Where Are Markets Now? Technical, Fundamental and Valuation Reference Points

My April 6th analysis of the current stock market rally was based solely on economic fundamentals and indicators (see previous report). Today I revisit my outlook on the current market condition, but from technical and valuation perspectives as well as fundamental. Before continuing, I must confess that I too have imbibed from the punch bowl and enjoyed (to a degree of moderation, mind you) some of the euphoric orgy amongst bulls having their way with short sellers. However, my decision to participate in the rally has been based purely upon technical analysis (see Market Condition Summary (03-06-2009) report’s closing comments) as I still have little faith that fundamentals will improve significantly over the next 2 to 3 quarters, which is the maximum amount of credit I am willing to extend the stock market as a leading indicator.

The purpose of today’s analysis is not to make any definitive calls on the market direction, but, instead, give readers some guideposts and parameters for navigating the reality of dynamic and random chaos, i.e. the stock market.

Technically, where are we now?

1. At the moment, this rally is looking like a failed attempt to break the primary downtrend. The S&P 500 remains confined to trading within a bearish channel pattern (see chart below). Of course, it is still early into earnings season and "it ain’t over until it’s over", so we just have to wait and see.
2. The first rally, i.e. November-21-2008 low to January-06-2009 high, produced a gain at +27.37% and thus far, the second rally, i.e. March-09-2009 low to April-17-2009 high, has delivered a return at 31.32%.
3. Despite the second rally being more impressive than the first, it has yet to take the S&P 500 near the January 2009 high at 943.85. This is a major area of resistance for the market, as it is ground zero for the massacre that followed and drove the S&P 500 down to the level of 666. In order to break above this resistance, it must advance more than +10.8% from Thursday’s close at 851.92. Doing so would equivocate to a blistering +41.55% gain from the March-09-2009 low.
4. At the very minimum, the S&P 500 needs to take out the April-17-2009 high to maintain its short and intermediate term uptrends.

Where do valuations take us?
Assuming the existing rally can continue, let us hypothetically project the S&P 500 challenging resistance at 943.85:

1. Data from Birinyi Associates shows the S&P 500’s current actual P/E ratios for TTM (trailing twelve months) at 13.09 and FWD (Forward 12 months) at 14.99. The current dividend yield is 3.27%. Trading at a minimum level of 943.85 brings the FWD PE to 16.61, FWD earnings yield to 6.02%, and dividend yield down to 2.85%. For comparison, one can use the "risk-free" 10-year treasury bond, currently yielding 2.92%, courtesy of the Fed’s willingness to purchase treasuries and hold down rates. (Note that these numbers are "estimates" and "estimates" will vary amongst various sources. Although this report only concerns the S&P 500, I have included a table of major equity indices for a comparative analysis of current market values vs. a return to the January highs.)
2. Valuations are derived from profits. If the above valuation is to be accepted, one should assume a stabilization in earnings. The consensus among analysts is that after 6 straight quarters of declines, at least 3 more quarters of declining earnings are expected. For FY2009, there were 415 negative vs. 82 positive earnings revisions over the last 12 weeks; 329 negative vs. 129 positive earnings revisions over the last 4 weeks; and 205 negative vs. 73 positive earnings revisions over the last 1 week period. The trend for these earnings revisions deserves to be monitored regularly to help quantify both fundamentals and sentiment.
3. Dividend yields should also be taken into account since stocks have historically returned around 6% a year, exclusive of inflation, since 1900. Those dividends play an integral part in these historical returns and still do, despite their diminishing role as times have changed and management teams deploy capital in alternative ways to create and return value to shareholders. But in the 4th quarter of last year, something happened. In a Darwinian economic environment, 288 companies reduced or eliminated their dividends. Such drastic measures do not align with the optimistic bullish outlooks. Yet, I re-emphasize that a stabilization in earnings would allow companies to pay their dividends and any positive return could easily outperform the treasuries.

Fundamentals, to where are they pointing?
Let us take things on a quarterly basis, but I will not attempt to cover every fundamental issue. Instead, I shall highlight some major themes. In the spirit of collaboration, I encourage and invite readers to share their comments and insights in a constructive manner for the benefit of us all.

