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A Good Thing?


The graph above comes courtesy of the Zero Hedge blog, and shows the Chicago Purchasing Manufacturers Index dropping into recessionary territory. This is an economic indicator that I follow fairly closely when it is released each month because it is a fairly accurate representation of US economic activity.

Readings on this index above 50 tell us that the US economy is expanding. Readings below 50 tell us that we are contracting. This week’s release of the April numbers showed a drop to 49, a 3 1/2 year low and the first reading in recessionary territory since the recovery began in 2009.

If that isn’t enough, take a look at this one:


This graph, also from the Zero Hedge blog, overlays the US Macro Economic Index over the S&P 500. Its pretty easy to see that this indicator of economic activity is confirming the Chicago PMI reading of economic doldrums in our country.

However, the perplexing thing is that the stock market has continued to move higher in spite of the economic signs that the country is in trouble.

Over the past couple of weeks, we’ve seen the following announcements:

>First quarter GDP came in at 2.5% instead of > 3% forecast

>Durable Goods Orders were down -5.7% compared to the -3% estimate

>The Dallas, Philadelphia and Empire State PMI’s all came in below expectations

>March Existing Home Sales report showed significant weakness

>Corporate Earnings Reports have been ugly, with such big names as Apple, Exxon, IBM, Amazon, MMM, AT&T, Procter & Gamble. Intel, Qualcomm, General Electric, United Technologies, United Health, JPMorgan, Wells Fargo, Bank of America, Morgan Stanley, Goldman Sachs, Caterpillar, McDonald’s and Starbucks all missing their earnings estimates.

But what has the stock market done? As you can see, its gone up.

Everyone knows that I have said (for a few months now) that the market has gone up unsupported by the fundamentals. It has gone up based upon the fact that investors are buying overvalued stocks because they believe the Fed liquidity will keep pushing the market higher. So far, they’ve been proven right and I have looked wrong.

However, at some point, earnings and economic fundamentals will matter and all of this move – or at least most of it – will be wiped out in a correction that will take 100 or 200 points off the S&P 500 Index.

Looking at a fair value for the S&P 500, if you take trailing 12-month operating earnings per share of $97.53 and multiply that times an average P/E ratio of 15, you come up with a value of 1,462.95 for the index compared to 1,582.70 where it stands now.

If we were looking at a period of time where corporate earnings were going to explode higher (8% higher earnings growth would give a fair value of 1,579, or roughly where we closed today), then you can justify today’s prices. But, as you can see from the list of companies that missed earnings and lowered their forward earnings estimates, that its likely not reasonable to expect earnings to explode higher.

What we are seeing is called a P/E multiple expansion. Investors are pushing the price of the index higher, increasing the P part of the equation, while earnings are flat to contracting, lowering the E part of the equation. This is really not a sustainable situation, but it is one that can continue on for some time.

What we could very well see is a rolling correction instead of full market correction. A rolling correction is one where various economic sectors of the market fall in price while others continue to move higher.

If you check out the year-to-date performance of the various economic sectors of the market, you will see that we have in fact been experiencing a rolling correction:


You can see that the defensive areas of the market (Utilities, Staples, and Health Care) are all performing quite well, but that the other economically sensitive areas of the market are in trouble.

But, with the report from Procter and Gamble this week, and many of the other S&P 500 leaders listed above, check out what has happened to the sector performance over the past week:


Technology has made a big push higher from its YTD depths as investors have begun to shift money out of overvalued defensive areas into the undervalued areas.

One week doesn’t make a trend, but if this investor action continues, we will likely see the losing sectors YTD begin to be winners and the winners YTD fall – all with not a lot of impact on the overall index.

In anticipation of this happening, we have begun to add to the YTD losing sectors, putting some cash to work – not a huge amount, but selectively buying when the market gives us an opportunity. For example, we picked up some IBM at $192 and its now trading just below $200; some Caterpillar at $80.53 which is now trading for $83; some GE at $21.72 which is now trading at $22.15; some Intuitive Surgical at $471 which is now trading at $490; some Gold Miners Index find at $28.36 now trading at $29.65; and some others.

We are entering the critical “sell in May and go away” time of year, so we do not want to be overly aggressive.

On a final note, I wanted to show you the year-to-date performance of various sectors of a balanced portfolio:


An interesting thing I want to point out is that if you look at the performance of the index itself, you see that YTD the S&P 500 is up 10.97%. However, if you look at the individual sectors, Utilities are up the most on the year at 7.5%.

What we have is a situation where investors are dropping a lot of cash on mutual funds who are buying S&P 500 futures that are driving up the performance of the index itself but the actual companies in the index are not performing. This happens from time to time and it is just not sustainable.

If you were in a typical balance portfolio that is 65% equities and 35% fixed income, your YTD performance would be roughly 4% based solely on the index numbers above.

If you were in an all equity portfolio diversified across all sectors, included both large and small cap stocks, and included both domestic and foreign stocks, your YTD performance would be roughly 4.9% based upon the index numbers above.

The impact of the Federal Reserve’s money printing is finding its way primarily into large cap S&P 500 type stocks through the futures market. Actual company stock prices are less impacted and as you see in the sector detail above, the index is overstating the real returns of the market.

Is the money printing a good thing? Temporarily for S&P 500 index investors the answer is yes, but if history is a guide, at some point both earnings and economic fundamentals will matter again. And when that happens, investors will want to have cash on hand so they can be buyers based upon valuation.

That is still our primary strategy until either we get a correction or earnings and economic fundamentals return to an economic expansion reading. Until then, risk management dictates that we be conservative.

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