OCTOBER 4, 2015
THE primordial BEGINNING OF A rally?
BOUNCE LAST WEEK AFTER TESTING AUGUST LOWS PROVIDES HOPE
Last week most major indices bounced higher after testing the low set in late August. Several weeks ago we predicted this test of the August lows would occur. Retesting prior price levels is a well-established market pattern that is accessible through technical analysis. Prior lows are commonly retested before the market proceeds higher. If the market does rally from here, in technical analysis jargon, it is called a 'W bottom.'
By combining the disciplines of fundamental analysis of markets (valuation), econometric analysis, technical analysis, and individual stock analysis, we can avoid profit-destroying drawdowns and achieve returns in our model portfolios that are substantially higher than buy-and-hold based on fundamental value analysis. Even though we move our portfolios toward cash to avoid market risk, we do not have high turnover. Our two portfolios trade an average of fewer than three stocks per position per year.
MOST MAJOR INDICES SUCCESSFULLY TESTED SUPPORT
The charts below depict the Dow Jones Industrial Average ($INDU, Chart 1), the NASDAQ Composite ($COMPQ, Chart 2), the S&P 500 ($SPX, Chart 3), and the Russell 2000 small-cap index ($RUT, Chart 4). These charts show the patterns that have developed from June through present. Notice that the first three charts show that stocks bounced off the same level as the August lows while the Russell 2000 has gone further downward to establish a lower-low:
Chart 1: Dow Jones Industrial Average
Chart 2: NASDAQ Composite Index
Chart 3: S&P 500 Index
Chart 4: Russell 2000 Small-Cap Index
Notice the lower low on this chart from late August to present.
It's a bit concerning that the Russell 2000 small-cap index (Chart 4) set a lower-low compared to its late August bottom. Small-cap stocks
are more economically sensitive than their larger capitalization brethren. The reason for this is that most small-cap companies have sales limited to the US, while larger companies frequently have international sales and are more diversified (and therefore more resilient).
The recent weakness in some US and world economic data may be discouraging investors from buying the stock of small companies. Small companies usually lead the broader market in price performance, so the fact that the Russell 2000 continues to drop is disconcerting.
Nevertheless, Charts 1–3 demonstrate that the newer companies that comprise the NASDAQ Composite, as well as larger companies that make up the S&P 500 and the Dow Jones Industrial Average have indices that successfully tested the August low and bounced higher last week.
OVERALL MARKET VALUATION STILL TOO HIGH
Despite the recent downturn in prices, the S&P 500 is still trading at about 20.5 times its constituent companies’ profits, i.e., P/E ratio. That’s a healthy premium to its long-term average of 15.7. But as a number market participants have pointed out, it’s still below its early 2000 ratio of about 29-times earnings. Maybe they believe that comparison justifies higher prices, but that's certainly dubious thinking.
While the P/E ratio remains the most popular way that investors and advisors value stocks, earnings per share can be massaged through buybacks, cost cutting measures, or 'creative accounting.' This manipulation makes the metric less useful. Maybe it’s easier just to look at a ratio that is less prone to the hands of an over-eager masseuse: Price to Sales.
We use the Price/Sales ratio as an essential component for selection of individual stocks for our portfolios because it is one of the best (and 'cleanest') predictors of future individual company share prices. Stocks with a low Price/Sales ratio are far more likely to see their share price rise than a stock with a high P/S. Likewise, it is also a more appropriate signal of overall market froth than the P/E ratio. The P/S ratio is flashing red since early 2014 when it set a 13-year high, a level not seen since the dot-com bubble.
S&P 500 Price/Sales ratio is still higher than it has been since 2001.
During the summer, the P/S ratio of the S&P peaked at 1.86, 26% above the median price-to-sales ratio over the past 22 years. The last time the ratio was above that level was at the market top in 2000.
