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Brexit Breaks the Banks

June 27th, 2016

The common stock of the European Banks is getting crushed in this post Brexit selloff.  Our own S&P 500 is holding up better on a relative basis.

SPX 2016-06-27

Double Click on any Image for Full Sized View

The graph above is the one you have seen here on the blog a few times before.  It shows the S&P 500 Index for the past 18-months and how it has primarily traded in a 4% range during that time.

There are two important points to note on this graph before we look at the banks:  (1) the index has dropped below the bottom of the trading range in a definitive way; and (2) the index is sitting right on two major support levels – (a) the market closed today with the index at 2,000.35, virtually sitting on the psychologically important 2,000 level; and (b) after an intraday low of 1991, the market recovered above the 1998 level of the lower support as defined by the previous month’s trading activity.

With the S&P 500 down about 2% year-to-date, our market is not in a free fall.  If you don’t know what a free fall looks like on a chart, look at Barclays Bank:

BCS

And, how about Lloyds of London:

LYG

And we can’t ignore Royal Bank of Scotland:

RBS

These banks are off double digit percentages each of the past two trading sessions.  They trade for roughly 30% of book value.  This is a BIG warning sign that there is something really wrong in the global banking system.  The British banks are being hit by investors, but if you look at any of the other big European banks you will see that they have also sold off in a significant way, maybe not as bad over the past two days, but over the past year many of the most leveraged ones are down 50%.

The US banking system is far healthier than its European counter-part.  The banks here have significantly more capital and significantly less leverage.  That’s not to say that if there is a European banking crisis and the governments there have to inject capital to keep the banks afloat that it won’t impact our banking system – it will, the world is way to interconnected and most of the big banks are involved in complicated derivative contracts in the Trillions of dollars which are off balance sheet but a contingent liability none the less.  If even one bank goes down and cannot make good on its counter party obligations, the impact will be felt globally (if you haven’t rented the movie The Big Short, you should to get a flavor for what this could potentially look like if not managed correctly by the banks and the European governments).

As always, I have an indicator that has served me well beginning with the 1987 stock market crash which was caused by a disruption in the global financial markets, the TED Spread.  This TED Spread graph plots the difference between US Treasury yields and Eurodollar deposit yields.  As the spread increases, it indicates that investors perceive there is increased risk in dollar denominated deposits in European banks and require a higher return.  Back in 1987, the spread got to over 200 basis points.  During  the 2008 crash, it approached 475 basis points.  Today, it is sitting around 39 basis points, but up from 11 basis point at its low in 2010.

TED

If we start to get a sustained move higher, that will be a sign that there is something seriously at risk in the global financial system – which will be a sign that its time to get very conservative in portfolio management.  For now, the steady trend higher, albeit still at low levels, causes us to keep track of this indicator as a prudent risk management practice.

But lets take a look at our top graph again, except this time I’ve added two short-term directional indicators to give us an idea of what might happen tomorrow:

SPX 2016-06-27 v2

The bottom two panels of the above image are the Relative Strength Indicator (RSI) and the Stochastics.  Both flash reversal signals when the indicator line drops below the bottom horizontal line.  You can see that the RSI (upper most of the two panels) is sitting right on the line and the Stochastics (bottom of the two panels) is still well above that line and falling.

If both were above the line and falling, it would indicate that we would likely have another down day in the market tomorrow.

If both were below the line it would indicate that the market is getting ready to turn higher – even if for just a short term bounce.

However, with neither one below the line but one sitting on it, you have a less than 50% chance that the market bounces higher tomorrow.

In spite of the odds, I have more than a feeling after having worked with this stuff for 35 years that we could bounce higher tomorrow, particularly since the index ran higher off the lows at the end of the day. The computers kicked in their buy programs when the market hit a triple bottom for the day which was a level that the index bounced higher from the previous two times (below is the chart of just today’s action on the index):

spx today

The overnight news will determine much of how we open tomorrow – it will be day three since the Brexit, so the media are getting tired of reporting on the same thing and will be looking for new news to make.  So absent another day of chicken little news casts, and if we get some stability in prices in Europe over night, our own markets should see some buying and bounce higher.  If there is more bad news, it will likely continue to fall.

Remember, invest what you see and not what you believe is our golden rule here on the blog.  We will see what tomorrow brings us and make investment decisions accordingly.

