Market Indicators & Strategy Report Jan. 4, 2015

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MMI Beings 2015 in Bullish Territory

Our Major Market Indicators ended 2014 in bullish territory, with the S&P 500 just shy of its all-time high. The S&P 500 index finished the week ended Friday January 2, 2015 at 2058.20. For the year 2014 the S&P 500 gained 11.39% on a price basis (excluding dividends), though in the month of December the index fell (0.42%). The index closed just below its all-time high which it hit intra-day on December 29th.  This week the MMI fell to 60.33 from the prior week’s 62.33. Below, the weekly graph of our Major Market Indicators shows the trend over the last few months.

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MARKET SENTIMENT INDICATORS: Bearish

The market sentiment indicators improved incrementally from the prior week, but still score as bearish. The put/call ratio on the CBOE (66/100) improved into the bullish range but this was offset by the drop in the S&P 100 put/call which fell to 104/100 and out of bullish territory. The TIM Group Market Sentiment indicator moved into the bullish range at 44.30, and this accounts for the net improvement over the prior week. The remaining bullish sentiment factor was mid-December short interest ratios on the NYSE (4.00 days) and the NASDAQ (5.03 days).

The bulk of our sentiment indicators remain in bearish territory. Volatility indicators (VIX and VXN) rose by week’s end but are still below our benchmark for bullishness, standing at 17.79 and 19.20 respectively. We score VIX at greater than 20 as bullish. The chart below shows the high-low range for the VIX for the past 25 years, along with the average VIX for the year.

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Source: Standard and Poors Corporation www.spvixviews.com

The ARMS index on both the NYSE (1.28) and the NASDAQ (0.89) are still too low to indicate an oversold position. The confidence index, the index of high-grade bonds yield vs. intermediate grade bonds yield (3.62%/4.50%) produces a ratio of 80%, indicative of too narrow a quality spread. Finally, the Consensus Index and the Market Vane Index are both running too optimistically, a further bearish sign.

Overall, only one-third of our market sentiment score weight is in the bullish range, so by definition we are calling sentiment bearish in the aggregate.

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TECHNICAL INDICATORS: Bullish

A majority of our technical indicators score bullish this week. For the week, 9 out of 15 indicators are bullish, vs. 13 out of 15 last week. In the past week the advance/decline volume ratios on the NYSE and the NASDAQ both fell out of the bullish range, subtracting two points. These ratios fell to 0.75 and 0.71, respectively. We also track the advance/decline ratio of the number of stock issues traded, and in the week the NYSE ratio fell to 0.72 (1355 issues advanced, 1893 declined), and this subtracted one point. We score the 10 day moving average of up volume vs. down volume in the NYSE, and this fell to a 0.90 ratio, accounting for the fourth point lost in scoring. (The previous two indicators for the NASDAQ were already bearish from the prior week).

Bullish readings are coming from new highs outpacing new lows by a ratio of 3.47:1, as well as all the indexes we score trading above their 200 day moving average. The S&P 500, DJIA, NASDAQ composite, the NYSE composite, the Russell 1000 equal weight ETF and the Russell 2000 equal weighted ETF (a proxy for the index) are all above their respective 200 day moving average.

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators are bullish. Money market funds balances remain over 11% 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 33.6% of margin debt at last reading (November), 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.

Total flows into the market as calculated are registering a bullish inflow. We had a positive week of mutual fund flows, at $1.77 billion, though this was composed of $4.72 billion negative outflows from traditional funds vs. $6.49 billion inflows to ETFs. This came one week after Lipper reported a record week for mutual fund inflows. Our four week total of fund flows is a positive $17.5 billion. The corporate acquisition market was muted this week due to the holiday. M&A for the trailing four weeks stands at $18.5 billion. Announced stock buybacks continue strong at $30.8 billion for the trailing four weeks, though again the last two weeks have been quiet due to the holidays.

IPO activity was non-existent this past holiday shortened week, and only $17.8 billion worth of new market capitalization added to the market over the trailing four weeks. The chart below shows we’ve had the highest year in over a decade in terms of the number of new IPOs coming to market. The second chart shows a pipeline of approximately 130 deals waiting to scoop up investor money in 2015.

