First Quarter 2016 Investment Climate: The Market

The Market

Crossroads present themselves here as well.   The trend of the market indexes and the market internals appear to be in a pattern we have not seen in years.  Since March of 2009 we have been in an unrelenting uptrend.   Corrections have occurred and they have generally been steep and short.  But, if we look out over the past two years of flattish behavior, and the rolling over pattern that began with the last weekly closing high in May of 2015, the market is signaling something new.  Look at the DJIA chart below, a weekly chart going back to 2005.  The foot to the pedal relentless march higher fueled from Quantitative easing introduced to a dramatically oversold condition in March 2009 has faded and we now find the current gas tank reading is very close to empty, as we search for the next gas station amidst the many choices presented by the Crossroads. Given the US economic data discussed above, we may find we are walking and pushing with sheer sweat and muscle a market that needs a spark to turn over the engine one more time.  We need more than Central Bank money creation, currency debasing and interest rate destruction to support the fundamental economic needs and opportunities our world offers.

DJIA

 

  1. Price Earnings: The measure of value represented by the Price Earnings ratio indicates an overvalued market.  Often this is the market’s way of looking forward to accelerating growth, pricing in the optimism of higher profits and revenues from expanding consumption and productivity in the future.  With worldwide economic growth forecasted at sub-3%, the pricing in of optimism may be overdone.  Presently the S&P 500 PE ratio is 22.46X.  The median since 2005 is 18.77X.  The current PE is higher than any point since 2010, and has risen from a bottom on November 25, 2011 of 13.31X.  I find it hard to justify the price in the PE formula and can only conclude at this juncture that price has to come down.  Now, there are some who argue that the market should trade expensively in the current low interest to NIRP environment.  I have looked at this and while some aspects of the argument make sense, in the whole I do not find it credible when all of the pieces are put together.  I will delve a bit deeper on this topic in the subsequent discussion of the 187 portfolio.  One last point to make here which is an important fact:  The rise in the S&P index is lagging the growth in the PE ratio.  This effectively means earnings are contracting when compared to price.  A huge warning sign.
  2. Resistance:  The S&P, DJIA, DJ Transports and NASDAQ are all hitting upper resistance points from the bottom.  I utilize moving averages for each index where I calculate the average, and then create an upward and lower average that surrounds the actual average.  These lower and upper bands have shown to be very reliable bounce points.  Over the past seven years when the indexes have pulled back from their upward advance, invariably the lower bands have proven to be the point where the decline ended and the resumption of the advance continued.  Presently, the opposite is happening.  The January to mid-February trend to the downside of the indexes has just seen a dramatic reversal.  Guess where the indexes now sit?  They are reaching the upward moving average band from below.  If we apply the historic experience of an advancing trend continuing once the lower band was reached as a support level, then the market is now signaling the arrival of an interim top in a downward trending market.  I expect the declining market trend to be confirmed when the indexes bounce off of the upper resistance band, resulting in a falling market in the weeks ahead.
  3. Relative Strength:  The RS indicators are indicating an overbought condition.  The up and down point moves over the past twelve weeks are exceptionally high compared to history.  Individually, they would indicate extremes but combined they have been neutral over the past four or so weeks.  Presently, the downward point measure is shedding the declines from January and this is resulting in a heavier weight on the seesaw from upward points.  Typically, the market will seek to bring the pendulum back to equilibrium, and this foretells a decline in the coming weeks.
  4. Breadth:  The comparison of the S&P and the NASDAQ to the DJIA indicates a narrowing of breadth.  The NASDAQ is presently at 27.25% of the DJIA, down from 29.46% back in September 2015.   The S&P is at a similar point.  Additionally, the advance decline lines of issues have been deteriorating over the past year.  The divergence of the point moves in the indexes to the number of issues advancing vs declining shows a contraction of participation and a narrowing of overall rising companies vs declining companies.  The absence of broad participation speaks loudly to the underlying weakness of the market internals.
  5. New highs and lows:  The net here has been in a declining trend for quite some time.  Presently the last week’s reported net new highs over new lows totaled 139 for the NYSE and 5 for the NASDAQ.  This compares to the last peak of net new highs over lows from June 2014 of 523 for the NYSE and 188 for NASDAQ.  Again, lack of participation by the broader market is telling.
  6. Current Interest Yield Gap:  The CIYG favors stocks over bonds.  In regard to portfolio allocation, the dividend returns from equities is very favorable as compared to the interest coupon from bonds.  The gap today is 1.05% (bonds over equities), which is very low based on historic comparisons.  The median gap over the past eleven years is 2.64%.  Of course, the return of principle profile for equites vs bonds gives a greater risk profile to equities, which indicates that a higher dividend return is needed as compared to interest rates to offset the return of principle exposure.  Should the interest rate environment change and the tightening of credit appear, then the spread will widen and equities will likely face price pressure as portfolio allocations move to fixed income.

 

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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