Mark

Brexit Investment Update

June 24th, 2016

Common stocks are under pressure today due to the Brexit vote to leave the European Union.

spx 2016-06-24Double click on any image for a full sized view

You saw this chart a couple of days ago when I was showing you the 4% sized trading range of the S&P 500 Index over the past 18 months.  Today, I am showing it to you again with the impact of today’s post-Brexit sell-off.

You can see that the index has move down toward the lower boundary of the range (the red bar on the far right of the chart), but that it is still well inside the two blue bars.

There is no reason to get overly aggressive based upon today’s move, but I have made a couple of trades in client accounts that would be classified as opportunistic:

1.  A couple of months ago, I told you that I was adding the Vanguard Long Bond ETF to client accounts as insurance against some unplanned for event.  When the market is near a top, any sort of negative surprise will send the market down and long bonds up.  Today, I sold it for a total return of just under 4% over the past 10 weeks.  This investment performed exactly as expected and gave us a premium performance over the stock market which is up 0.3% year-to-date.  Since this was added as insurance, today was the perfect day to cash it in.  We still have an allocation to intermediate term bonds, including treasury, corporate and mortgage, so there is still insurance in place – but those are more dividend plays until the market corrects more and we have additional need for cash to pick up targeted purchases at better prices.

2.  With the proceeds of the sale above, I added starter positions in two adated beta ETF’s (index ETF’s that mimic a portion of the S&P 500 that I view as being in the sweet spot investment-wise at the moment) just to take advantage of today’s sell-off.  I added the S&P 500 High Quality ETF and the Deep Value ETF to get some additional exposure to the stock market but with holdings that should outperform the broader market during the likely turbulent period ahead.  Both funds feature companies with solid balance sheets, strong dividends, and cash flow.

3.  And with the balance of the sale proceeds I added a short-term position in the ETF that mirrors the London stock market.  It was down more than 10% and we will either hold it for a short-term gain or hold it for an intermediate period depending upon the post-Brexit prospects for the British economy and its corporations.  The British Pound is at its lowest level in 30 years, so the companies headquartered in England should get a significant upward revision in earnings since they will be able to sell their exports significantly cheaper to buyers who have an immediately stronger currency (making the British goods cheaper by comparison).  Plus our buying the ETF at a 10% discount should make for a decent investment.

I have some other trades to make, but will probably sit tight and see what the market tells us before adding additional equity exposure. Over the weekend there could be scare stories hitting the news that will send the wolves to the gate and give us a lower purchase level next week.

Britain’s Brexit Breakdown

June 23rd, 2016

This Brexit schedule will guide you through the night of vote counting and reporting.  Credit goes to The Guardian for this guide:

0_map_britain_1987_enlarged

10pm (6pm CST)

Polls will close, and on election nights this is normally the moment broadcasters show their exit polls and make their projection for the night ahead.

However, that won’t happen this time as there’s no exit poll for this referendum. Some banks are said to have commissioned private exit poll, but they will be kept for their employees.

So if anyone tells you they know what’s going to happen at this stage, they’re a chancer, unless they are an eagle-eyed watcher of sterling derivative markets. Sky News has commissioned a survey from YouGov of people previously polled, asking how they voted on the day. This will be released at 10pm, but this is not, repeat not, an exit poll and shouldn’t be treated like one.

If you prefer moving pictures (tsk!) this is the line-up from the broadcasters.

BBC1: David Dimbleby will anchor BBC1’s coverage until the early hours. Emily Maitlis will be presenting as well and Jeremy Vine will have his snazzy graphics. The BBC’s political editor, Laura Kuenssberg, and economics editor, Kamal Ahmed, will do the bulk of the analysis. If you’re not in the UK, you can watch the coverage on BBC World News.

ITV1: Tom Bradby will host the broadcaster’s coverage with the political editor, Robert Peston, and national editor, Allegra Stratton, speaking to politicians and pundits. Julie Etchingham will also present, and there will be live reaction from Brussels with ITV’s Europe editor, James Mates.

Sky News: Adam Boulton hosts, alongside political editor Faisal Islam, boasting a team of 50 correspondents at counts across the country.

CNN International: For international viewers, Richard Quest and Hala Gorani will anchor from CNN’s London bureau, with a touring “Brexit campervan” providing outside coverage. Christiane Amanpour will be with guests and analysts outside the Houses of Parliament, with correspondents contributing from Berlin and Brussels.

