A Cautious Look at Where Markets Are Headed

I concluded a post on stock markets over the weekend saying:

After equities’ seven-month climb, stock markets certainly look vulnerable for a decline. Two downside reversal days - on Wednesday and Friday - would seem to indicate that stocks could commence a pullback to work off the overbought condition, allowing fundamentals to reassert themselves.

Global stock markets, as well as other risky assets, closed sharply lower over the past few days as concerns mounted over the sustainability of the global economic recovery and the outlook for central bank policy.

The performance of the major asset classes is summarized by the charts below, with the top one showing the period from the March 9 stock market lows until October 19 peak and the second one the subsequent period. The numbers indicate an all-change pattern in the performances as risk aversion re-entered financial markets and government bonds and the U.S. dollar regained some favor.

Click to enlarge:

Source: StockCharts.com

Click to enlarge:

Source: StockCharts.com

A summary of the movements of major global stock markets since the March 19 peak, as well as various other measurement periods, is given in the table below.

The MSCI World Index and the MSCI Emerging Markets Index have declined by 5.3% and 6.2% respectively since the highs of October 19, with markets like Ireland (‑13.2%), Brazil (-10.5%), Austria (-10.8%) and Belgium (-9.0%) falling by significantly more. Also, higher risk indices such as small caps have borne the brunt of the selling, with the Russell 2000 Index down by 9.0%. This is a pattern that one would expect as investors shift the emphasis to higher quality.

Click here or on the table below for a larger image.

The major moving-average levels for the benchmark U.S. indices, the BRIC countries and South Africa (where I am based) are given in the table below. A number of indices, including the S&P 500 Index, have fallen below their 50-day moving averages over the past few days, but all the indices are still holding above their respective 200-day moving averages. The 50-day lines are also above the 200-day lines in all instances.

The October lows are also given in the table as a break below these levels would indicate a reversal of the uptrend since March, i.e. reversing the progression of higher reaction lows.

Click here or on the table below for a larger image.

Over the past few days a number of commentators have made pronouncements about the extent of a possible decline. For example, Jeremy Grantham (GMO) expects the S&P 500 to drop by 15% to 25%, David Rosenberg (Gluskin Sheff & Associates) sees markets falling by 20% and Doug Kass is looking at -5% to -12%.

This brings me to the topic of valuations. Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 27.0; using “as reported” (GAAP) earnings the figure shoots up to a giddy 95.7! Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2009 reduce the valuations to 19.0 and 24.4 respectively. Looking further out to the end of 2010, the prospective PEs are 14.1 and 22.9 respectively - still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows that the “normalized” price-earnings ratio of the S&P 500 Index is currently 18.7. This compares with a long-term average of just more than 16.3 and implies an overvaluation of 15%. Considering a geometric rather than an arithmetic average of earnings, the overvaluation increases to 25%. The graphs below show data since 1950, but the actual calculations date back to 1871.

Click to enlarge:

Meanwhile, David Rosenberg highlights that this is not the onset of a sustainable secular bull market as we had coming off the fundamental lows of prior bear phases, such as August 1982, when:

• Dividend yields were 6%, not sub-2%.

• Price-to-earnings multiples were 8x, not 27x.

• The market traded at book value, not more than twice book.

• Inflation and bond yields were in double digits and headed down in the future, not near-zero and only headed higher.

• The stock market competed with 18% cash rates, not zero, and as such had a much higher hurdle to clear.

• Sentiment was universally bearish; hardly the case today.

• Global trade flows were in the process of accelerating as barriers were taken down; today, we are seeing trade flows recede as frictions, disputes and tariffs become the order of the day.

• A Reagan-led movement was afoot to reduce the role of government with attendant productivity gains in the future, as opposed to the infiltration by the public sector into the capital markets, union sector, economy and of course, the realm of CEO compensation.

Back to technical analysis, Adam Hewison (INO.com) also sounded a cautious note on the outlook for the S&P 500 as explained in one of his popular technical analysis presentations. Click here to access the presentation.

I conclude with a comment from David Fuller (Fullermoney) who said:

At this stage of the bull cycle, I think a correction of approximately 10-15% for developed country stock markets and somewhat more for emerging markets would be good news for investors with cash to invest. Such a mean reversion towards rising 200-day moving averages would blow the recent froth off valuations and stem talk of an early change in monetary policy.

I will bide my time while the fundamentals play catch-up. Meanwhile, caution remains the operative word.

Comments

[pdtor:]

Downturn could morph into something more serious,as so many players are gameing the market,especially the banks and hedge funds. It could be sudden and vicious, and test the lows of Nov. 08.Just a guess, holding onto my $$$ to buy.I expect $$$ to go up, as a save haven, gold and energy, commodities to go down. Loooking for a very volitile 3 mo.

