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The height of fear is often when markets put in their bottoms, and fear is not in short supply today. While there are many macro-economic items to mull over-- such as the Grecian haircut on debt repayment and the possibility of another recession – it is difficult know when to buy, sell, or hold when talking about these complex issues with vague trading signals.

Is there reason to believe that markets are firming? What are a couple of techniques to look at?

The FED Model

I have never favored valuation techniques when considering market timing. The valuation concept is to compare share price to some fundamental ratio to determine good value or not. While this has its place, all too often the fundamental value dumps instead of prices going up. Investors who know the high stakes are simply pricing in a large amount of risk into these troubled markets. What are the valuation figures?

The earnings yield (using current year estimates) sits at 7.89%, which is a far cry above the 2.2% yield ten- year Treasury note for a 5.7% gap. According to the FED model, the S&P 500 is a good buy and has been for some time.

The massive drawback that I can see is that the model is rooted in the forecasting power of (forward) price-to-earnings ratios. The earnings yield is an inverse P/E ratio. In a static market, a forward earnings yield of 10 would mean 10% profit. An earnings yield of 20 (or a forward P/E of 5) would equal 20% profit. But the market is dynamic and always changing, making price-to-earnings or earnings yield a crude way to value the market. In addition to problems with moving share prices, you also have to accept that the forward earnings yield is simply an estimate that may or may not happen. I am not a big proponent of the ‘buy low P/E stocks because they are dirt cheap’ mentality.

Trending Earnings Forecast

Another way to time the market is to use earnings momentum. You take the current year’s earnings forecast on the S&P 500 (SPY) and watch for trends. You can further improve upon this by adding moving averages to smooth out little spikes up and down. The current year’s earnings forecast since March 2011(daily revisions) is below compliments of Portfolio123.

Click to enlarge

As you can see, despite a sharp earnings upgrade last week, the overall trend is still down. With the aid of moving averages to create a timing trigger (I use 3 and 15 weeks), the market could enter early bull territory as early as next week. As we near the end of the current year, however, the forecasting ability lessens and I find myself drawn to using next year’s earnings forecast – which is still in a tail slide.

Click to enlarge

You can read a little more about this market timing forecast here.

Long-Term Moving Averages

Instead of focusing on short-term or other interpretive signals, I will refer to the paper, Technical Analysis with a Long Term Perspective: Trading Strategies and Market Timing Ability. The researchers in this paper used a variety of techniques for market timing that utilized very long-term moving averages that spanned for years. Between 1994 and 2009 they were able to generate 572% returns as opposed to the 90% benchmark returns of the S&P 500. You will need to read the paper to learn the exact technique, but the one method with high economic significance used the 'best-fit long-term moving average' over the trailing 4 years to make a trading rule for the forward 4 years.

What do very long-term averages tell us about the current market based on the past 4 years of data? Since our markets have whipped up and down with high volatility, the less responsive long-term moving averages have not been able to keep up during the past 48 months. Below are two medium / long range moving averages which we are quickly nearing, but still underneath.

  • The 200 day is at 1275
  • The 300 day is at 1241

I also find it useful to use a shorter-term moving average, such as the 100 day, when confirming market trends using the analyst earnings forecast. We just popped above the 100 day on Friday and are touching the underside of the 300 day as we speak.

What This All Means

What does this mean for me? Well, I think that the recent rally is making a valiant attempt at something far grander. Has it hit the target to buy? Not for me. It could happen as soon as this week, but I have my doubts. As I look to next year’s earnings forecast trend, it would take a few strong weeks of upward revisions to have me believing that it is the right time to buy. While the market is making some alluring technical moves, I try to use these only as a backup signal.

Some like to buy in all conditions – which is a smart move if you don’t intend to sell with market timing signals. Buying in bull markets and holding in bear markets (without adding to your position) does not make sense, as you buy during high valuations only. Peter Lynch suggests buying regularly in all markets, and if you are not going to use market timing it is a good alternative.

While I see lists of cheap stocks being advertised including companies such as Johnson & Johnson (JNJ), Ford Motor Company (F), Intel Corp (INTC), and Microsoft (MSFT), I am going to wait a little longer yet for the market to prove to me that it deserves my money.

Source: Has The S&P 500 Signaled A Market Bottom?