12.30am (6:30pm CST)

The voting is done by 380 council areas, not by constituencies, so it will play out slightly differently from election night. Sunderland (always the first in a general election) and Wandsworth are expected to declare first, and we can learn a bit from their results, depending on whether either campaign does better or worse than expected.

Wandsworth should have a very strong remain showing, with Sunderland showing a narrower lead for Brexit, about 55-60%. Anything lower than that for Brexit will be a great start for remain campaigners.

The City of London is expected to be among the first as well, declaring around 12.45am and likely to show a substantial lead for remain. The remain vote is likely to look high in the early hours of the morning. If it doesn’t, that’s a big problem for in campaigners.

Gibraltar and the Isle of Scilly will have high remain votes, but the voter numbers aren’t exactly huge. More telling will be results from Salford and Stockport, which will start to give us a sense of whether Labour’s safe seats in northern England are as pro-leave as has been predicted. That conversation could dominate the punditry for an hour or so.

Another to watch is Swindon, where leave will hope for a win, but a chunk of middle-income voters in their early- to mid-30s in the area – natural David Cameron voters – might push it towards remain.

Hartlepool, a leave heartland, is expected to declare during the hour, as is Merthyr Tydfil, which should also show a lead for leave.

Northern Irish results should start coming in, which will be interesting as there’s been very limited polling in the area. Most areas in Belfast should declare during the hour and instinct would suggest a remain lead, over concerns about the border crossing.

1am (7pm CST)

Gibraltar and the Isle of Scilly will have high remain votes, but the voter numbers aren’t exactly huge. More telling will be results from Salford and Stockport, which will start to give us a sense of whether Labour’s safe seats in northern England are as pro-leave as has been predicted. That conversation could dominate the punditry for an hour or so.

Another to watch is Swindon, where leave will hope for a win, but a chunk of middle-income voters in their early- to mid-30s in the area – natural David Cameron voters – might push it towards remain.

Hartlepool, a leave heartland, is expected to declare during the hour, as is Merthyr Tydfil, which should also show a lead for leave.

Northern Irish results should start coming in, which will be interesting as there’s been very limited polling in the area. Most areas in Belfast should declare during the hour and instinct would suggest a remain lead, over concerns about the border crossing.

2am (8pm CST)

This hour is a good time to start concentrating, so put some coffee on.

Westminster, Wandsworth, Ealing and Oxford may give remain the lead here. These are likely to be very safe areas for a remain vote, with high numbers of graduates and younger voters.

We’ll also start to see a number of Scottish results rolling in, from Shetland, East Ayrshire and Angus. If these show only a weak lead for remain, it might be time for Cameron to worry.

Key Welsh boroughs to watch are Blaenau Gwent and Neath Port Talbot, where the opposite is true: Vote Leave will want a good win here, especially in the area troubled by the steel crisis, which Brexit campaigners have linked to the EU.

Castle Point, a key Eurosceptic area in south Essex, will declare around 2.30am. About 70% of voters are in favour of leaving the EU.

Crawley in West Sussex, a bellwether seat in the general election and also likely to be pretty evenly split at the referendum, is also due to declare, as is South Norfolk, where the split should also be telling.

According to JPMorgan’s analysis, commissioned for investors, even if leave ultimately ends up victorious, the remain camp is likely to be in the lead until about 3am. If leave has a total vote share of about 40-45% at this stage, Stronger In will be celebrating.

But if that percentage for leave is more like 45-50%, it will be a very close run thing. Anything higher than that is an indication of a good night to come for Boris Johnson and Nigel Farage. Still, pundits are unlikely to call the race this early.

3am (9pm CST)

Boston in Lincolnshire, where 68% of voters are predicted to be in favour of Brexit, is likely to declare now. Cambridge, one of the strongest remain cities in the country, will declare here, though surrounding Cambridgeshire is very much out-land. Jeremy Corbyn’s distinctly Europhile constituency, Islington, will also declare during the hour.

Look out here for West Oxfordshire, home to David Cameron’s Witney constituency, so the result will be symbolic of something or other.

