Market Indicators & Strategy Report Dec. 7, 2014

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MMI Remains in the Neutral Range

Our Major Market Indicators fell slightly this week, to 55.26 from 57.33, still in the neutral zone. Major index performance was mixed, with the S&P 500 index up 0.4% this past week ended Friday to 2075.37, while the NASDAQ fell to 4780.75 from 4791.63, a loss of 0.23% and the Dow Jones Industrials gained 0.73%. Since bottoming at 1820.66 on October 15th the S&P has gained 14.0%. Below, the weekly graph of our Major Market Indicators shows the trend over the last few months. This week we made one small change to our methodology for scoring earnings momentum. Please see the earnings momentum category below.

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MARKET SENTIMENT INDICATORS: Bearish

The market sentiment indicators fell to a 33% score from 42% in the prior week. Much of our scoring is based on a contrarian judgment. The VIX and
VXN implied volatilities fell slightly this week, with the VIX ending the week at 11.82 vs. 13.33 and the VXN at 14.37 vs. 14.74. Put/Call ratios are mixed, with the CBOE ratio at 61/100, just barely bullish, while the S&P 100 is out of the bullish zone at 107/100. The ARMS Index (TRIN) on the
NYSE fell out of the bullish range this week, down to 1.14 vs. 1.51 in the prior week, accounting for the change in our sentiment score. The ratio of bullish to bearish individual investors in the weekly AAII investor sentiment continues to track high, at 1.65x (42.7% bullish to 25.9% bearish). Also, the ratio of yield on high-grade vs. intermediate grade bonds is running too tight, a bearish sign. November 14th short interest ratios remain at bullish levels, with the NYSE short ratio rising to 4.50 days vs. 4.10 at the prior report. The NASDAQ short interest ratio also rose, to 4.36 days from 3.96 days. In all, just one-third of our sentiment indicators scored bullish, leaving the sector bearish in total.

TECHNICAL INDICATORS: Bearish

Technical indicators this week fell into bearish territory with only 40% of our indicators bullish. The ratio of new highs to new lows fell this week to 1.18x vs. 2.23x in the prior week. The ratio of advancing to declining volume on the NASDAQ fell to 1.03 x. These two indicators account for the decrease in the technical indicator score for this past week. Maintaining a bullish technical picture is the present level of the major indexes above their 200 day moving average. The S&P 500, DJIA, NASDAQ composite and Russell 1000 equal weight ETF are all above their 200 day moving average, helping to maintain our bullish posture for this group of indicators. On the downside, the equal weight ETF tracking the Russell 2000 continues to trade just a bit below its 200 day moving average.

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators remained bullish this week. Mutual fund flows were muted this week at only $1.6 billion. Our trailing four week total of fund inflows was $19.4 billion. The corporate acquisition market was slow this week, with the largest deals at only $3.5 billion: Otsuka Holdings Co. of Japan acquiring Avanir Pharmaceuticals. Announced stock buybacks rose to $13.2 billion for the week and $44.3 billion on a trailing four week basis. The biggest buybacks announced came from MasterCard ($3.75 billion) and Northrop Grumman ($3 billion).

The IPO market was sleepy this week, registering only one deal for a little over $100 million of market value added to the markets. (Four week total = $17.9 billion). Secondary stocks offerings were a bit more active, adding $3.6 billion for the week. Insiders sold a net $6.3 billion of stock for the trailing four weeks.  Overall, we count up a net positive increase of liquidity to the domestic market of approximately $82.3 billion for the past four weeks, which is bullish.

VALUATION INDICATORS: Neutral

Our valuation indicators score did not change this week. Our fair value target for the S&P 500 is 2583, up 24.5% from 2075.37, the close on December 5th. The target uses a 21.7x multiple applied to 2014’s estimated operating earnings of 119.09. 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 17.8 times the trailing four quarters operating earnings. This is above an historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 17.4x 2014E and 16.0X 2015E.

FactSet computes a forward P/E on the forward 12-months at 16.2X based on Thursday’s (12/4/14) close on the S&P 500. This P/E is above the 5-year average (13.6x), 10-year average (14.1x) and 15-year average (16.1x). However the 15 year average includes the tail end of the internet bubble valuations. However, the forward P/E ratio is at its highest level since 2005.

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We use other metrics to evaluate valuations, but we admit the above chart makes us wonder if index price levels can be maintained if earnings
expectations continue to decline, as outlined below.

We estimate the total domestic market capitalization is trading at 103% of 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 41.8% premium,
which is clearly expensive. The next revision of the third quarter’s GDP estimate will be released December 23rd.

Small cap stocks, as judged by comparing the T Rose Price New Horizons Fund to the S&P 500 are still not cheap, at a 1.8 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 at 1.23x, or the equal-weighted Russell 200 ETF at 1.10x.

Overall, valuations remain neutral, despite the run-up in stock prices of late, because half of our indicators are in bullish territory as defined.

EARNINGS MOMENTUM INDICATORS: Bearish

We made one change to our methodology this week. In computing the MMI score for earnings momentum, we double weighted the emphasis we place on reported earnings surprises: the ratio of the number of earnings announcements greater than expectations, vs. the number of earnings announcements which lagged expectations. Almost the entire S&P 500 has reported the third quarter, and the positive to negative ratio of earnings surprises was 4.33x, a bullish score. Reported earnings have come in ahead of forecast for Q3-2014, at a positive growth rate of 8.0%, vs. the +4.6% estimate as recently as September 30th. However the earnings momentum category remains in a bearish mode due to a preponderance of bearish scores. Earnings expectations for Q4-2104 as well as the full years 2014 and 2015 continue to decline. Q4-2014 estimates have been lowered to 3.4% growth, vs. 8.8% at 9/30/14. 2014E earnings are now projected by the street at a positive growth rate of only 5.8%. 2015 estimates have come down to an estimate of 9.4% earnings growth forecast. Overall earnings momentum looks weak and is not supportive of a bullish outlook.

MONETARY POLICY: Bullish

The Federal Reserve is still accommodative. Fed policy for a Fed funds rate at zero to 25 basis points looks to stay in place through at least early spring 2015. The most recent Fed funds rate was 0.12%.

Our excess liquidity indicator is bullish at 282 basis points. This is evidence the Fed is still in easy money mode, providing over 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. We arrive at this figure by subtracting the percent change in velocity from the year over year percent change in M2 money supply. Then we subtract the most recent quarter’s percentage change in nominal GDP.

The Treasury yield curve is accommodative to growth. The spread between the ten –year and one-year rates is about 2.14%, a positively sloped yield curve.

Junk bonds are pricing at a higher yield this week than last. Using the HYG fund as a proxy, the yield-to-maturity of that fund closed at 5.86% this week vs. 5.56% last week. The spread of high yield bonds vs. 10 year Treasuries stands at 3.57%, and this is smaller than what would be required to score as bullish.

The spread between 10 year Treasury and the base rate of Treasury TIPS stands at 173 basis points. This so-called breakeven level indicates TIPS are discounting a very low inflation expectation – below the Fed’s target of 2.0%! This is at the bottom of the range this spread has posted in recent years.
Our overall reading of monetary policy indicators sums to a bullish score.

CONCLUSION: Neutral

In summary, our MMI score stayed in the neutral zone at 55.26 this past week, down from 57.33. Liquidity and monetary policy indicators are bullish, while market sentiment, technical, and earnings momentum factors send a bearish signal, with valuation at neutral. The composite MMI score for all the major market indicators is in the neutral zone. The market indicators are not signaling how to lean at this time.

Greg Eisen
Singular Research Analyst and Market Strategist