MMI Continues to Flash Bearish
Our Major market Indicators continue to flash a bearish signal, just as they’ve done since our report dated September 21, 2014. At that date the S&P 500 was 2010.14. The index closed this past Friday at 1906.13, a loss of (5.2%). This week the MMI fell to 41.83. So we continue to recommend a bearish posture.
We note that some investors might be tempted to “buy the dip” now that we’ve just had the worst week of stock performance in quite some time. We believe the market indicators are telling us “not so soon”. Below, the weekly graph of our Major Market Indicators shows the trend over the last few months, and the fall-off into bearish territory over the most recent week.
MARKET SENTIMENT INDICATORS: Bullish
Remarkably, market sentiment indicators turned bullish this week as a group. Much of our scoring is based on a contrarian judgment. So, the VIX and VXN volatility indicators moved up sharply to 21.24 and 22.62 at the end of the week, and we interpret this as bullish. The put/call ratio on both the CBOE and S&P 100 were up this week, and we score these as positive bullish, too. The same holds true for the ARMS index. One indicator which had been bullish in previous weeks turned bearish: the so-called “confidence index”. We compare the yield on a representative sample of high quality bonds vs. the yield on a similar type sample of intermediate grade bonds. Surprisingly, the yield on intermediate grade bonds fell sharply this week, down 89 basis points. The spread between high quality and intermediate quality narrowed to a level we consider bearish. But this was the only movement in a negative direction. Short interest ratios of days to cover remain high on both the NYSE and NASDAQ, at 4.50 and 4.55 days respectively. Given the sharp drop in market prices we’ve just endured, it’s not surprising that investor sentiment has turned sour, but we interpret that in most cases as a bullish sign.
TECHNICAL INDICATORS: Bearish
Technical indicators remained bearish this past week, as they have been since turning in that direction in our September 21st report. The ten day ratio of moving average new highs vs. new lows was bullish for the NASDAQ (but not the NYSE). The only other technical indicator we score bullish is the S&P 500 itself, which is trading just barely above its 200 day moving average.
The remaining index measures we track scored bearish as they all sat below their 200 day moving average as of Friday’s close. These include the Dow 30 Industrials, the NASDAQ composite, the NYSE composite, the Russell 1000 equal-weight ETF and the Russell 2000 equal-weight ETF.
Reflective of this, the ratio of new 52 week highs to new lows fell to a ratio of 0.16:1. This is supported by volume figures. The ratio of weekly advancing vs. declining volume for the NYSE was 0.51, while the NASDAQ A/D volume was an even worse 0.45 times. Both these amounts are bearish. Finally, last week’s ratio of advancing to declining stocks was weak at 0.33 for the NYSE and 0.21 for the NASDAQ.
Overall, the technical picture looks quite weak. This coming week we will focus on whether the S&P breaks below its 200 day average.
LIQUIDITY INDICATORS: Bearish
Our liquidity indicators were unchanged for the week, and continued to score bearish. We had a very negative week of mutual fund flows, at ($6.7) billion, but this was composed of $300 million positive inflows to traditional funds vs. ($7.0) billion outflows from ETFs. This was the second week in a row of fund outflows. The corporate acquisition market continues to show life, with over $13 billion of cash acquisitions announced, including BD’s acquisition of CareFusion for over $10 billion cash (plus some stock). M&A has been consistent over the past month. Announced stock buybacks were down for the week, but over $13 billion on a trailing four week basis. IPOs were more than an offset for the positives. Our scoring counts the effect of the trailing four weeks, and the huge Alibaba IPO is still in our numbers (though this is the last week!) and this weighs down the liquidity overall score. Yet since Alibaba the quantity of IPO dollars getting thrown at the market has declined each week. Given the weak market environment we won’t be surprised if the IPO pipeline backs up like jets at the airport in a snowstorm. The pipeline of IPOs stands at 141 active deals. Secondary stocks offerings continue at a benign volume level.
The IPO machine roared in September!
Overall, we count up a net decrease of liquidity to the domestic market of approximately $(141) billion for the past four weeks, which is bearish.
