stayed in neutral territory this week, similar to last week. Over the past month the major indexes have retreated between five and six percent. Over that same period since our last report the MMI has been in neutral territory, ending the week at 53.83. A reminder: the MMI index is not considered an arbiter for the next week’s performance, but rather a longer term outlook of the forward nine to twelve months. The S&P 500 ended this past week at 1988.87, down (5.46%) for the past month and (3.4%) year-to-date. Similarly, the tech-stock driven NASDAQ is down (5.85%) for the past month but still up for the year 1.95%! The Dow Jones Industrials are down for the month and year-to-date by (5.54%) and (6.62%), respectively. Below, the weekly graph of our Major Market Indicators shows the trend since May of 2014.

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MARKET SENTIMENT INDICATORS: Neutral

The market sentiment indicators score as neutral. Since we use a mostly contrarian judgment on sentiment; a bullish behavior by market participants registers as bearish. In terms of bullish indicators, the Volatility indicators (VIX and VXN) stood at week’s end at 26.05 and 28.75; implied volatility is high. We score VIX/VXN at greater than 20 as bullish. The Put-Call ratios are a “split decision”. The CBOE ended the week at 78/100, which registers as bullish, while the Put-Call on the S&P 100 was also bearish at 93/100 (we require greater than 125/100 to register this as bullish). The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of only 0.85, also a bullish reading. The short ratio on both the NYSE and the NASDAQ were bullish, at 4.70 and 4.47 days to cover respectively. Finally, the Consensus Index registered bullish (for the first time since we began publishing in May 2014!)  at 46.0%. All these factors were positive contributions to the score of sentiment indicators for this week.

On the bearish side of the ledger, the confidence index, the index of high-grade bonds yield vs. intermediate grade bonds yield (3.81%/4.92%) produces a ratio of 77.4%, indicative of too narrow a quality spread. The TIM Group Market Sentiment indicator stood in the bearish range at 55.4%, and the Market Vane Index at 50.0% is running slightly too optimistically, a further bearish sign. The ARMS index on the NYSE and NASDAQ (0.95 and 0.68) are also bearish.

Overall, half of our market sentiment score weight is in the bullish range, and half in the bearish, so by definition we are calling sentiment neutral in the aggregate. Slightly more bullish is the chart below from Citigroup, indicating panic at their last reading.

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TECHNICAL INDICATORS: Bearish

Our technical indicators score just 1 out of 15 indicator points bullish this week, which while an improvement over the prior week’s 0 out of 15, is still indicative of a market in correction. The only technical indicator we score positive is the ratio of advancing vs. declining volume on the NASDAQ; for the past week there were 1.24 advancers for each decliner.

The remaining technical indicators, unsurprisingly, scored bearish. The advance/decline volume ratio on the NYSE was 1.07, not enough to score bullish. Bearish scoring also came from the ratio of the number of issues advancing vs. declining for the week on both the NYSE and NASDAQ. The 10 day moving average of up vs. down stocks on those two exchanges again scored bearish. The ratio of new highs to new lows was 0.34 and this too was bearish.

We also score a number of indexes vs. their 200 day moving average. All of these indexes were trading below their 200 day by the following percentages: The S&P 500 (4.17%), the NASDAQ Composite (1.73%), the Dow Jones Industrial Average (6.43%), the NYSE Composite (6.02%), the Russell 1000 equal weight ETF (EWRI) (4.83%), and the Russell 2000 equal weight ETF (EWRS) (8.06%).

To sum up the technical picture, almost all indicators are negative, so the technical indicators are bearish.

 

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators are bullish. Money market funds balances are over 11.3% of the market cap of equities, which provides buying power to support stock prices, a bullish score. On the other hand, customer credit balances at brokerages stood at only 28% of margin debt at last reading (July 2015), a low level and a bearish score. In a sharp sell-off, customers either have to post more cash to bring their margin account above the minimum maintenance threshold, or margined stocks will be sold to meet the cash call. This low cash level implies increased risk of customers having to meet margin calls with stock sales rather than posting more cash.

