Market Indicators & Strategy Report Nov. 2, 2014

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MMI Ends the Month in Neutral Territory

Our Major Market Indicators rose further into the neutral zone this week, further confirming the recovery from the sharp selloff which bottomed in mid-October. The S&P 500 index has roared back from the low of 1820.66, closing this past Friday at 2018.05, a gain of 10.8% from the low. The index has now recovered essentially all the value lost since September 19th, when it peaked at 2019.26. This week the MMI rose to 55.83 from the prior week’s 51.67, a clear neutral signal. Below, the weekly graph of our Major Market Indicators shows the trend over the last few months, and the fall-off into bearish territory followed by the recovery into the neutral zone in the last two weeks.

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MARKET SENTIMENT INDICATORS: Bearish

The market sentiment indicators were unchanged from the prior week as a group. The VIX and VXN implied volatilities have fallen back from bullish levels above 20 down into the teens, with the VIX ending the week at 14.03 and the VXN to 15.81. Of note, the short ratio of all NYSE stocks fell to less than 4.0 times (3.70, actually) for the first time we recall since we’ve been publishing the weekly MMI. This is still a bullish ratio, but we note the drop.
In all, just one-third of our sentiment indicators scored bullish, making the sector bearish in total. Put/Call ratios are mixed – the CBOE ratio of 62/100 is modestly bullish, while the NYSE’s 80/100 fails the bullish test. Other indexes such as the ARMS, AAII, Consensus and Market Vane, all fall short of bullishness. The TIM Group market sentiment indicator is the exception to that.

The spread between high quality corporate bonds and intermediate grade bonds has narrowed such that we find it bearish. One bright spot remaining is the level of the short ratio – the days to cover all short stocks based on current average trading volume – is still high enough to warrant bullishness. Nevertheless, sentiment overall is bearish in the aggregate.

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TECHNICAL INDICATORS: Bullish

Technical indicators have roared in the past two weeks, a function of the very sharp “V” shaped rally of the overall market. Literally ALL of our major market technical indicators are flashing positive as of the end of October.  While this group of indicators was bullish last week, a few of them have turned the corner to move up into the bullish ranks this week. These include weekly new highs/new lows ratio, which was up to 2.29x, the 10-day moving average up vs. down volume of the NYSE, at 1.74x, the NYSE Composite now trading at greater than its 200 day moving average, and the Russell 2000 equal weighted ETF (a proxy for the index) which is now just barely above its 200 day average.

All the other indexes we’re tracking (S&P 500, DJIA, NASDAQ composite and Russell 1000 equal weight ETF) are above their 200 day moving averages. Also, weekly advance/decline volume on the NYSE and NASDAQ skew to the positive, an indication of a broad based rally in these markets. Overall, this is as good as it gets technically!

 

LIQUIDITY INDICATORS: Bearish

Our liquidity indicators remain bearish. Although our total flows as calculated are registering a positive value, it hasn’t gotten back up to a level to justify a bullish rating.

We had a positive week of mutual fund flows, at $8.77 billion, but this was composed of $1.0 billion negative outflows from traditional funds vs. $9.7 billion inflows to ETFs. Our four week total of fund flows remains negative. The corporate acquisition market was muted this week with less than $1 billion of deals announced. M&A for the trailing four weeks is slightly negative, reflecting the reversal of the Abbvie acquisition of Shire. Announced stock buybacks continue strong at $15.8 billion for the week and over $46.7billion on a trailing four week basis. Big buybacks this past week included Visa ($5 billion) and IBM ($5 billion).

IPOs activity was muted this past week, with only $3.0 billion worth of new market capitalization added to the market (four week total = $17.6 billion). The IPO market has slowed down considerably since the euphoric Alibaba deal in mid-September. Secondary stocks offerings continue at a benign volume level, adding $245 million for the week (and $4.1 billion for the trailing four weeks). Insider selling was stronger than normal in the most recent week – around one-third of the total selling dollar volume came from one insider, Bill Gates. He’s been rather consistently selling down his Microsoft holdings over time so this isn’t shocking.

Overall, we count up a net increase of liquidity to the domestic market of approximately $13.8 billion for the past four weeks, which is not enough to warrant a bullish rating.

