Market Indicators & Strategy Report February 1, 2016

MMI Continues In Bear Territory Though Improved Over The Past Month

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Our Major Market Indicators closed the month of January still in a bearish range for the ninth straight week. The market hit a short term peak in early November (but early December for the NASDAQ) and since then the indexes have given ground through year-end. Since November 3rd the

S&P 500 is down (8.3%) and the DJIA is down (8.4%), while since December 2nd the NASDAQ is down (10.9%) and the small cap Russell 2000 has been even worse, down (14.1%). The MMI entered bearish territory starting with our report dated December 6th, which corresponds with market close on December 4th. MMI ended this past week at 46.83, which represents a recovery since its lowest score on December 31st. The S&P 500 has recovered some ground lost since it bottomed on January 20th.

The chart below shows the performance of the significant indexes since their recent top – November 3rd for two of them and December 2nd for the other two. Again, the Major Market Indicators fell into a bearish score starting the first week of December.

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Below, the weekly graph of our Major Market Indicators shows the trend since May of 2014 through January 31, 2016.

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MARKET SENTIMENT INDICATORS: Bullish

The market sentiment indicators score bullish this past week, as compared to neutral a month ago. Since we use a mostly contrarian judgment on sentiment; a bullish behavior by market participants registers as bearish, and vice versa. In terms of bullish indicators, the Volatility indicators (VIX and VXN) stood at week’s end at 20.20 and 23.64, which added one point to our score; we score VIX/VXN at greater than 20 as bullish. The Put-Call ratio on the CBOE ended the week at 64/100 was thus was marginally bullish. The confidence index, the ratio of the index of high-grade bonds yield vs. intermediate grade bonds yield (3.72%/5.42%) produces a ratio of 68.6%; we score any spread under 75.0% as bullish. The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of 0.75, and so since this shows a tendency for individual investors to lean bearish, we score this also as a bullish reading. Also, the Consensus Index and the Market Vane Index registered 48% and 49% respectively, both bullish indicators. Finally, the short ratio on both the NYSE and the NASDAQ were bullish, at 3.80 and 5.19 days to cover respectively. Note the NYSE short ratio fell significantly this past week, from 5.10 to 3.19x.

On the bearish side of the ledger, the Put-Call ratio on the S&P 100 was bearish at 107/100. Also, the ARMS index on the NYSE and NASDAQ (0.68 and 0.59) also were bearish. Finally, the TIM Group Market Sentiment Indicator was over 50.0% (51.40%) and thus bearish at week’s end.

The chart below from Citigroup indicates their reading of sentiment is back in the “panic mode” levels previously seen in late summer. This is consistent with our scoring – a sour sentiment by investors is bullish in a contrarian sense.

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TECHNICAL INDICATORS: Bearish

 

The technical picture is still dismal. Our technical indicators only scored 2 out of 15 indicator points bullish this week, so the technical picture is overwhelmingly bearish. The volume ratios we track produced the two points of bullish scoring this week. The advance/decline volume ratio on the NYSE closed at 1.52, and we score any ratio over 1.12 as bullish.  Likewise, the weekly advance/decline ratio for the NYSE was a bullish 2.81 (a score above 2.00 is bullish). This is the ratio of the number of issues advancing vs. declining for the week just ended.

The technical picture gets bearish from there. The advance/decline volume ratio on the NASDAQ closed at 1.11, and that is bearish. The weekly advance/decline ratio on the NASDAQ was 1.43, and again this too was bearish. The 10 day moving average of up vs. down stocks on those two exchanges was also bearish on both counts: The10-day moving average of the NYSE scored bearish at 1.03 and the 10-day moving average of the NASDAQ was bearish at 0.92. Finally, the ratio of new highs to new lows was only 0.22, 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 moving average at the end of this past week, by the following percentages: The S&P 500 (5.15%), the Dow Jones Industrial Average (5.26%), the NASDAQ composite (6.79%), the NYSE Composite (8.15%), the S&P 500 equal weight ETF (RSP) (7.57%), and the S&P Small Cap 600 equal weight ETF (EWSC) (18.12%). Since all these indexes are below their respective 200 day moving average, they all score bearish.

Note that starting this week, Guggenheim, the sponsor of the two equal weight ETFs we measure, decided to change their ETFs drastically. We previously scored the EWRI (the Russell 1000 equal weight ETF) but this week Guggenheim closed that fund and rolled it into the RSP – their S&P 500 equal weight ETF. So we’ve followed suit and are measuring that ETF, the RSP, against its 200 day moving average.