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Source: www.ipoboutique.com

Secondary stocks offerings were also absent this week, but raised $8.1 billion for the trailing four weeks.  Insider selling has quieted down the last couple of weeks, but pulled $4.3 billion of cash out of investor hands in the past four weeks.

We calculate November (the most recent month available) cash inflows to domestically focused equity hedge funds at approximately $2.82 billion. 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 net flow of liquidity to the domestic market of approximately $39.4 billion for the past four weeks, which is enough to warrant a bullish rating.

VALUATION INDICATORS: Neutral

Our valuation indicators continue to score at a neutral level. Our fair value target for the S&P 500 is 2625, representing a 27.5% upside from the close on January 2nd. The target uses a 22.2x multiple applied to 2014’s estimated operating earnings of 118.12. 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. This is above an historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 17.4x 2014E and 16.1x 2015E.

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.

Those bullish factors are offset equally by some bearish indicators.  We estimate the total domestic market capitalization is trading at 101.4% 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. Also, compared to GDP the market is at a 42.5% premium, which is bearish in its own regard.  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 1.78 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.24x, or the equal-weighted Russell 200 ETF – 1.05x. The small cap Russell 2000 index lagged the S&P by 786 basis points in 2014 performance.

Overall, valuations are neutral, with bullish indicators offset equally by bearish indicators. However, on a forward basis, the S&P 500 is priced above historical averages.

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EARNINGS MOMENTUM INDICATORS: Neutral

The MMI score for earnings momentum did not change this week, as unsurprisingly the earnings announcement front has been asleep the last two weeks of the year. For the third quarter the positive to negative ratio of earnings surprises was 4.18x, a bullish score. Reported earnings came 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. Earnings momentum on a forward basis is not as strong. Earnings expectations for Q4:2104 as well as the full years 2014 and 2015 continue to decline. Q4:2014 estimates have been lowered to 2.6% growth vs. 3.8% at 11/28/14.  2014E earnings are now projected by the street at a positive growth rate of 5.7% vs. 5.8% at the end of November.  2015 estimates have come down to an estimate of 7.9% growth rate vs. 8.6% vs. 9.4% at 11/28/14. On a PEG ratio (P/E to growth rate) basis earnings still look relatively cheap, at a PEG of only 1.96 times. Overall earnings momentum now scores neutral as we head into the end of 2014.

The fourth quarter growth expectations as stated above call for 2.6% earnings growth. On a sector basis, there are winners and losers, with energy being the obvious big loser. Below is a chart of sector earnings growth expectations for Q4:2014

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MONETARY POLICY: Bullish

The Federal Reserve has ended its balance sheet expansion (for now). Current policy is to hold the overnight Fed funds rate down at zero to 25 basis points, and lately has hovered around 13 basis points. The most recent policy statement states the FOMC “judges that it can be patient” before any rate increase would occur. We don’t believe the Fed funds rate target will change at least for the next five or six months. We expect a change in language will foreshadow such increase. But as always, the money authorities are “data dependent”.

Our excess liquidity indicator is bullish at 283 basis points.  This is evidence the Fed is still in easy money mode, providing more than 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 annual 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 1.84%, a positively sloped yield curve.

Junk bonds are pricing at similar yield this week to last.  Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 5.97% this week vs. 5.96% last week. The spread vs. 10 year Treasuries tightened to 3.86%, and this is not bullish.

Most market participants agree the rally we’ve enjoyed since March 2009 has been fueled in no small part by the accommodation of the Federal Reserve. Bearish investors are anticipating the Fed “taking away the punchbowl” in the near term. Offsetting that sentiment, we offer the below chart of the breakeven spread between 10 year T-bonds and 10 year Treasury TIPS, which stood at 164 basis points on December 30th. This is close to the bottom this spread has posted in recent years, and well below the 2.18% historical average. This chart’s decline over the last five months represents the market’s expectation of decreased inflation, which would seem to work in favor of keeping the Fed Funds target at its current near-zero level.

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CONCLUSION: Bullish

In summary, our MMI score moved down to the bottom of the bullish zone to 60.33 this past week. The only bearish component in the MMI is the market sentiment factors, while technical, liquidity and monetary policy categories send a bullish signal, with valuation and earnings momentum at neutral. The year is off to a good start with the major market indicators sending a bullish signal.

Greg Eisen
Singular Research Analyst and Market Strategist