4am (10pm CST)

Time to hear from Tendring – home of Ukip’s only MP, Douglas Carswell, who represents Clacton – which is unsurprisingly one of the most Euroskecptic areas of the country. Great Yarmouth and Blackpool, both Brexit heartlands, could also bump up the leave share of the vote during the hour.

Harrogate, one of the most affluent areas of North Yorkshire, will be an interesting result to watch, especially if the leave campaign does better than expected.

Once South Staffordshire, Havering and Gravesham, all strong leave areas, are counted, the running tally should give a pretty fair idea of how the overall result will look, percentage-wise. Broadcasters may start officially calling the result from now.

5am (11pm CST)

Manchester will declare by 5am, almost certainly for remain. However, by this time, about 80% of authorities are expected to have made a declaration, and it would be a huge surprise indeed if the final percentages differed greatly from the running tally at this hour.

Bristol, one of remain’s strongest areas and also the country’s slowest counter, will declare by about 6am, but it’s unlikely to make a massive difference.

7am (1am CST)

The official result should be in by now – unless there are substantial recounts needed and it is close – and Jenny Watson, who chairs the Electoral Commission, will announce the final tallies in Manchester.

Mark

Stock Market Trading Range

June 21st, 2016

Today’s chart shows the S&P 50o Index in a Trading Range with the RSI indicator and Volume by Price overlays for the common stock in the indices.

SPX 2016-06-21Double click on any image for a full sized view

The graph above shows the action in the S&P 500 Index over the past 18 months.

You can see that we have a really well defined trading range with the upper boundary being the all-time high of roughly 2,135 and 2,040 (roughly 4.5% below the high).

There are two very obvious corrections out of the trading range that dropped to a level of 10% below the 200-day moving average (for those of you who are long-time readers of the blog, you know how important the range of 10% above and below the 200-day moving average is for the S&P 500 – 10% above acts as a solid resistance and 10% below is a solid support level – or in other words, when index is trading 10% above the 200-day moving average you consider selling and when its 10% below the 200-day moving average you consider buying).

But our case today is not that cut and dried.  This trading range has become a significant obstacle to investing.  It is clear that investors do not have the confidence in the economy to push the index to new highs.  Who can blame them?  Corporate earnings have been falling for the past 18-months – check out the same graph above except I’ve added GAAP Earnings (the green line) which drops each quarter over the 18-month time frame:

 SPX 2016-06-21 EPS

If a company’s stock price is just the present value of its future earnings, and the index is made up of individual companies, the only way for stock prices to go up at a time when earnings are falling is for investors to place an ever-higher valuation on those earnings.  That can be justified to a certain extent by the low interest rates we have, but given they have been stuck at current levels for seven years that justification eventually runs its course at a certain level of valuation.

Without some catalyst to drive the market higher, like a change in governmental fiscal policy, a change in the tax code, or some macro event that jump starts production, an ever-growing valuation is not likely.  The market will have to correct sometime to fix the over-valued levels we are currently experiencing.  However, this sideways trading within the range can go on for a long time – a lot longer than anyone believes – before the index breaks out of the range.

I am sticking with our defensive asset mix for the present time.  If the market were to fall and correct some of the over-valuation or if something were to cause it to move to a new high and remain above that level for at least three trading days, then I would get more aggressive and put some of the money to work we have reserved for that purpose.  But until we break out of the trading range and the index gives us a buy signal, right here, right now, the current strategy of defensive holdings, cash and fixed income is the right place to be.

Mark

Yield Curve Ball

May 26th, 2016

Inverted Yield Curve 2000Double click on any image for a full sized view

One of the things that I find really troublesome is the Yield Curve, or more specifically, what the Federal Reserve will do to stimulate the economy when we get to the next recession and stock market correction.

The Yield Curve is a line graph that plots the span of interest rates from overnight rates to 30-year bond rates on a single day.  In a normal situation, short-term rates are lower than long-term rates and the line graph has an upward slope to it.  But there are times, in particular when you are at a recession, that short-term rates are higher than long-term rates – this is called an inverted yield curve.  This situation comes from investors fleeing the stock market due to the risk of corporate earnings falling in the recession. The investors are reinvesting their money in the safety of bonds, driving the longer term rates down since there is so much demand.  The inversion can also be aided by a Federal Reserve that doesn’t cut interest rates fast enough to avoid the recession.