The other change Guggenheim made was to change the benchmark of its small cap equal weight ETF: they’ve moved from using the Russell 2000 to the S&P 600.  The ETF itself is still in existence, but reflecting this change of benchmark they changed the ticker, from EWRS to EWSC.  We’ve followed along with Guggenheim and are scoring the EWSC against its 200 day moving average.

In total only 2 of a possible 15 points scored bullish in this category, so we rate the technical indicators are bearish overall.

 

LIQUIDITY INDICATORS: Bearish

Our liquidity indicators are bearish, but somewhat improved from past weeks. Money market funds balances are 12.3% 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 27.7% of margin debt at last reading (December 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 bearish was our cumulative market liquidity calculation for the trailing four weeks. Total flows into the market as calculated are registering a bearish inflow. Mutual funds (including ETFs) have seen net outflows over the past four weeks, with a net ($27.41) billion withdrawn from the market for the four weeks. We should point out that the most recent week’s flow reported by Lipper this past Wednesday was a negative ($1.2) billion, which while negative is the third consecutive week of improved mutual fund flows. In the corporate acquisition market we count only the cash component of M&A deals as announced. The sum of that figure for these four weeks was $19.69 billion. The significant deals announced this past four weeks include Shire PLC buying Baxalta (BXLT) for $18.00/share cash plus 0.1482 Shire PLC shares. That adds approximately $12.2 billion to positive market cash flow. The other large deal was the Johnson Controls (JCI) merger with Tyco (TYC).  This is a tax inversion, and on paper Tyco is acquiring JCI, but JCI is really the buyer, as the new headquarters will be in Johnson’s home town. We peg the cash portion of this deal at $3.9 billion.

Announced stock buybacks contributed another $26.7 billion to our liquidity calculation in terms of total buyback authorizations announced. The most significant buyback announcements were made by Wells Fargo ($17.6 billion) and FedEx Corp ($3.3 billion). Stock buybacks have been and continue to be an important source of liquidity to the market.

IPO activity has crawled to a halt these last four weeks. We’ve only identified one IPO pricing in January, with $2.2 billion of new market capitalization was added to the market for the trailing four weeks. That issue was Nomad Foods Limited (ticker: NOMD).

The chart below shows the dollars of proceeds in billions from IPOs over the past decade. 2006 and 2007 were peak years before the crisis, and 2013 and 2014 caught up to and exceeded those years, but 2015 was a disappointment in comparison. There certainly is a large number of private equity financed companies looking for an exit strategy, and we wonder if this fall-off of IPOs will significantly affect private equity acquisitions and overall strategy in 2016?

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Secondary stocks offerings have picked up from the prior month, with $8.2 billion of cash offerings in the trailing four weeks. Note that we exclude sales by large shareholders (private equity) which do not increase the total number of shares outstanding. Insider selling pulled $0.75 billion of net cash out of the equity markets in the past four weeks, as insider selling remains muted at present vs. prior levels.

We track cash inflows to domestically focused equity hedge funds on a monthly basis. We calculate cash outflows from domestically focused equity hedge funds at approximately ($2.88) billion in December. 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 $4.95 billion for the past four weeks, which is not enough to warrant a bullish score. We require at least $20.0 billion of calculated positive liquidity to warrant a bullish score, so therefore the liquidity calculation is bearish.  We double weight this calculation in our MMI scoring. Combined with the other factors above we score liquidity as bearish.


VALUATION INDICATORS: Bullish

Our valuation indicators score at a bullish level this week. Our fair value target for the S&P 500 is 2172, representing an 11.9% upside from the close on January 29th. That upside potential is a bullish indicator in our calculation. The target uses an 18.45x multiple applied to 2015’s estimated operating earnings of 117.70. 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 16.3 times the trailing four quarters operating earnings (through the third quarter of 2015), compared to an historical norm of 15.5 times operating earnings. On forward-four-quarters earnings, the S&P 500 is priced at 16.25 times earnings, while it is now trading at 16.5x 2015E and 15.7x 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, 1.46x.

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 resulting target, 1954, produces a prospective vs. the week’s close of only 0.73%. Since this is less than a 10% potential gain, it scores bearish.

Small cap stocks, as judged by comparing the P/E of the T Rowe Price New Horizons Fund to the P/E of the S&P 500 are not cheap enough, at a 1.57 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.30x, or the equal-weighted Russell 2000 ETF – 0.93x. However we use the first calculation in our scoring, so this indicator scores bearish.

There are other bullish indicators.  Compared to GDP the market (using Wilshire’s total market value) is at a 23.6% premium. Since this is less than a 25% premium to GDP, we score this bullish. We estimate the total domestic market capitalization is trading at 81.7% 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. 

