Last week we checked in with the respected firm of Ned Davis Research to find them continuing to be bullish on equities.
While their official stance is clearly bullish, I’ve heard that NDR is more accurately reluctantly bullish - especially if you read their daily commentary. Today I wanted to go over two studies from NDR with completely different conclusions that may perhaps shed more light on this.
The first one is based on the Conference Board’s Consumer Confidence Index. As you no doubt already know, the US consumer is in dire straits and the various surveys that measure their pulse attest to this, to different degrees. Many are pointing to this fact as an argument for a double dip recession.
The recent Consumer Confidence report for July came in at 50.4, down from 54.3 in June 2010:
But according to a historical study by Ned Davis Research, poor consumer confidence is actually contrarian bullish for the stock market. NDR chopped the Consumer Confidence survey into three categories: low, medium and high. Next, NDR looked at the returns of the Dow Jones Industrial Average over the next 12 months.
They found that when Consumer Confidence is high (above 113) the Dow returns +0.2 per annum. When it is medium (between 66 and 113) +5.9% and most interestingly, when it is low (below 66 - as it is now), the Dow gains an average of +13.1%.
I had noticed the same pattern in the Michigan Consumer Confidence index visually a few years ago but NDR’s crack team of number crunchers presents it into a quantifiable edge.
Large drops - like the kind we saw in February of this year, when Consumer Confidence dropped 1.1 points - are also significant. According to NDR, when the consumer confidence index drops by at least 9.8 points within a month, the S&P 500 index gains an average of +8.7% in the following 12 month period.
For many people (especially those new to the markets), this upside-down view of the world where bad is good and good is bad is simply unnerving. If that is the case for you, think about it this way, when things are at their worst, those who want to sell have sold and the market has, in effect, washed out the weak hands.
As an example, the lowest Conference Board Consumer Confidence Index level was 25 in February 2009, just weeks before the stock market made its cycle low.
For more, see this column at Bloomberg: “Buy Signals Flashing With Plunge in Confidence”.
After being surprised by the strength of the earnings performance during this earnings season, Wall Street analysts are rushing to update their spreadsheets so they are not left (even more) flatfooted.
Since the start of the year, they have collectively upped their estimates of earnings by +7% but they are now seriously increasing their future estimates. Currently, the Wall Street consensus is for S&P 500 firms to increase their earnings by +33% this year and by another +16% next year.
And it is this very overconfidence that is troubling to NDR. According to another study by the firm, forward analyst expectations for earnings growth is a contrarian indicator.
When analysts are feeling optimistic and expecting forward earnings expectations to be 15% (or higher), the average annualized returns for the stock market are -12%. When analysts are expecting earnings growth to be just 5% (or less), the stock market jumps higher by an annualized rate of +18%.
This paradoxical relationship is built on the fact that as a group, analysts are more affected by last year’s earnings than actual estimates of future earnings. In behavioral economic terms, there is an “anchoring effect”. For more, see this FT article: “When upbeat analysts’ consensus spells danger”.
For more on using forward operating earnings to value the S&P 500, see John Hussman’s recent commentary here.
These two perspectives on the market not only illustrate the binary nature of the financial markets and the US economy, they also underpin how muddled things are (at least to me). Since I’m off for holidays within a few days, I’m comfortable standing aside as I have been for a while now and watching for the market to prove itself to me one way or another.