Tipping the balance to the positive was our cumulative market liquidity calculation for the trailing four weeks. Total flows into the market as calculated are registering a bullish inflow. Mutual funds (including ETFs) have seen outflows over the past four weeks, with a net $(20.8) billion pulled out of the market for the four weeks. Offsetting this, the corporate acquisition market is still hot, contributing $64.8 billion of cash flow in the trailing four weeks. We count only the cash component of M&A deals as announced. The big contributors these last four weeks were the acquisition of Partner RE  (PRE) by Exor (EXOSF) for $6.6 billion, Berkshire Hathaway  (BRK.A) buying Precision Cast Parts (PCP) at $32.6 billion, and Southern Companies buying AGL Resources (AGL) for $7.9 billion.

Announced stock buybacks picked up these last four weeks compared to our prior report: $26.5 billion total buyback authorizations were announced vs. the $17.6 billion we reported last month. Significant buyback announcements were made by American International Group ($5 billion), Motorola Solutions ($2.0 billion), Aflac ($2.6 billion), and Sirius XM ($2.0 billion). Stock buybacks have been and continue to be an important source of liquidity to the market.

IPO activity has been zero the last two weeks, since late August is always a slow season. As a result, only $7.7 billion of new market capitalization was added to the market for the trailing four weeks.

The chart below shows the amount of IPO proceeds raised over the past ten years. Since 2014 had the huge Alibaba IPO in September, with nothing similar on the horizon 2015 continues to appear to be a down year after three progressively larger years of IPO proceeds.

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YTD Prior Yr Current Yr % Change
8/31 $40.6 bil $22.3 bil -45.2%

 

Secondary stocks offerings have slowed, with only $5.2 billion in the trailing four weeks. Insider selling pulled $5.8 billion of cash out of investor hands in the past four weeks.

We track cash inflows to domestically focused equity hedge funds on a monthly basis. We calculate cash inflows to domestically focused equity hedge funds at a negative outflow of approximately $(4.8) billion in July. Given the relative secrecy of hedge funds this calculation will always be a rough approximation, but we are applying our methodology on a consistent basis, month-to-month.

Overall, we count up a positive net inflow of liquidity into the domestic market of approximately $47.1 billion for the past four weeks, which is sufficient to warrant a bullish score. Combined with the other factors above we arrive at a bullish view on liquidity.


VALUATION INDICATORS: Neutral

Our valuation indicators rank at a neutral level this week. Our fair value target for the S&P 500 is 2427, representing a 22.0% upside from the close on August 28th.  That upside potential is a bullish indicator in our calculation. The target uses a 20.3x multiple applied to 2015’s estimated operating earnings of 119.44. 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 16.7 times the trailing four quarters operating earnings, compared to an historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 16.7x 2015E and 15.1x 2016E. The upside to the fair value target is sufficient to rate bullish.  So too is the ratio of the S&P’s earnings yield vs. the Single-A 10-year bond yield.

We score the target for the S&P 500 a second time, with a more conservative price target discounted 10% from the prior target. We require a minimum of a 10% upside from the current index price to this second target in order to score the indicator as bullish. The result, 2184, is only 9.8% above the week’s close of 1988.87.  Since this is less than a 10% potential gain, it scores bearish.

There are other bearish indicators.  Compared to GDP the market is at a 33% premium. Small cap stocks, as judged by comparing the T Rowe Price New Horizons Fund to the S&P 500 are not cheap, at a 1.85 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.34x, or the equal-weighted Russell 2000 ETF – 1.01x.

We estimate the total domestic market capitalization is trading at 90.3% of replacement cost of the asset base of non-farm, non-financial corporate businesses. By this metric, our version of Tobin’s q, stocks are cheap. Since this is less than 100% of replacement cost we score this a bullish indicator.

The pullback this past month has cut the valuation metrics for the market, though the S&P 500 is still trading at a premium to its historical average. We attempt with these indicators to discern if there is a case for continued price improvement, despite first impressions which might indicate otherwise. Overall, valuations are neutral, with bullish indicators equal to bearish indicators.