1. I do not think many would argue against the U.S. economy remaining in the tunnel of darkness for 2Q 2009, so we get a bye on trying to call this one. Even though the Fed and the Bush and Obama administrations have pledged a combined almost $13 trillion in stimulus plans, the I.V. treatment will take time to work through our economic system. The credit markets still have not thawed and until lenders regain the confidence to lend, there can be no economic growth or recovery if businesses and consumers do not have access to credit.
2. Meanwhile, unemployment continues to rise and the nation’s automotive industry is on life support. GM’s plans to shut down factories over a 9 week period this summer will probably cause even more collateral damage. My guess is that this event will also psychologically impact consumers and investors to remain cautious and whatever scars it leaves will not heal overnight.
3. On the plus side, inventory stocks have declined 6 straight months to such low levels that a rebound in production is almost inevitable. Inflation is not a danger yet with so many unemployed workers (labor wages represent the majority of production costs) and surplus capacity utilization for our factories. However, this may not necessarily lead to recovery. In fact, the IMF forecast for the U.S. is -2.5% GDP growth in 2009 and 0.00% growth for 2010.
4. The Fed's target rate is almost near zero and virtually punishes one for remaining in cash. One guest analyst on CNBC estimated that cash on the sidelines equals about 15% of the aggregate market value for stocks. That is one major tsunami waiting to happen.
5. Regarding housing, things seem to be getting better and worse at the same time. Foreclosures continue to rise, but as prices are falling and rates are cheap for those who can obtain loans, existing home sales are gradually increasing. One overhang on the industry is the still large inventory supply. While summer is a peak season for new construction building, this time it might be different due to competing foreclosures and a rise in bad loans for construction and development.
6. Worthy of more than honorable mention is the American consumer who is spending less and saving more. I really think that this time it is different in that this recession will modify discretionary consumer habits for a long time. Lest we forget, a middle class is defined as the segment of a country’s population with "x" dollars of discretionary income to spend on discretionary items. The middle class has taken a real beating during this recession and probably needs more time to recover.

Summary
Well, I admit that I have not covered every issue. Technicals, valuations, and fundamentals may each tell their own story, but in concert can provide additional confirmation and help reduce market risks. The current evidence seems to weigh in favor of this being only a bear market rally, but hopefully the above analysis provides some reliable reference points to better navigate and evaluate this market.

Disclosure: Hillbent.com, Inc. or its affiliates may own positions in the equities mentioned in our reports. We do not receive any compensation from any of the companies covered in our reports.

Comments

[TheFounder:]

Fully agree with this analysis.

I have read other estimates that the S&P cumulative profits are exopected to stabilize at appx $40-45/year for the next few quarters. This would imply a forward P/E of 21 currently and 23 at the January 2009 high point.

If that is true, the market will probably re test the March 09 lows again, and possibly establish a new lower base to build from.

Apr 24 06:47 AM

[twotraps:]

Good Morning, great article, I agree with the assessment that prices have yet to prove the larger downtrend has been broken. Not to make too many discretionary calls on what the meaning of the current development area 'is' or 'is not'....this larger range trade is a hell of a lot better than limit up or down while the larger world economy gets the bad news digested.

Also, I am interested to know how/why you use 10.8%...I also use 10 and 25% on all time frames to gauge strength or weakness. Just curious how your idea comes into play here. I like using the interplay between those two levels becuase it offers a range of expected development and guage of strenght or weakness.

I have not rules out some sequence where S&P's try to move toward 943, it will be very interesting to see if that level is accepted or rejected.

Apr 24 06:53 AM

[prudentinve...:]

Great article. I must confess I am a bit puzzled by "Data from Birinyi Associates shows the S&P 500’s current dividend yield is 3.27%". Is this from a data base which may have fallen out of date, or does it reflect all recently announced (but yet to be implemented) dividend cuts?

Many of the announced dividend cuts take effect as of the next quarter following the announcement, so it would be greatly appreciated if you can clarify and post the result.

Thanks.

Apr 24 07:20 AM

[mrmillergd:]

Thanks for a great multi-viewpoint analysis. From three different angles I believe you've shown that the recent optimism may be misplaced.

Apr 24 07:29 AM

[dcb:]

Great article. combination of all issues. thanks. I am adding you to watch list!!!

Apr 24 08:25 AM

[ArkansasAngie:]

Now the only question is -- to what lengths will the FEDury go to keep the market up?

Prehaps the better question is what will they not do?

Apr 24 09:18 AM

[Aquater:]

A great article, with a wide coverage and in-depth analysis. I am adding you to my watch list. It seems the rally is getting exhausted and may turn albeit slowly.

Apr 24 10:12 AM

[Homo econom...:]

Excellent article.

Reflecting on the current euphoria in the markets it is interesting to note the aberration between economic reality and speculative bullish tendencies. Over the LR financial markets are correlated with economic activity (i.e. GDP etc.); with growth prospects and economic indicators continuing to look bleak the probability of a V shaped recovery are minimal.

Optimism is a positive force, delusion is another altogether.