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VALUATION INDICATORS: Neutral

Our valuation indicators score fell this week from a bullish to neutral level. The rally of the past two weeks has brought the market value of the domestic equity market back up above the level of replacement cost, the one changing market indicator in the valuation series.

Our fair value target for the S&P 500 is 2618, representing a 30% upside from the close on October 31th. The target uses a 22.0x multiple applied to 2014’s estimated operating earnings of $119.14. 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 16.9x 2014E and 15.5x 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 102% 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 38% premium, which is bearish in its own regard. 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 1.65 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.17x, or the equal-weighted Russell 200 ETF – 1.06x. Nevertheless, the small cap Russell 2000 index has lagged the S&P
by 835 basis points year-to-date.

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. The correction the index just experienced did nothing to alter this.

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EARNINGS MOMENTUM INDICATORS: Bearish

The MMI score for earnings momentum did not change this week. So far 363 companies have reported third quarter earnings, and the ratio of positive to negative earnings surprises stand at a positive 4.81x, enough to warrant a bullish score. Another positive indicator is the “PEG” ratio. The ratio of trailing P/E on the S&P 500 divided by the trailing EPS growth rate is under two times. This ranks on the cheap side of the divide.

However, the earnings momentum category remains in a bearish mode, due to the remaining indicators we chart scoring in the bearish camp. Earnings estimates for Q4-2104 as well as the full years 2014 and 2015 have been coming down at a rapid pace. Q4-2014 estimates have been lowered to 4.2% growth, vs. 6.0% growth last week and 8.8% at 9/30/14. Yet reported earnings have come in ahead of forecast so for in Q3-2014, at a positive growth rate of 7.3% so far, vs. a +4.6% estimate as recently as September 30th. This is a familiar pattern: estimates start out high, and are reduced in the weeks and months preceding earnings season, only to see companies beat the reduced expectations.

Full year 2014 EPS estimates stand at a 6.0% rise, compared to +6.9% at 9/30/14. 2015 estimates have also come in; now the street forecasts 10.1% growth vs. 11.8% as recently as 9/30/14.

Overall, the indicators show a bearish backdrop as earnings estimates continue to get cut, despite the recent optimistic GDP calculation for Q3 of +3.5% real growth.

The chart below shows the number of positive vs. negative earnings pre-announcements issued so far for Q4-2014 by companies. The negatives far outweigh the positives.

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MONETARY POLICY: Bullish

The Federal Reserve ended its balance sheet expansion this past week. QE3 is over. Current policy is to hold the overnight Fed funds rate down at zero to 25 basis points, and lately has hovered around 9 basis points. The most recent policy statement refers to “considerable time” before any rate increase would occur. We don’t believe the Fed funds rate target will change anytime soon – meaning at least for the next six months. But the money authorities left themselves room to alter course when necessary, takin their cue from inflation expectations. Our excess liquidity indicator is bullish at 287 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. The recently released velocity figure for July 2014 shows a continued decrease in velocity.

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 stood at 5.34% this week vs. 5.33% last week. The spread vs. 10 year Treasuries tightened to 3.01%, and this is not bullish.

The breakeven spread between 10 year T-bonds and 10 year Treasury TIPS stood at 192 basis points, indicative of weak inflation expectations. This is close to the bottom this spread has posted in recent years. This represents the market’s expectation, not the “official” inflation data, which stood at 1.7% for the year ended September 2014. Inflation at this level is supportive of keeping the Fed Funds target at its current near-zero level.

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CONCLUSION: Neutral

In summary, our MMI score moved up into the mid-rage of the neutral zone to 55.83 this past week. The bearish components in the MMI are the market sentiment, liquidity, and earnings momentum factors, while technical and monetary policy categories send a bullish signal, with valuation at neutral. The indicators have scored neutral two weeks consecutive after five straight weeks of bearish readings. The market has just experiences a rapid snap back recovery of index prices, but the Major Market Indicators are not telling us to be a buyer at present. Instead, we are getting a weak neutral signal, and thus we are keeping a neutral, cautions posture.

 

Greg Eisen
Singular Research Analyst and Market Strategist