Market Indicators & Strategy Report November 2, 2015

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MMI Are Still Neutral

Our Major Market Indicators stayed in neutral territory this week, similar to last month. Over the past month the major indexes have recovered much of the ground they lost in the sell-off. Since the market topped around September 28th the indexes have recovered most of their losses.  The S&P 500 is up 10.53% from its bottom; the DJIA is up 10.38%, and the NASDAQ is up 12.32%.  The small cap Russell 2000 has been marginally worse, recovering only 7.19%. Over that same period MMI has been in neutral territory most of the time, ending the past week at 55.67. A reminder: the MMI index is not considered an arbiter for the next week’s performance, but rather a longer term outlook of the forward nine to twelve months. Below, the weekly graph of our Major Market Indicators shows the trend since May of 2014.
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MARKET SENTIMENT INDICATORS: Bearish

The market sentiment indicators score as marginally bearish this past week. Since we use a mostly contrarian judgment on sentiment; a bullish behavior by market participants registers as bearish, and vice versa. In terms of bearish indicators, the Volatility indicators (VIX and VXN) stood at week’s end at 15.07 and 17.30, which added one bearish point to our score; we score VIX/VXN at greater than 20 as bullish. The ARMS index on the NYSE and NASDAQ (1.35 and 1.00) both registered bearish, which counts for two bearish points. The confidence index, the index of high-grade bonds yield vs. intermediate grade bonds yield (3.74%/4.94%) produces a ratio of 75.7%; we score any spread over 75.0% as bearish. The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of 1.96, also a bearish reading; again this is a contrarian approach. Finally, the Consensus Index and the Market Vane Index registered 56.0% and 62.0% respectively, both bearish indicators. All these factors (seven out of twelve) were bearish contributions to the score of sentiment indicators for this week.

On the bullish side of the ledger, the Put-Call ratios are both registering bullish scores. The CBOE ended the week at 62/100, which registers as bullish, while the Put-Call on the S&P 100 was also bearish at 170/100.

The TIM Group Market Sentiment indicator registered bullish at 47.7%. Also, the short ratio on both the NYSE and the NASDAQ were bullish, at 4.70 and 4.34 days to cover respectively. However, these 5 indicators were in the minority this week, and thus the majority of the overall market sentiment score is bearish in the aggregate. The chart below from Citigroup indicates their reading of sentiment is itself at panic levels.

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TECHNICAL INDICATORS: Bearish

Our technical indicators scored just 3 out of 15 indicator points bullish this week, so the technical sector is bearish overall. The advance/decline volume ratio on the NYSE and NASDAQ was 0.84 and 0.91, not enough to score bullish. Bearish scoring also came from the ratio of the number of issues advancing vs. declining for the week on both the NYSE and NASDAQ: 0.87 and 0.74. The 10 day moving average of up vs. down stocks on those two exchanges again scored bearish at 0.92 and 0.98. Finally, the ratio of new highs to new lows was 0.99, and this too was bearish.

We also score a number of indexes vs. their 200 day moving average. The most prominent of these indexes were trading above their 200 day moving average, and thus were bullish, by the following percentages: The S&P 500 +0.86%, the NASDAQ Composite +2.39%, and the Dow Jones Industrial Average +0.49%. The other indexes we score continue to lie below their 200 day moving averages, and were bearish: the NYSE Composite (2.70%), the Russell 1000 equal weight ETF (EWRI) (3.33%), and the Russell 2000 equal weight ETF (EWRS) (5.81%).

To sum up the technical picture, it’s still primarily negative, though it has improved since our report a month ago.  Still, the technical indicators are bearish.

 

LIQUIDITY INDICATORS: Bullish

Our liquidity indicators are bullish. Money market funds balances are 10.9% 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 30.1% of margin debt at last reading (September 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 positive was our cumulative market liquidity calculation for the trailing four weeks. Total flows into the market as calculated are registering a bullish inflow. Mutual funds (including ETFs) have seen inflows over the past four weeks, with a net $7.1 billion contributed to the market for the four weeks. The corporate acquisition market has been HOT these past four weeks.  There have been quite a few large deals announced over that time. We count only the cash component of M&A deals as announced, that figure for these four weeks was $93.8 billion. The biggest contributors these last four weeks were the acquisition by Dell Corporation (with help from private equity partners) of EMC Corp (EMC) for $46.8 billion, Western Digital (WD) buying Sandisk (SD) at $17.5 billion, and Walgreens Boots Alliance (WAB) buying Rite Aid (RAD) For $9.1 billion.

Announced stock buybacks contributed another $52.8 billion to our liquidity calculation in terms of total buyback authorizations announced. The most significant buyback announcements were made by Johnson and Johnson ($10.0 billion), Alphabet (the firm formerly known as Google) ($5.0 billion), Corning ($4.0 billion), and IBM ($4.0 billion). Stock buybacks have been and continue to be an important source of liquidity to the market.

IPO activity has picked up these last four weeks. $31.0 billion of new market capitalization was added to the market for the trailing four weeks. The biggest new issues were Ferrari (ticker: RACE) at $9.8 billion, and First Data (ticker: FDC) at $14.1 billion.

The chart below shows the number of IPOs priced over the past eighteen months. Since the mid-summer downturn in activity we’ve seen a return to more normal levels.

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Secondary stocks offerings have slowed, with only $4.2 billion in the trailing four weeks. Insider selling pulled $2.3 billion of net cash out of investor hands in the past four weeks.