In the graph above from the peak of the stock market in 2000 (the red vertical line) you can see the yield curve on that specific day (the red downward sloping line) was inverted.  The recession was upon us and the stock market started its long journey down as corporate earnings were less than expected.

Normal Yield Curve 2003Fast forward to the bottom of the stock market in 2003 (again the red vertical line) and you can see that the Federal Reserve had cut short-term interest rates from roughly 6% to 1% in order stimulate the economy.  The yield curve resumed its normal shape and companies started to experience increased earnings coming out of the recession, those earnings increases translated into a bull market for stocks.

Inverted Yield Curve 2007Fast forward to the top of the market in 2007 and you can see that we again have an inverted yield curve.  Shortly after this date, the recession takes hold and corporate earnings begin to fall sending the stock market down decisively (this was a lack-of-liquidity driven market crash as much as falling corporate earnings).  To combat the recession and to add liquidity to the financial system, the Federal Reserve cut interest rates again.

Normal Yield Curve 2009You can see that at the bottom of the market in 2009, we again have a normal yield curve with short-term rates cut by the Federal Reserve from just under 5% to just above 0%.  Those near 0% rates fueled a rally in the stock market that ran to last May’s highs.  Unfortunately, corporate earnings have started to fall again and there is talk of another recession coming our way.

Flattening Yield Curve 2016This is the yield curve today.  You can see that it is still a normal yield curve, but that it is noticeably flatter than the one above (this could possibly presage an inverted yield curve – but it would be difficult to get long-term rates near zero, but anything can happen in this economy where we have no past history to learn from).  You can also see that the Federal Reserve has kept short-term rates at the near 0% level.  The question we should all want an answer to is what will the Fed do when we get to the next recession if it cannot lower interest rates since they never raised them as would be normal during an economic cycle.

There is a lot of speculation that our Federal Reserve will follow the European Central Bank in two ways:  negative interest rates and purchasing corporate bonds in a new round of quantitative easing.

We haven’t talked about QE in a while here on the blog because the Fed ended that practice a couple years ago – QE is where the Federal Reserve prints money to flood the economy with liquidity by buying government bonds.

Both of these actions, if the Fed were to follow the ECB’s lead, would be unprecedented.  Much of the economic stagnation we currently have comes from the 0% rates – consumers and businesses have loaded up on debt to record levels given the low rates.

Consumers have incomes that have not kept up with their debt fueled spending and they are not the catalyst for economic activity that they once were.

Corporations have used the debt to buy back their outstanding shares of stock, a financial trick that makes their earnings per share appear to go up simply because there are fewer shares to spread the earnings over.  The side effect of borrowing to buy back shares is that reinvestment into property, plant and equipment as well as research and development has been curtailed, adding to our economic stagnation.

What unintended harm can negative rates or QE for corporate bonds have?  I don’t know but it will likely continue to provide the wrong incentives for consumers and corporations while not doing anything to stimulate the economy.  This is our yield curve curve ball, or with a nod to Wheel of Fortune, our yield curve ball.

A Return to Volatility or Not?

May 10th, 2016

S&P 500 Index 20-yearsDouble click any image for a full sized view

There was a recent report from one of the Wall Street banks saying that the current volatility in the markets is a new phenomenon and that for the balance of the year investors should expect to experience more of it.

I’ll take the under on the first part of that statement.

Over the past 20 years, we have had similar volatility until just recently, so in effect the current bit of volatility is really a return to normal market action.  If you look at the graph above  you can see that the current volatility in the market started in the summer of last year, after roughly three years of calm upward movement in the market.  Prior to the fall of 2012, the graph shows similar volatility during its bigger secular bull and bear moves back to 1996.

As for the balance of the year, I agree that the markets will continue with the current level of volatility, albeit in a downward direction.  In the two most recent blog posts that I wrote, I discuss this very thing.  To summarize those posts, the intermediate to long term direction of the market is down and investors need to have a defensive asset mix including a healthy allocation to cash so that when there are short-term movements up or down within the major trend, they can use it for trading purposes.

If investors are not comfortable with trading for short-term gains, then buying a bond fund has historically acted as a hedge against major market crashes.  Here are a couple of graphs depicting how stocks and bonds trade in near mirror image, this first one shows the Dot Com boom and bust:

S&P V Bonds - NASDAQ Crash

and this second one shows the Subprime Mortgage crash:

S&P V Bonds - Subprime Crash

The downside with the bond fund is that if the Fed really gets into interest rate hiking mode, the bond funds will go down in value commensurate with the size of the rate hikes and the duration of the fund.