VALUATION INDICATORS: Bullish
Our fair value target for the S&P 500 is 2624, up 37.7% from 1906.13, the close on October 10th. 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. This bond yield, asnoted above, dropped precipitously this past week, accounting for the high P/E multiple. The S&P 500 is trading at 16.8 times the trailing four quarters operating earnings. This is above the historical norm of 15.5 times operating earnings.
Total domestic market capitalization is at $22.91 trillion. Excluding financial services, we calculate market capitalization is 4% less than 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 cheap. However, compared to GDP the market is at a 32% 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 – 1.3x, or the equal-weighted Russell 200 ETF – 1.01x.
The chart below indicates that the S&P 500 index had gotten a bit ahead of itself compared to earnings, but that it recently has come back down to trend-line.
Change in 12M EPS vs. Change in Price: 10-Year
Overall, valuations have turned slightly bullish, based on the earnings growth achieved last quarter and the pullback in stock prices of late.
EARNINGS MOMENTUM INDICATORS: Bearish
We’ve transitioned to tracking the third quarter’s earnings. Although only 29 companies have reported so far, the ratio of positive to negative earnings surprises, while a positive 2.71x, is still not enough to warrant a bullish score.
Earnings growth expectations have come down for the third quarter, now standing at a positive 4.5% compared to 4.7% at September 30th and 9.0% as at June 30th. Yet the actual results will probably be better than that. FactSet recently reported that over the last four years the earnings growth rate increased 2.3 percentage points from the end of the quarter until the end of earnings season due to upside surprises – over that same period 72% of companies beat the consensus earnings estimates.
Earnings estimates for the fourth quarter of 2014 have come down since the end of the third quarter. The growth rate stands at 8.3% vs. 8.8% at the end of September. The revision ratio of upward to downward revisions reflects this, at 0.36. As a result, earnings expectations have come down for 2014 to a 6.7% growth rate, vs. 6.8% at the end of September, and 7.1% at the end of June. Expectations for 2015 have also dipped since the end of September, to 11.6% growth vs. 11.9% at the end of September.
On a PEG ratio basis, the S&P 500 is trading at a PEG ratio of 2.11 (trailing operating earnings), well under the historic average of 2.58 times, a positive sign. But this is on a trailing basis. If earnings disappoint, the PEG ratio may not stay as cheap as it appears.
The following chart shows the amount by which reported earnings have exceeded expected earnings each quarter for the past three years.
MONETARY POLICY: Bullish
The Federal Reserve is still accommodative, but the market has ignored that fact lately. The Fed continues to taper buying new securities, and it will
stop all new purchases before this quarter is over, probably at the October meeting. 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. We don’t believe the Fed funds rate target will change anytime soon. We read the Fed’s comments as indicating it will step in and reverse course if necessitated by weakening economic conditions.
Our excess liquidity indicator is bullish at 274 basis points. This is evidence the Fed is still in easy money mode, providing 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 spread between one year T-bills (constant maturity) and 10 year T-bonds is 217 basis points, down from 223 at the end of August. The 10 year yield closed this past Friday at 2.28%, a low for the year. This demonstrates a lack of inflation expectations. At the other end of the quality spectrum, high yield bonds spreads contracted have widened over the last month to 331 basis points from 252 basis points. High yield spreads have widened materially since the beginning of summer.
The graph below depicts the annual percentage change in M2 money supply vs. the velocity of M2, on quarterly basis. Since the mid-1990s velocity has been on a downward trajectory, and money supply growth has trended positively. Since GDP = Velocity x Money Supply, and since the velocity has been decreasing, increased money supply has been the prescription for maintaining GDP growth. As long as the machine we call the economy continues to sputter at lower and lower velocity, we expect the Fed to continue to make money available on easy terms, since maintaining consistent economic growth is key to fulfilling one of its dual mandates – fostering maximum sustainable employment.
In summary, our MMI score is solidly in the bearish zone, at 41.83. The bearish components in the MMI are the technical, liquidity,earnings momentum, while the investor sentiment, valuation and monetary policy categories send a bullish signal. The indicators have scored bearish for four straight weeks, and while a quick recovery of stock price momentum is possible, the market isn’t telling us to expect that at present. We maintain a bearish posture.
Singular Research Analyst and Market Strategist