On August 1, the S&P 500 PE stood at 1.75. On Sept. 30, it had fallen only to 1.63. That’s off from the 1.86 high from the summer, but it’s still above any print the ratios had over the last 13 years, and well above the median P/S ratio over the last 22 years.
This market may be a lot of things, but it’s certainly not cheap.
WHAT CAUSED THE MARKET TO BOUNCE?
When the Bureau of Labor Statistics released the September employment report last Friday (October 2), it was reported that there were 142,000 jobs added in September. This report was a big disappointment when compared to the 200,000 jobs that a consensus of economists expected. Groans could be heard from traders on the floor of the New York Stock Exchange when the number was announced, and initially markets began to drop.
However, at about 10 am a reversal began to take place. The 10-year Treasury Note yield began to drop, reaching as low as 1.907% from 2.042% on Thursday. However, the benchmark note's yield began to recover somewhat and ended the day at an interest rate of 1.97%, down -3.46% for the day.
Apparently the disappointing jobs report made traders believe that the Federal Reserve will have much more difficulty in increasing interest rates. Federal-funds futures, used by traders to place bets on central-bank policy, showed a 5% likelihood of an interest-rate increase at the Fed’s Oct. 27-28 policy meeting, compared with 14% before the jobs report, according to data from CME Group. The odds were 27% for the Dec. 15-16 meeting, compared with 44% before the data was released.
As a result of the combination of lower interest rates and the likelihood that an increase in the Fed Funds rate is going to be put off until next year, investors decided that stocks were still the only game in town. As a result, most major indices ended up sharply higher. The Dow was up 200.36 points (1.23%) for the day. The S&P 500 advanced 27.54 points, or 1.4%, to 1951.36, with energy stocks up the most.
The Dow Jones Industrial Average was up 1.23% last Friday based on the disappointing jobs report.
Once again it appears we're in the bizarre world where bad economic news is good news for stocks. This is the world where the spigot of liquidity from central banks continues to pour money into the economy, with the majority of that money finding its way into assets (primarily stocks).
While the employment report underscores that the global slowdown is weighing on growth in the U.S., it is too soon to draw conclusions about what that means for U.S. corporate profits and stock-market moves over the longer run. However, as we reported earlier, sales and earnings for the major US indices have been declining. It's going to be difficult for stock prices to continue to rise if sales and are slumping, especially since the market is richly valued at this time.
Investors Intelligence Advisors Sentiment Survey
Is the continuation of easy money from central banks going to be enough to elevate the stock market back to new highs? There are a lot of headwinds, but there's also a lot of pre-existing negativity by investors and advisors about those headwinds. In fact, the Investors Intelligence 'Advisors Sentiment Survey' shows a sentiment reading of -10.4%, down from -4.2% the previous week. The last such occurrence was in the fall of 2011 with a similar reading of -11.9%. That was a setup for a major rally, so perhaps that's what we'll see again.
Investors Intelligence Advisors Sentiment Survey , courtesy of InvestorsIntelligence.com.
Deeply oversold sentiment readings are bullish for the market because it means there is a lot of money sitting on the sidelines. Bull markets like to climb a 'wall of worry,' embarrassing most investors and advisors. We certainly have enough potential risks and negativity to go around. But we need to see a little more climbing up that wall before we jump back in.
Will be monitoring the markets carefully and if we see a breakout from the current consolidation zone, plus a bullish upturn for our Market Risk Oscillator and other indicators, we will purchase new stocks to take advantage of the upward thrust that securities could have ahead of them. If that occurs midweek, we will send an email notice to our paid subscribers with links to the portfolio updates.
On the other hand, the overall, longer-term price trend is now downward. This may turn out to be just a counter-trend rally. It will take some powerful buying activity to repair the technical damage that was done during the August selloff. What could possibly be the catalyst for such powerful buying activity? It's difficult to see any such catalyst.
Since we are investors and not short-term traders, we need to see the trend reverse and head higher before filling our portfolios. There will probably be a lot of turbulence ahead, so buckle in.
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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