MAY 30, 2016
MARKET AT A CRITICAL JUNCTURE
We hope our US subscribers had an enjoyable Memorial Day weekend. Our thoughts are with the families of those who have sacrificed their lives defending the United States and our allies.
MARKET AT A CRITICAL JUNCTURE
As shown in Chart 1 below, major market indices are at a critical point and are now challenging an immediate level of overhead resistance. By 'immediate level,' we mean that there is additional overhead resistance higher on the charts for each of these indices:
CHART 1: Most market indices are now challenging overhead resistance. This week will be critical.
What happens this week will be critical for the near-term future of the market. If the current resistance holds and stocks turn downward, other factors (discussed below) could convert the situation in a very bearish direction. On the other hand, if stocks break through this resistance, it could be bullish. For this reason, we need to keep maximum flexibility. This is the primary reason that we are holding cash in each of our model portfolios at this point.
Stocks are facing far more challenges than just technical-based overhead resistance, as discussed below.
HISTORY OF RANGE-BOUND MARKETS
Consider these facts about the market:
• The S&P 500 is down -0.6% in the last year
The Russell 2000 is down -7.9% in the last year
• The Nasdaq Composite is down -2.93% in the last year
As you can see from Chart 2 below, the S&P 500 has been range-bound since late 2014:
CHART 2: The S&P 500 has been range-bound for more than one year.
As of today, the S&P 500 has a streak of 260 trading days without a new record high. The last time this occurred was 1995 and only two other long-term rallies (272 days in 1984 and 361 days in 1961) went longer without new highs. More often than not, these dry spells are foreboding for equities.
What does history say about markets that fail to make new highs for more than one year? According to Bloomberg, "Among the 13 instances since 1946 that began with stocks going as long as they have now without posting new highs, 10 ended in bear markets." That's a 77% chance stocks are going to finish this period with a bear market selloff. That said, it's also a 23% chance there could be a powerful bullish thrust higher.
RISK-REWARD FAVORS THE BEARS
As discussed in last weekend's Value Alert newsletter, we have heard from several subscribers who are concerned that we have been in cash for so long. However, today's risk-to-reward ratio as it pertains to investing in stocks is outrageously out of favor for the investor on the long side of the trade. Consider these facts about the current market environment:
• 1st negative pre-election year (2015) since Hitler invaded Poland in 1939
Failed Santa Claus Rally (December 2015)
• Worst 'first five days' of the year in history (many consider the first five days an indicator for the rest of the year)
• Worst January since 1923 (January can be an indicator for the remainder of the year)
One of the longest Bull Markets in history (7.25 years vs. average of 4.3 years)
• 51% of small-cap stocks are in a bear market (i.e., lost more than -20% from high)
• 45% of the Russell 3000 stocks are
in a bear market
DECLINING EARNINGS AND RISING PE RATIO
We regularly update Chart 3 below, showing the trend of Earnings and the Price/Earnings (P/E) ratio for the S&P 500. Once again, the trend remains the same, with continued deterioration of fundamentals:
CHART 3: Earnings continue to decline while the P/E ratio continues to climb.
The bottom window in Chart 3 shows that earnings have declined for a full year, beginning in the second quarter of 2015 through the second quarter of 2016. At the same time, the middle window shows that the P/E ratio of the S&P 500 has set a new high for this cycle and currently stands at 24.4 (average is about 15).
Many prefer to use the forward year's earnings forecasts to establish whether the market is expensive or cheap. However, having had experience in two major Wall Street firms analyzing stocks and developing these estimates, we can attest to the fact they are nothing more than fluff that brokers use to keep inexperienced investors in the market. There is no substance behind them whatsoever. "Always forecast up!" is the motto at Wall Street brokers. That said, the forward earnings forecast-based PE for the S&P 500 at 17.7 is still quite high relative to an average closer to 12 or 13.
S&P 500 SALES PLUMMET
The decline in S&P 500 profits coincides with a steep decline in sales that began in the second quarter of 2015. It is virtually impossible for earnings to pick up when sales are falling off a cliff. While many look to indicators such as employment statistics, inflation, and GDP (which get all the mainstream headlines), Chart 4 below showing S&P 500 sales is the single most definitive indicator of the status of the US economy:
CHART 4: S&P 500 revenues began a steep dive beginning the second quarter of 2015.
TOTAL DEBT-TO-CAPITALIZATION RATIO DANGER
The Total Debt-to-Capitalization Ratio is an indicator that measures the total amount of debt in a company's capital structure. It measures the amount of a company's financial leverage, which can be a double-edged sword. While higher leverage can increase a company's Return on Equity, it also reduces financial flexibility and if debt payments are too high relative to free cash flow, can lead to insolvency.
Chart 5 below shows one of the consequences of near-zero Fed-manipulated interest rates. The amount of debt-to-capitalization for S&P 500 companies has reached an all-time high for this cycle and is accelerating even as sales and profits plunge:
CHART 5: The S&P 500 Total Debt-to-Capitalization ratio shows that debt has reached an all-time high for this market cycle.
With a full-tilt decline in sales and earnings underway, an accelerating pace of debt burden on S&P 500 companies could prove to be the straw that breaks the camel's back. Should a recession occur (long overdue), sales and earnings will nose-dive even further. This will lead to defaults and bankruptcies and may cause the impact of a recession to be much more severe than normal.
OUR PLAN FOR THIS WEEK
We will continue to keep our portfolios in cash at this time, but will be watching market charts carefully this week. If prices break through the resistance shown in Chart 1 above, we may be purchasing long positions. On the other hand, if the resistance holds and prices drop, we may be buying inverse ETFs or ETFs that rise during adverse economic conditions. If you have questions about our approach, please feel free to contact us.
Best Wishes for Another Week of Intelligent Value Investing,
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