However, if the market crashes (and it is always possible given the risks to the financial markets that are out there) then a high quality US Treasury fund will be the best investment imaginable.   Since US economic activity is pretty tepid, there is little chance of significant rate increases in the near future, so booking profits in your stock portfolio (or stock mutual funds) and buying a high quality US Treasury Fund plays the percentages pretty well.

Why do I mention crashes?  Well, a lot of smart investors are already talking about it.  One is Carl Icahn whose hedge fund is 150% net short.  He is on record of stating that the market has a greater change of going down 20% than going up 20%.  Carl may or may not be right, but having some protection for your portfolio and structuring it in a defensive manner when the market is near an all-time high with falling earnings and poor technicals seems to be the prudent thing at the present time instead of swimming against the tide.

Price Momentum Guidance

May 9th, 2016

PMODouble click on any image for a full sized view

After Thursday’s post on the Fair Value of the S&P 500 along with a technical analysis demonstrating investor sentiment, I received a couple of emails from readers who wanted to know a bit more about the technical aspects of what I follow to help determine market direction.

For a big picture intermediate-long term view of where we are headed, I use a 20-year monthly price chart and compare it to the Price Momentum Oscillator (PMO).  I know sounds like Sanskrit for some folks so let me explain.

The price graph (the top panel of the image) above is based upon the monthly movement of the S&P 500 compared to the 10-month moving average of the index.  You can see that the red/black line moves above and below the moving average, indicating bull Vs bear markets.

You can also see a bunch of red circles which I’ll explain in a bit.  For now, though, look at the one on the price graph far to the right.  You can see that the market is moving up and down across the moving average.  To me, this says the market is in a topping process – investors no longer have the conviction to keep pushing it higher but there are still some dip buyers out there that will jump in if it falls to a certain level.

Those red circles are pretty important when you compare them to the PMO.   The PMO is an indicator of the strength of price movement within the market.  Instead of a visual analysis of the index itself, this indicator measure the activity in the market and tells you if investors are acting bullishly or bearishly.

When we look at the PMO on a long-term chart like the one above, you can see in the red circles points in time when the blue line crosses over the red indicator line.  Those crosses are critical as they demonstrate that investors’ are acting in either bullish or bearish manner and that the direction of the market is taking a change.

So for now, we are being cautious and defensive is critical as a strategy but being nimble and putting cash to work on a short term tactical basis when the market gets short-term oversold.  Then when it gets short-term overbought (there are other indicators that I use for short-term market movements that I’ve highlighted here on the blog previously), we are raising cash again to get back to a defensive position.

Our typical practice is to utilize  index exchange traded funds (ETF’s) for this short-term tactical investment activity.  I’m actually pretty grateful that ETF’s have come to such prominence in the past few years given their liquidity and ease of trading, making this a much more efficient and effective process.  As an example, when market was at the February lows, we purchased shares of the Russell 2000 ETF then as the market became short-term over-bought we sold it for a 5% gain after three weeks or so and reinvested the proceeds back into a cash equivalent until the market gets back to short-term over-sold.  Wash, Rinse, Repeat :)

As I write this, the market is hovering around break-even with little volume – another sign of the indecision among investors.  When there is indecision, the best thing to do is sit back and watch for signs that a sustainable move will develop in one direction or the other.   Unfortunately, given the reading of the PMO, breaking out to new highs is unlikely so our defensive strategy is the best choice for now.

S&P 500 Fair Value

May 5th, 2016

S&P valuationDouble click on any image for a full sized view

With the market appearing to rollover and head lower, I thought it would be informative to take a look at our S&P 500 Fair Value calculation again.  Its been a while since I’ve written about it, but with the annual “sell in May and go away” slogan being bantered about in the financial news and opinion articles/interviews now seems a good time to determine if the market is overvalued or undervalued at current levels.

As a refresher for long time readers of the blog, the calculation above takes four different metrics of the market based upon the historical mean valuation levels and computes a current value for the market using current data.

