A little over 30 miles from my office is the beautiful beach. Often times I would take a short break during the market sessions and stare north, observing the weather above the beach. On days with good weather I would sometimes escape the office routine and head to the beach but on days with bad weather I quietly return to managing my portfolios. Similar to observing beach weather, I also look at US equity market conditions. Unfortunately the conditions I am currently seeing remind me of a bad beach day. The factors that are causing this inclement weather in US equities are as follows:
- Upcoming US budget & debt ceiling debates
- Market P/E overvaluations
- A bearish candlestick pattern.
Because of these conditions investors are cautioned from taking any long positions in the US equity markets over the next couple of months. Rather investors are encouraged to take advantage of the harsh weather through ProShares Short S&P 500 ETF (NYSEARCA:SH). By scrutinizing the price movements of the S&P 500, I believe investors can risk a rise of 1.73% in the index for a 4.42% decline from current market prices, a risk/reward ratio of 1:2.55.
Dark Fundamental Clouds
Investors have been through this situation before. Congressional gridlock is driving uncertainty into the US equity markets. Just as in 2011, this gridlock will lead to a pullback in the S&P 500. Even the Fed is cautious. In its last FOMC statement and projections the Fed pushed out their expectations for the thresholds to tapering and a fed funds rate increase. The Fed's projections now show the unemployment rate to fall below 7% and the PCE Index to increase to 2% by mid 2014. Furthermore the Fed expects US GDP growth to be less than 2.4% in 2013 and range between 2.2% to 3.3% for 2014. The charts below show the Fed's central tendencies and ranges of economic projections, 2013 to 2016 and over the long run.
While some may view the continuing of the QE programme due to the extension of the unemployment and inflation projections as positive, these revisions make me wary. Investors should view these changes as a sign of a stalling economy which can lead to a pullback in the US equity markets.
Dark Valuation Clouds
The Fed's revisions have also made US long term bonds more attractive than equities. By prolonging the expectations for the thresholds to be met, the Fed hinted to the markets that QE will last a little while longer, placing US long term bonds at bid. Thus investors can return to long term bonds being a choice in their global macro asset allocation as current yields appears more attractive than equity prices. To put things into perspective the annual distribution yield on (NYSEARCA:TLT) stands at 2.95% while the annual distribution yield on (NYSEARCA:SPY) stands at 1.99%, almost 100 basis points lower. Furthermore when conducting some minor comparative analysis between stocks and bonds, the ratio / recently broke below its 30 day moving average, which is bearish equities over bonds if the price continues to move lower. The picture below gives the ratio summary of /. Given these dark clouds investors can also consider taking a position in rather than an outright short on the S&P 500.
From a P/E valuation perspective the S&P 500 appears to be overvalued, indicating that company earnings has not caught up with the recent rally in prices. Currently the S&P 500 P/E stands at 16.39x, while its 1-Year and 3-Year averages are 15.17x and 14.53x respectively. Investors should be patient until price movement realign itself with company earnings or even take advantage of the overvaluation through a position in SH. The charts below show the 1-Year and 3-Year P/Es of the S&P 500.
Dark Technical Clouds
During the period September 18th to September 20th 2013, the S&P 500 index exhibited a Japanese candlestick pattern called the evening star, which is a bearish formation. To corroborate the formation of this pattern the S&P 500's daily RSI entered into overbought territory and crossed back below the 70 level during the formation of the evening star. The last time the RSI made a similar action was in early August 2013, where the index then fell a little over 5% in August. Initial expectations are for the S&P 500 to return to the 1630 level, a little over 6% from the recent highs. The chart below gives the daily chart of the S&P 500 Index.
Investors can use the ETF to benefit from the anticipated negative moves in the S&P 500 Index.