Again, thank-you for your analysis.

Apr 24 11:03 AM

[gordon:]

Past recessions had P/Es 7-10. I don't believe your 14, if you look at earnings "sand-bagging" to beat a much lowered number, they are about 25% below yoy. That's a p/e of closer to 20, twice what is "value". This is momentum trading, aided by TARP funds funneled to the primary dealers, burning the shorts. I say it's a government conspiracy to force money into stocks by keeping fixed income yields near zero. It should be criminal, but using the Patriot Act, the original intent to protect defense/telecom contractors for "US security", but Obama et al can and is using it to hide the health of the banks' bad loans/derivatives. They do NOT have to open their books, if it's deemed a "national security issue". Nobody is talking about how the Patriot Act makes all of it legal.

Apr 24 11:36 AM

[gordon:]

Here's analysis of P/E based on OPERATING EARNINGS @ 14, but at 30 (THIRTY) based on REPORTED earnings. Typical bait & switch, like the new term "tangible common equity" for banks. The con-jobs never cease.
ftalphaville.ft.com/bl.../

Apr 24 12:28 PM

[John Lounsbury:]

JCH - - -

Good article. I will be using it as a hyperlink reference.

A related post from the Financial Times:
ftalphaville.ft.com/bl.../

Apr 24 12:55 PM

[Stocks007:]

Crash of 2000: unemployment was at 3.9% on 12/31/00. Doesn't sound like the best comp.


On Apr 24 12:09 PM Cetin Hakimoglu wrote:

> I disagree that the closure of plants will have a ripple effect on
> consumer spending. During the crash of 2000 many technology workers
> lost their jobs, but that didn't dent overall consumer spending.
> Unemployment continues to rise, but the market is ignoring it.<br/>
>
> ----------------------...
>
> Meanwhile, unemployment continues to rise and the nation’s automotive
> industry is on life support. GM’s plans to shut down factories over
> a 9 week period this summer will probably cause even more collateral
> damage. My guess is that this event will also psychologically impact
> consumers and investors to remain cautious and whatever scars it
> leaves will not heal overnight.

Apr 24 01:06 PM

[Bruce Pile:]

On the bull side, it's worth noting that the critical resistance levels at the previous high in January and the top of the trading channel have already been taken out by the indexes that have been leading the broader market's major turns. If you look at a Russell 2000 chart, its widening "megaphone" channel has been breached to the upside. Small caps led the turn down in '07 and seem to be leading a turn now. Also, the consumer discretionary index XLY, and the retail index RLX, which led the turn down in '07, have already breached their channels and passed the January highs, the XLY by a nose just today and the RLX by a lot many days ago. These megaphone channel breaks tend to be followed by sharp moves in the direction of the break, which would be up now.

On the bear side, you seem to have a helpless consumer, the driving force for all that was good in the U.S. economy for so long, who now must hope to maintain that vibrant spirit with the help of a massive burst of M3 to make an inflationary nightmare for his spending. You have house prices that may bottom soon but not climb for awhile. You have an unprecedented massive CDS problem in Debt World that hasn't been cleaned up.

On the chicken side, it's too scary to put any money to work anywhere.

Apr 24 09:01 PM

[Lilguy:]

Nice overview of the market. I, too, believe the market is going through a soon-to-end bear rally and I suspect it may re-test the earlier lows. (My thought is S&P500 somewhere in the 600s, but probably lower than the devilish "666" current intraday market bottom.)

Key to this is my continuing belief that the financial sector and the household sector (as consumer, investor, and debtor) will continue to deteriorate throughout the year. I can foresee a modest 4Q upturn in the economy as consumers try to be more optimistic and make the best out of a bad situation for the holidays. Then, I think our economy will continue to deteriorate until at least mid-2010. I can't think much further than that with all the balls up in the air.

Still, there may be opportunities for strategic investors to buy good stocks (per valuations above) that are offering stable, high yields. These stocks won't grow for several years (none really will), but they may offer better dividend returns that fixed income alternatives. As for traders, there is always an opportunity--up, down, or sideways--but you better wear your seatbelt and helmet cause its going to be a bumpy ride.

Apr 25 08:03 AM

[granger:]

You said it


On Apr 24 09:18 AM ArkansasAngie wrote:

> Now the only question is -- to what lengths will the FEDury go to
> keep the market up?
>
> Prehaps the better question is what will they not do?

Apr 25 08:06 AM

[gordon:]

Read john Maudlin on the "OPERATING EARNINGS " SCAM!
www.frontlinethoughts....

Apr 25 05:00 PM

[neattrader:]

Great article.

Apr 26 06:43 AM