What Do Timing Indicators Tell Us About The Present Market Condition?

by: Kurtis Hemmerling

Even the most fundamentally–based investor will periodically look at an index price chart, such as the S&P 500 (NYSEARCA:SPY), and try to guess the market’s direction. You do not need an in-depth understanding of technical analysis to find simple support and resistance levels or a commonly referred to moving average like the 50 or 200 day. What is the market telling us right now based on some common metrics, ratios, and indicators?

FED Model

This approach uses valuation comparison of the S&P 500 versus bond yields. If all things were equal and static (which they are not), the earnings yield would be your net profit for the year. This percentage compared to bond rates is used to determine which is a potentially higher yielding investment. This seemingly simple system has issues, though, as it doesn’t adjust for risk. A bond yield of 2% does not carry the same level of risk as the S&P 500 with a price to earnings ratio of 50. Also, this system only uses relative comparisons; what if we find both bond and equity market yields were too low on an absolute basis?

Nonetheless, when there is a wide gap between bond and S&P 500 yields, we might find a broad indication of value in one or the other. The 10 year T-Note sits at 2% while the S&P 500 forward earnings yield (based on current year's estimates) is 8%. Keep in mind that the seeming excess value of the S&P 500 is factoring in the possibility of a recession and includes some of the sovereign debt problems in the Eurozone.

As you carefully analyze the chart below (compliments of Portfolio123), the black line represents the current year's earnings yield estimate for the S&P 500 minus the 10 Year T-Note. In theory, if this black line is above 0 (risk premium% y-axis on right), the market should be a buy. The S&P 500, however, dropped more than 50% during 2008/09 while this indicator showed the market to be undervalued. The blue line is the S&P 500 price chart. Keep in mind that a boost in bond yields could also lower valuations, in addition to dropping corporate profits.

Click to enlarge charts

Trending Analyst Forecasts

Another market timing approach that I like to use involves tracking the current year’s earnings forecast in the S&P 500. An upwards trend in the current year earnings forecast is typical most years unless a recession is broadly forecast where aggregate earnings growth is negative. But more than positive earnings growth is needed for this method to indicate buying – there must be enough earnings growth to generate a little momentum. Thus, we use moving averages overlaid for our market timing signals. Two moving average pairs can be used – one for quicker response time and the other for lower turnover.

  • The 3 week current year S&P 500 earnings forecast moving average is above the 15 week moving average which indicates a buying condition
  • The 5 week current year S&P 500 earnings forecast moving average is above the 21 week moving average (by my calculations of $97.899 5 week over the $97.666 21 week) which indicates a buying condition

The chart below (compliments of Portfolio123) shows the excess gain of using the 3 and 15 week moving average on analyst forecasts of the S&P 500 since 2001.

Moving Averages

Another common approach for indicating a bull or bear market is to use the 200 day moving average. If this is true, we are still in a bear market. Over the last 10.5 years, has this approach provided economically significant results? My back-tested results show that this approach does produce some excess gains over 10.5 year of 42.3% total gains versus 4.8% of the S&P 500 index. However, on closer inspection the software (Portfolio123) uses equal weighting of the 500 constitutions instead of market-cap weighting. The results favor smaller stocks. The equal-weighted index without the 200 day moving average produces 67.2% total returns which betrays our moving average as actually reducing gain. At this moment we are below the 200 day moving average which is bearish.

*Equal-weighting gives the same weight to the S&P 500 titans such as Exxon Mobil (NYSE:XOM), Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), IBM (NYSE:IBM), and Chevron(NYSE:CVX) as it does the smaller stocks with only 1 - 1.5 billion in market cap such as AK Steel Holding Corp (NYSE:AKS), Monster Worldwide (NYSE:MWW), MEMC Electronics Materials (WFR), Janus Capital Group (NYSE:JNS) and Tellabs (NYSE:TLB).

Longer-term moving averages have been used, such as those employed in the paper, Technical Analysis with a Long Term Perspective: Trading Strategies and Market Timing Ability. While not mimicking their approach of curve-fitting the moving average to the trailing 4 years, I still employ a longer-term moving average of 350 days, which is one of the filters known to Turtle Traders (although they use many others to compliment it). This results in a slight excess gain over the equal-weighted index without timing. This signal gives 83.5% capital gain returns in 10.5 years versus 67.2% without it. The 350 day moving average sits around 1229 in the S&P 500 right now – which the index price is below. However, it should be noted that this approach has weak gains which are questionable statistically. Chart below (compliments of Portfolio123) shows excess gain in equal-weighted S&P 500 index using 350 day moving average as trigger.

Sentiment Indicators

Other investors use sentiment surveys as a contrarian market timing signal. When bullish or bearish sentiment is either too low or too high, a turnaround could be nearing. The Sentiment Survey from AAII.com reveals that both bullish and bearish sentiments are a few percentage points higher as less survey-takers are assuming a neutral stance. Still, this is close to historic averages, giving us little forecasting ability.

  1. Bullish Sentiment: 41.9% (average 38.8%)
  2. Neutral: 27% (average 33.4%)
  3. Bearish: 31% (average 27.9%)

Market Condition?

What does all of this tell us about the market? Valuation says the market is ripe for buying, although the imprecise trigger of this method could have us buying at the wrong times as the historical record shows. Sentiment is near average and dropping slightly. S&P 500 prices are near some key moving averages. Trends in analyst estimates are just a hair on the bull side. Sadly, this all adds up to a lot of indecision. The market looks extremely ugly right now, but it usually is when you start buying.

How do I personally read this? As of November 7th, the analyst forecast earnings trend went green and I switched to recommending cautious buying in the market for my Aggressive Dividends portfolio. As of the writing of this article, the Defensive, Value, and High Yielding portfolios (as tracked on the Aggressive Dividends website) have all beat the market by 3 - 4% over the last 2 weeks before factoring in dividends, which should boost that a little higher. Two of the strategies are showing a profit (not just beating the market) when the S&P fell almost 4%. Only the ADR foreign stock diversification portfolio is lagging with a slight market under-performance. I've noticed that these companies provide leveraged gains in bull markets but struggle otherwise. As we remain teeter-tottering on the edge, I have my finger on the sell trigger if conditions soften further and I am not fully convinced that the 1200 level will hold. I'm sure we will see a strong testing of that level Monday or Tuesday - but it is a good psychological support and this will give more of an indication of our next move.

There are a wide range of market timing methods not discussed, from the VIX, advance-decline charts analyzing breadth, put/call ratios, economic indicators, and more. If you have a market stance based on some sort of fundamental or technical analysis, I’d like to hear about it below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.