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 ($0.09) billion in September. 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 $116.2 billion for the past four weeks, which is much more than sufficient to warrant a bullish score. We double weight this calculation in our MMI scoring. Combined with the other factors above we arrive at a bullish view on liquidity.


VALUATION INDICATORS: Neutral

Our valuation indicators rank at a neutral level this week. Our fair value target for the S&P 500 is 2398, representing a 15.3% upside from the close on October 2nd.  That upside potential is a bullish indicator in our calculation. The target uses a 20.2x multiple applied to 2015’s estimated operating earnings of 118.46. 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 17.4 times the trailing four quarters operating earnings (through the second quarter of 2015), compared to an historical norm of 15.5 times operating earnings. The S&P 500 is now trading at 17.6x 2015E and 16.2x 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.

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 result, 2158, is only 3.8% above the week’s close of 2079.36.  Since this is less than a 10% potential gain, it scores bearish.

There are other bearish indicators.  Compared to GDP the market is at a 38% premium. Small cap stocks, as judged by comparing the T Rowe Price New Horizons Fund to the S&P 500 are not cheap, at a 1.65 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 – 1.18x, or the equal-weighted Russell 2000 ETF – 0.96x.

We estimate the total domestic market capitalization is trading at 94% 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.

The pullback from the current correction has cut the valuation metrics for the market, though the S&P 500 is still trading at a premium to its historical average. We attempt with these indicators to discern if there is a case for continued price improvement, despite first impressions which might indicate otherwise. Overall, valuation indicators are neutral, with bullish indicators equal to bearish indicators.

 

EARNINGS MOMENTUM INDICATORS: Bullish

The MMI score for earnings momentum is bullish this week. The earnings season for the third quarter 2015 (which is about 2/3rds complete) positive to negative ratio of earnings surprises is 3.37x, 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).

Third quarter 2015 earnings are currently estimated at a growth rate of negative (2.2%) compared to (5.1%) on September 30th. This improved expectation vs. the prior month’s estimate is judged bullish in our scoring, since the change has to be positive to be bullish, and if not bullish, then it’s bearish. So despite the third quarter’s earnings estimated to come in as a negative number, the fact that this negative earnings result has improved since the past month-end is itself a bullish indicator. 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 (0.1%) vs. 0.5% at the end of September. 2016 estimates also have come down to a growth rate 8.6% growth vs. 9.9% at the end of August. As stated above, in our judgment, a positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish. It’s worth pointing out that we rely on FactSet for these estimates.

On a PEG ratio (P/E to growth rate) basis S&P earnings still looks this side of cheap, at a PEG of only 2.33 times, compared to a longer term average of 2.58. Looking at small cap stocks, the Russell 2000 trailing P/E ex: negative earnings were 20.6x at 9/30/15, vs. a five year eps growth rate of 10.7%, implying a PEG ratio of 1.92 times.

Thus, overall earnings momentum now scores bullish since four out of our six indicators scored bullish.

The earnings outlook would look better, if not for the energy sector, and it would look worse, if not for stock buybacks. Almost two-thirds, 65%, of S&P 500 companies reported a lower share count for Q2:15 vs. Q2:14. In fact 21% of the index members reported at least a 4% lower share count year-over-year, while 9% of the index members reported at least a 4% higher share count.

Expectations are for a negative (0.7%) decline year-over-year in S&P earnings in Q2:15, and negative (5.1%) for earnings in Q3:15. Expectations now are only 0.5% growth for all of 2015. Growth rates are skewed by sector. The energy sector is projected to incur a (59.0%) decline in earnings for all of 2015. Materials are pegged for a (2.2%) in the full year 2015. On the other end of the spectrum, Telecom Services, Financials, Health Care and Consumer Discretionary are all forecast to grow by at least a double digit rate.  For Q3:15, FactSet calculates earnings growth for the S&P 500 ex: energy would be 2.3%!

Digging deeper into the source of growth, Standard and Poors reports that in Q2:15, 21% of S&P 500 companies reduced their share count by over 4%, while 9% of companies increased their share count by over 4%. These buybacks discussed above have consequences.

 

MONETARY POLICY: Bullish

Although the Federal Reserve continue to warn the markets it wants to begin raising short term interest rates, it has yet to pull the trigger, and has not raised its Fed Funds target. Current policy is to hold the overnight Fed funds rate down at zero to 25 basis points. The pressure is building, and it appears we will see a first rate hike before the year is over. It’s painfully obvious a 25 basis point increase in the Fed Funds isn’t all that meaningful in itself, but rather the market may be more focused on the implication there will be many more rate hikes to follow.

Our excess liquidity indicator is bullish at 19 basis points. This means the Fed is providing 0.19% 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.

The Treasury yield curve is accommodative to growth. The spread between the ten–year and one-year rates is about 1.89%, a positively sloped yield curve, and we score this bullish.

Junk bonds yields have moved up sharply over the past month. Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 6.78% this week and the spread vs. 10 year Treasuries stands at 4.66%, and this is bullish, since we judge anything over 4.0% as wide enough to rate bullish.

As shown below, forward inflation expectations remain well below 2.0%. This would appear to indicate the bond market, which we believe is collectively smarter than any one of us, 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 anxious to raise rates by the end of the year.

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CONCLUSION: Neutral

In summary, our MMI score sits in neutral territory at the end of last week.  Liquidity, earnings momentum and monetary policy indicators scored bullish, while investor sentiment and technical indicators score bearish and valuation indicators are neutral.

 

Greg Eisen

Singular Research Analyst and Market Strategist