Oct 29 10:06 AM

[Michael Clark:]

Charts are a bit damaged after today's action. See charts below:

seekingalpha.com/insta...

Oct 29 11:18 AM

[drewriders:]

Jim Cramer said yesterday that we have seen the highs in the market for the rest of the year. Sounds like it is time to buy!!!

Oct 29 11:19 AM

[Alphameister:]

Most commentaries on p/e ratios, yours included, simply compare current ratios to averages of the past, never mentioning the key variable of projected growth. If I (and many others) are right about the U.S. entering an extended period of subpar growth, it should follow that prevailing p/e ratios should also languish well below historical norms now and for the next five years or more.

Oct 29 05:08 PM

[AxIt:]

You could be right in saying that the US could be entering a period of growth that cannot match with the past (even if growth will be anyway). But in the last years global companies have increasingly expanded their revenue share outside the US and the last crisis is just speeding up the process: they wil look for earnigs where the growth is (China to name the usual suspect). P/E growth in the future will be driven by this.

On Oct 29 05:08 PM Alphameister wrote:

> Most commentaries on p/e ratios, yours included, simply compare current
> ratios to averages of the past, never mentioning the key variable
> of projected growth. If I (and many others) are right about the
> U.S. entering an extended period of subpar growth, it should follow
> that prevailing p/e ratios should also languish well below historical
> norms now and for the next five years or more.

Oct 29 06:00 PM

[Ted Kavadas:]

Interesting article, especially with regard to the historical earnings charts.

I believe that the stock market is wildly overvalued in relation to the strength of the economy.

Earnings are particularly controversial...as the article indicates, there is a large difference between operating vs. "as reported." However, I would also add that the sustainability and "quality" of earnings is exceedingly important, as much of the present earnings is derived through cost-cutting and other means, which is problematical.

There are also various dynamics of the stock market that are troublesome from a technical analysis perspective. For those interested I wrote about this a few weeks ago, and it is still relevant today. It can be found under my SeekingAlpha entry here:

seekingalpha.com/insta...

Oct 30 10:12 AM

[jdl51:]

It's hard to believe that with interest rates at 0, the 30 year mortgage at 5%, oil fairly stable, and earnings reports more up than down, that a protracted retreat in stock prices will happen. Correction, yes, but never before have we had interest rates this low with no hike on the horizon. Add to that the stimulus efforts worldwide I have to believe that next year will be a more gradual rise in stock prices than we've had the past few months with a few pullbacks along the way. Consumers should gradually work their way back into the picture, too. Automobile sales have been depressed lately and with a 12 million per year scrappage rate, it's only a matter of time before people will have to buy cars. We shall see.

Oct 30 11:40 AM

[granger:]

you nailed it in my opinion

On Oct 29 10:06 AM pdtor wrote:

> Downturn could morph into something more serious,as so many players
> are gameing the market,especially the banks and hedge funds. It
> could be sudden and vicious, and test the lows of Nov. 08.Just a
> guess, holding onto my $$$ to buy.I expect $$$ to go up, as a save
> haven, gold and energy, commodities to go down. Loooking for a very
> volitile 3 mo.

Oct 31 01:22 AM

[mbkelly75:]

All of this is very interesting - not just the article with some great historical charts - but the comments also - give a lot of food for thought. I have no idea where it is going from here, but there is quite a lot going on right now. I stay 100% invested and have for many years now in my Core Portfolio. Between a set percentage of Bond ETFs, PMs, and dividend-paying stocks - usually when one part goes up, another goes down, and from checking to see if it needs re-balancing every 2 (two) weeks and taking care of it when needed - I have a tendency to automatically sell high and buy low. Treating the portfolio as a single unit rather than a collection of individual investments works well for me. Even after more than 50 years in the markets, I still have additional money going in every month, because of the way it is set up. Dividends and interest are automatically re-invested in the security that paid them unless I tell the online broker not to (sometimes I need cash) - with a single click. I can change it back with another single click. This works for me.

Oct 31 09:15 AM

[jmann83:]

The last comment was interesting, if markets corrected that it could make the FED hold off raising rates, which is a big positive for equities, as we are right in the sweet spot; strong momentum, low inflation, low rates, replenishing of inventories, coming off a deep bottom, still massive amounts of money on the sidelines looking for a home, and seasonally speaking the best time to invest is Nov 1 - Mar 1. Any pullback will be shallow as those under-invested will use it as a chance to get back into the market. My bet is that equities will trade sideways for a soft pullback at some point soon enough, everyone is calling for markets to either go higher or lower, no one is expecting sideways, and like Mark Twain once said ''Whenever you find yourself on the side of the majority, it's time to pause and reflect''

Nov 01 01:49 AM

[mbkelly75:]

