The Stock Market: A Bumpy Road Ahead?
Posted February 22, 2011
In my January 25, 2011 blog post I wrote:
The S&P 500 stock index is up over 23% since last September 1st and there are increasing signs that the stock market rally is ready for a rest. In their Daily Market Report today Dorsey, Wright & Associates (DWA) pointed out one indicator that often signals a turning point in the market is an increase in “buying climaxes”.
What is a “buying climax”? A buying climax occurs when a stock (or index) makes a new yearly high, often early in a week but then declines and closes down for the week as a whole. A “buying climax” does not mean that a stock has finished its long-term move, or that a reversal in its long-term trend is imminent, it is simply a first indication that a near-term top has been reached.
Over the past few years we’ve seen some rather significant corrections begin with buying climaxes (last April for example), but many of them resulted in only modest setbacks afterward. It’s important to recognize that it is an early warning event, and not a trend changing event. The Investor’s Intelligence research service www.investorsintelligence.com shared the following in their most recent weekly update:
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Well, the S&P 500 stock index has risen another 4% since then and this huge move has been made without as much as a 5% “correction” in price. The chart below shows how steadfast and consistent that this rally in stocks has been. The resilience of this rally in light of the current geopolitical unrest in the Middle East is nothing short of amazing to me.
Source: Decisionpoint.com
Ok, so we know that the stock market will have a correction to digest its 29% gains but how bad will it be? Corrections of 5% - 10% in a bull market are typical and they may even get as bad as 15% - 20% like the one we had last April – June. If the decline gets worse than that then it’s probably the start of the next bear market which can never be ruled out. At this point I think the next correction will be of the 5% - 10% variety for the following reasons:
• Low stock valuations
• Ideal monetary conditions
• Strong up trends in stock prices across the broad market.
Stock valuations are still low based on history. The price/earnings (P/E) ratio for the S&P 500 index is about 13.4 using the 12 month forward earnings forecasts of Wall Street analysts which are at a discount to the long-term median P/E of 16 – 17. I’m confident in the earnings forecasts at this point because they continue to undershoot for the majority of companies. Another way to assess the risk/return ratio of stocks is to compare their “earnings yield” (earnings/price or E/P) with the yield of bonds. The “Fed Model” compares the “earnings yield” (E/P) for the S&P 500 using forward 12 month earnings forecasts with the yield on the 10-year Treasury note. This measure favors stocks over bonds big time right now as the S&P 500 earnings yield is currently 7.47% compared to the 3.48% rate on the 10-year Treasury note. History says that that gap between them will eventually close but the question is will it close because of higher stock prices, higher interest rates or a combination of both? Time will tell so it’s something we are monitoring very closely.
Despite Treasury rates rising quite a bit since last fall, monetary conditions are still very bullish. The rise in longer-term Treasury rates has not been accompanied by a corresponding rise in short-term rates, at least not yet. This has resulted in a very steep yield curve (a graph that shows how interest rates vary for short, medium and long-term maturities) as the spread between the short term rates and long-term ones is about as wide as it gets. This provides a very profitable platform for banks to increase their lending and earn a fat profit. Finally, based on history its ok for interest rates to be rising as they are now so long as it’s not too abrupt and their level is under about 6%. We have quite a ways to go to reach that 6% level which has hindered economic growth and ended bull markets in the past but we’ll be watching the market’s reaction to a continued rise in rates very closely.
Despite the market decline as I write this the stock market’s short, medium and longer-term price trends remain up. The first sign of weakness will come if the S&P 500 declines below its 20 and 50 day moving averages which are at 1,316 and 1,285 respectively. A correction down to the 50 day moving average would be about 5% off the bull market high. A more severe correction would take the S&P 500 down to its 200 day moving average of 1,196 or an 11% decline off its high. Time will tell how it all plays out but one thing’s for sure, we don’t want to chase prices in here. Many areas of the market are very “overbought” right now and have been for weeks so being patient and buying on pullbacks is our plan so long as the longer-term up trend remains n tact. Market corrections also provide an opportunity of selling the weaker holdings in a portfolio to make cash available for purchases in stronger areas.