Market Indicators & Strategy Report August 4, 2015

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MMI Imply A Bullish Outlook

Our Major Market Indicators rose back into bullish territory this week. Over recent weeks the indicators have seesawed back and forth between neutral and bullish, and this week rose to 63.67 from the prior week’s 58.50. The S&P 500 ended this past week at 2103.84, up 2.18% year-to-date. Similarly, the tech-stock driven NASDAQ is up 8.28% and the Russell

2000 is up 2.82%. Notably, the Dow Jones Industrials are down year-to-date by (1.14%). Below, the weekly graph of our Major Market Indicators shows the trend since May of 2014.

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MARKET SENTIMENT INDICATORS: Bullish

The market sentiment indicators score as bullish. Since we use a mostly contrarian judgment on sentiment; a bullish behavior by market participants registers as bearish. The Put-Call ratio on the CBOE ended the week at 63/100, which registers as bullish, while the Put-Call on the S&P 100 was also bullish at 136/100. The ARMS index on the NYSE and NASDAQ (1.85 and 1.55) are also bullish. The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of only 0.52, also a bullish reading. Finally, the short ratio on both the NYSE and the NASDAQ were bullish, at 4.80 and 4.34 days to cover respectively. All these factors were positive contributions to the score of sentiment indicators for this week.

On the bearish side of the ledger, the Volatility indicators (VIX and VXN) stood at week’s end at 12.12 and 14.59; implied volatility is low. We score VIX/VXN at greater than 20 as bullish. So we read volatility as bearish for now. The confidence index, the index of high-grade bonds yield vs. intermediate grade bonds yield (3.79%/4.87%) produces a ratio of 77.8%, indicative of too narrow a quality spread. The TIM Group Market Sentiment

indicator stood in the bearish range at 50.2%, the Consensus Index and the Market Vane Index (59% and 61% respectively) are both running too optimistically, a further bearish sign.

Overall, exactly seven-twelfths of our market sentiment score weight is in the bullish range, so by definition we are calling sentiment bullish in the aggregate.

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TECHNICAL INDICATORS: Bearish

Our technical indicators score 4 out of 15 indicator points bullish this week, which while low is an improvement over the prior week’s 2 out of 15. The advance/decline volume ratios on the NYSE and the NASDAQ are both in the bullish range, at 1.30 and 1.13, respectively. Bullish scoring also came from some the indexes we score trading above their 200 day moving average. The S&P 500 and the NASDAQ Composite closed the week 1.72% and 5.33% their respective 200 day moving averages, a bullish sign.

The remainder of the technical indicators registered a bearish reading. The Dow Jones Industrial Average, the NYSE Composite, the Russell 1000 equal weight ETF (EWRI) and the Russell 2000 equal weight ETF (EWRS) all ended the week below their respective 200 day moving average.  Also,  the ratio of new highs to new lows was 0.34; we tracked bearish readings

from the advance/decline ratio of the number of stock issues traded, and in the week the NYSE ratio was 1.85 (2,102 issues advanced and 1,335 declined), and on the NASDAQ the ratio was 1.15 (1,591 issues advanced and 1,383 declined). We score the 10 day moving average of up volume vs. down volume in the NYSE, and this stood at a 0.80 ratio, while the same indicator for the NASDAQ was a 1.16 ratio. To sum up the technical picture, the weight for the negatives outweighed the positives, so technical indicators are bearish.

 

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators are bullish. Money market funds balances are over 10.5% 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 27% of margin debt at last reading (June 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 fnds (including ETFs) have seen inflows over the past four weeks, with a net $10.1 billion contributed for the four weeks. The corporate acquisition market contributed $51.5 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 Receptos (RCPT) by Celgene (CELG) for $7.3 billion, Anthem (ANTM) buying Cigna (CI) at $27.0 billion as part of the continuing merger mania in the health care sector, Meiji Yasuda Life Insurance of Japan buying Stancorp Financial (SFG) for $4.9 billion, and Solvay, a European chemical company buying Cytec (CYT).
Announced stock buybacks have slowed some these last four weeks compared to our prior report: $17.6 billion total buyback authorizations were announced vs. the $28.7 billion we reported last month. Significant buyback announcements were made by Valero Energy ($2.5 billion), Corning ($2.0 billion), Starbucks (50 million shares, or approximately $2.9 billion), and Praxair ($1.5 billion). Stock buybacks have been and continue to be an important source of liquidity to the market.

IPO activity has slowed down in July, contrary to what we would expect (we’re all taking vacation in August, right?), with only $13.5 billion of new market capitalization added to the market for the trailing four weeks. After this slower than average July, the first week of August has ten IPOs scheduled, featuring Planet Fitness.

The chart below shows the amount of IPO proceeds raised over the past ten years. $20.9 billion has been raised so far YTD, vs. $39.7 billion in the prior year comparable period. 2015 is shaping up to be a down year after three progressively larger years of IPO proceeds.

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YTD Prior Yr Current Yr % Change
8/3 $39.7 bil $20.9 bil -47.4%

 

Secondary stocks offerings have slowed, with only $6.4 billion in the trailing four weeks.  Insider selling pulled $3.0 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 positive inflow of approximately $0.07 billion in June. 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 $56.4 billion for the past four weeks, which is more than 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 2460, representing a 16.9% upside from the close on July 31st.  That upside potential is a bullish indicator in our calculation. The target uses a 20.5x multiple applied to 2015’s estimated operating earnings of 119.81. 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 17.7 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 17.6x 2015E and 15.8x 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, 2214, is only 5.2% above the week’s close of 2103.84.  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 41% 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 1.75 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.28x, or the equal-weighted Russell 2000 ETF – 1.0x.

We estimate the total domestic market capitalization is trading at 95.8% 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.

While most commentators decry how expensive the market is, no one wants to abandon stocks early at the cost of missing an ongoing rally. 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 positive to negative ratio of earnings surprises is 3.32x, 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 (1.3%) compared to (4.5%) on June 30th, with 354 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 1.5% vs. 1.8% at the end of June. 2016 estimates also have come down to a growth rate 11.0% growth vs. 11.9% at the end of June. In our judgment, a positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish.

On a PEG ratio (P/E to growth rate) basis S&P earnings still looks this side of cheap, at a PEG of only 2.35 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 22.6x at 6/30/15, vs. a five year eps growth rate of 11.47%, implying a PEG of 1.97 times.

Please note we compare earnings growth in terms of its change to a recent anchor – June month end in this case. Everyone knows the earnings outlook is not rosy, 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 (1.3%) decline year-over-year in S&P earnings in Q2:15, the pain is not being doled out evenly. The chart below, courtesy of FactSet, shows the divergence between companies which get the majority of their profits from the U.S., vs. those which derive the majority outside the U.S., excluding the energy sector. This sharp divergence is reflective of the strong gains the U.S. dollar has made against competitive currencies of late. Thus, outside of the energy sector, companies deriving a majority of their sales from inside the U.S. will show a healthy earnings growth rate, while more internationally focused firms will be challenged to just breakeven.  In total, the S&P 500 ex-energy can be expected to grind out 4.1% earnings growth.

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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.

Our excess liquidity indicator is bullish at 235 basis points, down from 398 b.p. last month. This means the Fed is providing 2.35% 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 1.85%, 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 6.42% this week and the spread vs. 10 year Treasuries stands at 4.24%, and this is bullish, since we judge anything over 4.0% as wide enough to rate bullish.

As shown below, forward inflation expectations have moved up, although they are below year-ago levels.

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CONCLUSION: Bullish

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

Greg Eisen

 

Singular Research Analyst and Market Strategist