S&P 500 Valuation and Momentum: Outlook Neutral

RIAanalyst.com - 06/06/2009 - Market Outlook Neutral: Our current market outlook is “neutral” on the basis of fair valuation and weak but continuing bearishness in our preferred long-run momentum indicators. The following analysis applies to the S&P 500 (ETF: SPY) which we take as a proxy for equity markets in general.

Valuation (top-down): fairly valued - Our framework for market outlook is first and foremost concerned with valuation. We say the market is “fairly valued” if our analysis suggests an expected return for a buy-and-hold investor of between 8-12% per annum.

If the expected return is less than 8%, than we would say the market is overvalued (expensive). If it is more than 12%, than we would say that equity markets are undervalued (cheap). In our top-down analysis, we estimate a return expectation by applying a fair PE (12-17x) to forward EPS expectations and discounting back to today’s index price.

At present our expectation is for about a 10% total return on the S&P (see analysis below):

Valuation (bottom-up): fair to slightly undervalued - We get another view on overall market valuation based on our bottom-up valuations of stocks in our research-coverage universe. We currently have valuations (using our HISTVAL™ methodology) on 86 stocks in 28 different industry groups across all but two sectors (utilities and financials).

On average, the current price of those stocks is roughly 102% of their fair values (median 94%), which we would say is essentially fairly valued, confirming our top-down findings.

Momentum: bearish, but improving - With regards to momentum, we look at long-run technical momentum indicators, like the 20day vs. 200 day moving average, and the 260-day (1yr) Aroon Oscillator.

While these “slow” indicators are inevitably late with regards to major tops and bottoms, they also produce far fewer “false positives”, and far more infrequent changes in outlook than faster indicators. At present, these indicators remain bearish, though just barely (see momentum study below):

Combining valuation and momentum we like to say that any market that is overvalued is inherently dangerous, no matter the momentum of the market, and we recommend caution in all such cases.

On the other hand, when markets are cheap, we think it is prudent to wait for long-run momentum indicators to turn positive before jumping back in with both feet. Major bull and bear markets tend to last for several years, and major bear markets almost always include multiple false bottoms.

In addition, in down markets stocks that look enticingly cheap are often about to get much cheaper. By waiting for a real change in long-run momentum you can avoid catching those falling knives.

Given all that we have said, our view of the market is neutral and we suggest a similarly neutral tactical allocation. That is to say, we see no reason for investors to be either significantly more or significantly less aggressive than their strategic/default asset allocation would ordinarily suggest.

Disclosure: no positions in SPY

Comments

[Crude Oil T...:]

Just found this video on the S&P 500 on Adam Hewison's website,
"The S & P 500, A Conundrum Wrapped in an Enigma"

Watch video > tinyurl.com/n88669

Jun 07 12:55 PM

[RiskReturnO...:]

Very interesting analysis. Thanks.

I've got SPY as fairly valued now based on following EPS and PE:

2009 -- $46 * 17 = 780
2010 -- $55 * 15 = 825

The only sectors that look attractive are (for playing offense): XLE, QQQQ; and (for playing defense) XLV.

Otherwise, it's better to put your money in emerging markets and commodities: FXI, EWH, TAO, EWT, DBA, or DBV and TBT for the weak dollar trade.

Jun 07 04:23 PM

[Mad Hedge F...:]

Don't like it. The market has gotten so dead here that I have started watching Suzie Ormand to get trading ideas. So I’m not supposed to run large balances on my credit card? Who knew? A hedge fund friend told me that the market is now like watching a ball tossed in the air that is at the apogee of its move, just before the free fall begins. No news, with shrinking volume and volatility. General Motors (GM) isn’t a stock anymore, so all of the news flow there might as well be a History Channel documentary. You can only sell so many out of the money short dated calls on other stocks before bumping up against risk control parameters. Even if you do make money in these conditions, it is at the expense of a Maalox addiction to fight the multiple holes in your stomach. It’s not worth it. This is why I prefer to spend my summers mountain climbing or practicing my ballroom dancing. Please see my “Sell in May and Go Away” opus at (www.madhedgefundtrader...

Jun 10 11:06 AM