EARNINGS MOMENTUM INDICATORS: Bullish

The MMI score for earnings momentum is bullish this week. The earnings season for the second quarter 2015 (which is almost complete) positive to negative ratio of earnings surprises is 3.21x, a bullish score (we set a high bar for this indicator; since the earnings game system is set up to naturally encourage companies to “beat the street” we require a ratio of at least 3:1 for this indicator to score bullish).

Second quarter 2015 earnings are currently estimated at a growth rate of negative (0.7%) compared to (1.3%) on July 31st, with 490 of the S&P 500 companies having already reported. This incremental improvement vs. the prior month’s estimate is judged bullish in our scoring. However earnings expectations the full years 2015 and 2016 continue to decline: 2015E earnings are now projected by the street at a positive growth rate of 1.0% vs. 1.5% at the end of July. 2016 estimates also have come down to a growth rate 10.6% growth vs. 11.0% at the end of July. In our judgment, a positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish. It’s worth pointing out that we rely on FactSet for these estimates. FactSet differs from Standard and Poors: S&P reports that they calculate street estimates for 2015 at a negative growth rate of (1.2%) based on bottoms-up estimates.

On a PEG ratio (P/E to growth rate) basis S&P earnings still looks this side of cheap, at a PEG of only 2.22 times, compared to a longer term average of 2.58. Looking at small cap stocks, the Russell 2000 trailing P/E ex: negative earnings were 22.3x at 7/31/15, vs. a five year eps growth rate of 11.13%, implying a PEG of 2.01 times.

Please note we compare earnings growth in terms of its change to a recent anchor – July month end in this case. Everyone knows the earnings outlook is not rosy – in fact it’s fair to say we are facing an earnings recession but we score recent changes in earnings expectations because we infer the market is taking cues off of the latest directional change. Thus, overall earnings momentum now scores bullish since two-thirds of our indicators score bullish.

Although expectations are for a negative (0.7%) decline year-over-year in S&P earnings in Q2:15, and only 1.0% growth for all of 2015, the pain is not being doled out evenly. The energy sector is projected to incur a (55.6%) decline in earnings in Q2, and (56.3%) for all of 2015. Industrials are pegged for a (4.7%) decline in Q2, and (1.4%) in the full year 2015. Materials are forecast a decline of (1.0%) in 2015, while consumer staples and utilities carry growth rates for the year of just 1.6% and 1.7% respectively. For Q2:15, Thomson Reuters I/B/E/S calculates earnings growth for the S&P 500 ex: energy would be 8.9%!

MONETARY POLICY: Bullish

Although the Federal Reserve continue to warn the markets it wants to begin raising short term interest rates, it has yet to pull the trigger, and has not raised its Fed Funds target. Current policy is to hold the overnight Fed funds rate down at zero to 25 basis points. The pressure is building, and it

appears we will see a first rate hike before the year is over. It’s painfully obvious a 25 basis point increase in the Fed Funds isn’t all that meaningful in itself, but rather the market may be more focused on the implication there will be many more rate hikes to follow.

Our excess liquidity indicator is bullish at 234 basis points. This means the Fed is providing 2.34% more liquidity than the current nominal GDP growth rate. This figure takes into account the decreased velocity of money in recent periods.  We arrive at this figure by subtracting the annual percent change in velocity from the year over year percent change in M2 money supply. Then we subtract the most recent quarter’s sequential percentage change in nominal GDP. We score this amount of excess liquidity as bullish.

The Treasury yield curve is accommodative to growth. The spread between the ten–year and one-year rates is about 1.79%, a positively sloped yield curve, and we score this bullish.

Junk bonds are pricing at relatively tight yields vs. historical patterns. Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 6.68% this week and the spread vs. 10 year Treasuries stands at 4.50%, and this is bullish, since we judge anything over 4.0% as wide enough to rate bullish.

As shown below, forward inflation expectations have fallen well below 2.0%, which makes us wonder why the Federal Reserve would raise rates now?

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CONCLUSION: Neutral

In summary, our MMI score sits in neutral territory at the end of last week.  Liquidity, earnings momentum and monetary policy indicators scored bullish, while technical indicators score bearish and investor sentiment and valuation indicators are neutral.

 

Greg Eisen

Singular Research Analyst and Market Strategist