Market Indicators & Strategy Report Jan. 19, 2015

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MMI Stays Neutral In A Week The Market Retreats

Our Major Market Indicators rose further in the neutral range to 57.33 from 54.17. The S&P 500 index retreated 1.2% this past week to 2019.42, while the NASDAQ fell 1.5% to 4634.38 and the Dow Jones Industrials fell 1.3% to 17,511.57. Below, the weekly graph of our Major Market Indicators shows the trend over the last few months. The net change in score came from an increase in the investor sentiment, valuation and earnings momentum indicators, offset by decrease in the technical indicators. The Major Market Indicators are still sending investors a neutral message.

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MARKET SENTIMENT INDICATORS: Bearish

The market sentiment indicators rose marginally this week, with 33% of our indicators bullish vs. 25% in the prior week. The increase was due to the volatility indicators (VIX and VXN) rising to above 20, producing a bullish score in that indicator (we score this via a contrarian approach). VIX rose to 20.95 vs. 17.50 in the prior week and VXN leaped to 21.22 vs. 18.40. The scoring of all the other sentiment indicators remained the same this week.

The ratio of bullish to bearish individual investors in the weekly AAII investor sentiment continues to track high, at 2.14x (46.1% bullish to 21.5% bearish). Also, the confidence index (the ratio of yield on high-grade vs. intermediate grade bonds) is running too tight, a bearish sign at 76.2%. The TIM Group Market Sentiment indicator, Consensus Index and the Market Vane Consensus remain outside of a bullish range. Short interest numbers for December 31st were released this past week, and short ratios continue to be bullish, though there was a meaningful change at the NASDAQ, where the short interest ratio of days to cover fell to 3.87 from 5.03 at December 15th. In all, just one-third of our sentiment indicators scored bullish, leaving the sector bearish in total.

TECHNICAL INDICATORS: Bearish

Technical indicators fell again this week with now only one-fifth of our technical indicators scoring bullish. The equal-weight ETF tracking the Russell 1000 (EWRI) fell below its 200 day moving average, and this accounted for the scoring change for the week. The technical indicators which contributed to a positive score were the indexes which were above their 200 day moving average: the S&P 500, the NASDAQ, and the Dow Jones Industrial Average. The NYSE Composite and the EWRS (equal weight ETF tracking the Russell 2000) were below their 200 day M/A and thus bearish.

The ratio of new highs to new lows fell to 1.08:1 from 1.69:1, continuing to look bearish. Advancing to declining volume indicators on the NYSE and NASDAQ, both in share count and number of issues remained outside of a bullish range. Likewise, the 10-day moving average ratio of up volume vs. down volume on the NYSE and the NASDAQ is also low, outside of a bullish range. In total the technical picture remains bearish.

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators remained bullish this week. Mutual fund flows were negative this week, with $4.1 billion flowing out of funds and ETFs. Our trailing four week total of fund inflows stood at $21.9 billion entering mutual funds and ETFs over that period. The remainder of our liquidity indicators are slowly coming to life after the end of year holiday effect. The corporate acquisition market contributed $7.8 billion of cash takeovers to the total, with the largest contributions coming from Shire buying NPS Pharmaceuticals for $5.2 billion cash, and Amerisource Bergen acquiring MWI Veterinary Supply for a $2.5 billion cash effect. Announced stock buybacks came back to life, with $4.9 billion of announcements, led by Adobe ($2 billion) and Delphi Automotive ($1.5 billion).

The IPO market was slow this week – with only two small deals adding $442 million of market capitalization to domestic markets. However the IPO pipeline is strong. At the end of 2014 the pipeline stood at 126 companies seeking to raise $21.8 billion, with a net 6 additional companies filing so far in 2015. And that excludes the private companies known to be lining up banking representation! Secondary stocks offerings were more pronounced, adding $4.9 billion for the week, with the single biggest deal a combined common/preferred stock offering from Southwestern Energy.

Net insider selling for the past four weeks is low at only $1.9 billion. Insiders averaged closer to $3.7 billion net selling in 2014 on a trailing four week basis.

Overall, we count up a net positive increase of liquidity to the domestic market of approximately $48.6 billion for the past four weeks, which we judge bullish.

VALUATION INDICATORS: Bullish

Valuation indicators improved into bullish range this week. We estimate total domestic market capitalization is trading at 99.5% of replacement cost of the asset base of non-farm, non-financial corporate businesses, and since it is (slightly) below one times replacement cost, this is judged bullish and accounts for the increase in our score for the week. Compared to GDP the market valuation is at a 37.6% premium, which is clearly expensive and not bullish.
Our fair value target for the S&P 500 is 2739, up 35.6% from current levels. The target uses a 23.4x multiple applied to 2014’s estimated operating earnings of 117.23.

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 17.3 times the trailing four quarters operating earnings. This is above a historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 17.2x 2014E and 16.2x 2015E.

Small cap stocks, as judged by comparing the T Rowe Price New Horizons Fund to the S&P 500 are still not cheap, at a 1.79 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 at 1.31x, or the equal-weighted Russell 2000 ETF at 1.04x.

Overall, valuations score in bullish territory. This certainly is contrary to conventional wisdom, which is claiming an overvalued stock market. We urge investors to consider the extraordinarily low interest rate environment and its effect on valuation formulas. Look at the ten-year treasury this Friday (1.83%) and consider what will happen to stock valuations if that yield compresses to 1.0%!

EARNINGS MOMENTUM INDICATORS: Bullish

Earnings momentum scoring for the week improved into the bullish range, with two-thirds of our indicators scoring positive. We compare earnings estimate changes vs. a recent anchor – in this case December 31st readings. 2014’s estimated growth per FactSet has increased to 5.1% vs. 5.0%, and as an increase is a bullish reading. Other bullish factors include the ratio of positive to negative earnings surprises, which was very high this week as we’ve started to score the fourth quarter’s results. We also rated the PEG ratio of earnings growth as a positive, as we are only paying 1.89 times on a P/E to growth rate basis.

Admittedly, this increase in full year 2014 estimates looks like a statistical anomaly, as earnings expectations for Q4:2014 as well as the full year 2015 continue to decline. Q4:2014 estimates have been lowered to 0.6% growth vs. 1.7% at 12/31/14 and 2.6% before the holidays began. 2015 estimates have come down to an estimate of 6.3% growth rate vs. 8.2% at 12/31/14. Importantly, the Energy sector stands out as the outlier (no surprise) with an earnings decrease currently forecast at (32.4%) in calendar 2015. Overall earnings momentum now scores bullish as we have started reporting the fourth quarter of 2014.

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%. We don’t expect a rate hike until mid-year at the earliest.

Our excess liquidity indicator is bullish at 284 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 1.59%, a positively sloped yield curve, though it has compressed of late.

Junk bonds yields rose this week. Using the HYG fund as a proxy, the yield-to-maturity of that fund closed at 6.04% this week vs. 5.96% last week. The spread of high yield bonds vs. 10 year Treasuries rose to 4.21%. High yields spreads are still not wide enough to rank bullish.

Our overall reading of monetary policy indicators sums to a bullish score.

CONCLUSION: Neutral

In summary, our MMI score rose this past week to 57.33 from 54.17 last week. Liquidity, valuation, earnings momentum and monetary policy indicators are bullish, while market sentiment and technical indicators send a bearish signal. Overall the Major Market Indicators are sending investors a neutral signal.

Greg Eisen
Singular Research Analyst and Market Strategist