1.  Historic Mean P/E Ratio X Projected 2016 Earnings Estimates

  • Valuing the market based upon the underlying earnings of the companies computes a value based upon the returns that investors should expect to receive.  Our calculation shows that the value of the S&P 500 under this metric is 1800 compared to our current value of 2058  [Market is Overvalued]

2.  Historic Mean Shiller P/E Ratio X Projected 2016 Earnings Estimates

  • This metric uses the same calculation above except it substitutes the Shiller P/E for traditional P/E.  The Shiller P/E is calculated as a rolling 10-year average of the traditional P/E Ratio.  The idea is to smooth out the volatility of any one year for a more representative valuation.  Our calculation shows that the value of the S&P 500 under this metric is 1925 compared to our current value of 2058  [Market is Overvalued]

3.  Historic Mean Price to Book Value X Current Book Value

  • Price to Book Value is different from Price to Earnings in that P/E values the market by its earnings potential and P/B values it by the collective value of the assets of the companies in the market.  Our calculation shows that the value of the S&P 500 under this metric is 2028 compared to our current value of 2058  [Market is Fairly Valued]

4.  Historic Mean Price to Sales Ratio X Current Sales

  • Price to Sales is different from either P/E or P/B in that P/S values a company according to its operational efficiency in generating revenue.  Our calculation shows that the value of the S&P 500 under this metric is 1600 compared to our current value of 2058  [Market is Significantly Overvalued]

 The Final Step

  • To come up with an overall value, I use a weighted average of the above four calculations.  To me, the two most important valuations are the Shiller P/E value and the P/S value because I prefer to have the smoothed earnings valuation that minimizes volatility and I prefer to look at a company’s ability to generate revenue over the value of its assets which by its very nature is a liquidation value for a company and not an ongoing business.
  • Using the weighted average calculation on the chart above, you can see we come up with a Fair Value of 1823 for the S&P 500, or roughly 11% below the current value.

So how do we use this?  I like to take a graphic look at the market to see what technical levels based upon investor sentiment tell us:

S&P 500 2016-05-05This graph tells me a lot about the market that supports the fair value calculation.

First, if you look at the horizontal line I’ve drawn at the bottom of the graph, it shows you where the market fell to on the February correction.  That line corresponds fairly closely with our current Fair Value calculation.  We should view that as a major support level for the market for two reasons:

  • (1) its the prior correction low and it coincides with our fair value – this is the obvious one, and
  • (2) if you look at the far left side of the graph you will see some red and green bars; these represent the volume of buyers and sellers at the various price levels; down at the 1823-ish level on the index you see a small red bar which indicates that level has primarily seen selling but not a lot of it which tells me most investors view that level as one to hold onto their investments because they are not being paid to sell and there is not any panic feeling about the market falling to that level.

In just the opposite reading, look at the second bar from the top.  You see it is much larger than the bottom bar meaning there was a lot of trading volume at that level (which currently corresponds with the price level we are at now) and the bar is pretty closely split between green and red (with green slightly larger if you look really closely).  This tells me that investors have no conviction at that price level for the index, the buyers will be likely sellers if the market doesn’t move up and the sellers will likely be buyers if it does.

So since the market has rolled over, the former buyers will on whole want to lock in the current price before the market goes down more, adding to downward pressure.  Then as the selling gathers momentum, it should slow at the next level lower since there were fewer historic buyers.  Interestingly enough, that level provides some additional technical support as both the 50-day moving average and the 200-day moving average are right there.

The market has the opportunity to turn higher at that level, between 2043 and 2013, however if it doesn’t, it will then likely head toward our 1823-ish horizontal support line.  There will be other lesser support levels below 2013 and above 1823 which we can discuss if the market heads that way. However, you see the diminishing volume on the way down is predominantly green which means there are former buyers that will want to lock in their profits so they down show a loss, which will add to downward pressure on the index.

For now, though, my view is pretty bearish overall and view the market as headed lower.  It is VERY significant that (1) corporate sales and earnings continue to fall putting more downward pressure on our Fair Value and (2) the market has been unable to break above the all time high set last May and from a technical standpoint it looks like in the near-term the market is headed lower and will not make an assault on that peak anytime soon.

Because of this, we have an overweight of cash and bonds in client portfolios in order to (1) protect their capital and (2) to give us ammunition to pull the trigger on buying some of our favorite companies at lower values.

As things progress, check back here or you can subscribe by clicking the link above and get an automated shout out via email when a new post is made.

 Mark

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