Overall, with valuation indicators scoring bullish on 4 out of a possible 6 points, we rate the overall category as bullish.

EARNINGS MOMENTUM INDICATORS: Neutral

The MMI score for earnings momentum is neutral as of month end. The earnings season for the fourth quarter 2015 (which is about 40% complete) positive to negative ratio of earnings surprises is 3.79x, 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 greater than 3.0:1 for this indicator to score bullish). We double count this indicator since it’s such a key component of earnings momentum, and it scores two points.

Fourth quarter 2015 earnings are currently estimated at a growth rate of negative (5.8%) compared to (4.9%) on December 31st. This worsened expectation vs. the prior month’s estimate is judged bearish in our scoring. Earnings expectations the full years 2015 and 2016 continue to decline: 2015E earnings are now projected by the street at a negative growth rate of (0.8%) vs. (0.6%) at the end of December. 2016 estimates also have come down to a growth rate 5.0% growth vs. 7.5% at the end of December. A positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish. We rely on FactSet for these specific estimates. Note we score earnings momentum vs. the most recent month-end, again emphasizing the momentum. These three indicators all score bearish.

On a PEG ratio (P/E to growth rate) basis S&P earnings still looks relatively cheap, at a PEG of only 2.16 times, compared to a longer term average of 2.58. Since the S&P looks cheaply valued on a PEG basis, we score this

indicator as bullish. Looking at small cap stocks, the Russell 2000 trailing P/E ex: negative earnings were 21.23x at 12/31/15, vs. a five year eps growth rate of 10.75%, implying a PEG ratio of 1.97 times.

Thus, overall earnings momentum now scores neutral since three out of our six indicators scored bullish and three bearish. Momentum may score as neutral, but in an absolute sense, earnings are a horror show.

S&P 500 earnings are in their own recession. The fourth quarter of 2015 is presently estimated to be down (5.8%) vs. the prior year. If this holds, it will mark the third quarter in a row of year-over-year negative earnings comparisons. The last time we saw this was Q1:09 through Q3:09. Six sectors are forecasting declining earnings for Q4:15 and only four sectors are forecasting an increase. For the full year 2015 the estimated growth rate is now a negative (0.8%). It gets there with only four sectors showing declines. The energy sector’s earnings collapse by negative (60.6%) leads the way!

Expectations for 2016 earnings growth have declined over the course of the year, which is not a big surprise. The first quarter of 2016 is currently expected to register another year-over-year decline in earnings, with positive growth not resuming until Q2.

MONETARY POLICY: Bullish

The Federal Reserve finally raised the Fed Funds target in December, but will they do it again in 2016? Their guidance implies we should expect four increases in 2016, though with the market decline in the U.S. and the strong dollar, the Fed may use “data dependency” as the excuse to pause until the outlook is clearer.

Our excess liquidity indicator is bullish at 15.0 basis points. This means the Fed is providing 0.150% 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 year-over-year percentage change in nominal GDP. We score this amount of excess liquidity as bullish.

This week we received the initial advance estimate for Q4:2015 GDP. Real GDP growth came in at only +0.7%. Also, we got an initial reading of velocity of M2 money for the third quarter, at only 1.480, down from 1.493 for the second quarter. The continued decline in velocity is symptomatic of the conundrum we face: Increasing money supply won’t necessarily get the economy revving.

The Treasury yield curve is accommodative to growth. The ratio between the one-year rates and ten–year is about 0.24%, and this produces a positively sloped yield curve, and we score this bullish.

Junk bonds yields remain elevated. Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 8.11% this week and the spread vs. 10 year Treasuries stands at 6.21%, and this is bullish, since we judge anything over 4.0% as wide enough to rate bullish. We recognize this comes off as a contrarian view point.

The chart shown below shows the breakeven inflation rate between 10-year Treasuries and 10-year TIPS. Inflation expectations remain well below 2.0%. This would appear to indicate the bond market is forecasting a low inflation environment, which runs counter to the hawkish talk about raising rates. This makes us wonder why the Federal Reserve is so anxious to continue raising rates.

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Overall, the monetary policy indicators are bullish.

 

CONCLUSION: Bearish

In summary, our MMI score sits in bearish territory at the end of January.  Market Sentiment, Valuation and Monetary policy indicators scored bullish, while technical and liquidity indicators scored bearish, and earnings momentum indicators score neutral. The Major Market Indicators index has scored in the bearish camp since the beginning of December. We note the score, in an absolute sense, has risen from its bottom which might indicate the worst of the sell-off is behind us. This is the ninth week in a row for a bearish reading, and we continue to advise that caution in protective strategies is encouraged.

Greg Eisen CFA
Singular Research Analyst and Market Strategist