Sideways is actually the most likely way for the market to move in at ANY given time. Louis Jean-Baptiste Alphonse Bachelier wrote in his PhD thesis (the Theory of Speculation) in 1900 (!!!!) that there was only Three Market Conditions in ANY market and in ANY time frame: 1) Trend - meaning prices move in the same general direction - up or down - over a period of time, 2) Counter-Trend (also known as a "sideways market", - this is when the prices change a little and move in a range over an extended time period, and 3) Breakout - this is when the prices "break-through" to a new high or a new low. A couple of things to keep in mind here is that 1) It does not matter WHAT market you are in or if you are Day-Trading, Forex Trading, Swing Trading, or looking for the Long-Term Investments - the market can ONLY do one of these three things at a time. A full 60% of the time - it will trade sideways, 30% of the time - it will trend one way or another, and only 10% of the time will the market break one way or another. Most people only make use of one of these movements - the rest of the time - they are sitting out and waiting. Not only is it most likely to trade sideways, there is also a lot of money that can be made during these times. I learned to use ALL of them and it has helped me a lot over the decades. Among other tools, I use Moving Averages to help me find good times to follow a trend, and my Core Portfolio with it's set percentages of several types of investments and frequent checking to see if it needs re-balancing does well in sideways markets. Think about it.


On Nov 01 01:49 AM jmann83 wrote:

> The last comment was interesting, if markets corrected that it could
> make the FED hold off raising rates, which is a big positive for
> equities, as we are right in the sweet spot; strong momentum, low
> inflation, low rates, replenishing of inventories, coming off a deep
> bottom, still massive amounts of money on the sidelines looking for
> a home, and seasonally speaking the best time to invest is Nov 1
> - Mar 1. Any pullback will be shallow as those under-invested will
> use it as a chance to get back into the market. My bet is that equities
> will trade sideways for a soft pullback at some point soon enough,
> everyone is calling for markets to either go higher or lower, no
> one is expecting sideways, and like Mark Twain once said ''Whenever
> you find yourself on the side of the majority, it's time to pause
> and reflect''

Nov 01 02:01 PM

[untrusting ...:]

mbkelly75,
You have posted some good comments on your investing style and methods, and obviously they have paid off for you over a considerable period of time.

Question: to what extent, if any, are your investments leveraged via margin? If so, how do you decide at what levels to utilize margin? Just curious as to how this fits into your strategy and methods.


On Nov 01 02:01 PM mbkelly75 wrote:

> Sideways is actually the most likely way for the market to move in
> at ANY given time. Louis Jean-Baptiste Alphonse Bachelier wrote in
> his PhD thesis (the Theory of Speculation) in 1900 (!!!!) that there
> was only Three Market Conditions in ANY market and in ANY time frame:
> 1) Trend - meaning prices move in the same general direction - up
> or down - over a period of time, 2) Counter-Trend (also known as
> a "sideways market", - this is when the prices change a little and
> move in a range over an extended time period, and 3) Breakout - this
> is when the prices "break-through" to a new high or a new low. A
> couple of things to keep in mind here is that 1) It does not matter
> WHAT market you are in or if you are Day-Trading, Forex Trading,
> Swing Trading, or looking for the Long-Term Investments - the market
> can ONLY do one of these three things at a time. A full 60% of the
> time - it will trade sideways, 30% of the time - it will trend one
> way or another, and only 10% of the time will the market break one
> way or another. Most people only make use of one of these movements
> - the rest of the time - they are sitting out and waiting. Not only
> is it most likely to trade sideways, there is also a lot of money
> that can be made during these times. I learned to use ALL of them
> and it has helped me a lot over the decades. Among other tools, I
> use Moving Averages to help me find good times to follow a trend,
> and my Core Portfolio with it's set percentages of several types
> of investments and frequent checking to see if it needs re-balancing
> does well in sideways markets. Think about it.

Nov 01 02:30 PM

[mbkelly75:]

Good question with a simple answer - I do not use margin at all right now. I did when I was trading commodity futures, and I might use them for trading Forex as margins are very well suited for use there. Margins also have a place with options trading, but I do not use those much anymore either. For regular stock investments or even for swing trades, I do not use margins. They give you larger profits but also can give you larger losses. In general, I do better without using them. They are simply too much of an additional risk for me without enough additional benefit. Some very smart people that I listen too have suggested to never risk more than 1%-5% (less is better) of your capital in a single trade - including margin costs.


On Nov 01 02:30 PM untrusting investor wrote:

> mbkelly75,
> You have posted some good comments on your investing style and methods,
> and obviously they have paid off for you over a considerable period
> of time.
>
> Question: to what extent, if any, are your investments leveraged
> via margin? If so, how do you decide at what levels to utilize margin?
> Just curious as to how this fits into your strategy and methods.
>

Nov 01 03:04 PM