Once again, summer is coming to a close (for school kids that already happened) but the market remains in "bad news is good news" mode and bullishness appears reluctant to concede. Labor Day gave U.S. consumers one more day of barbecues and the beach while European stocks rallied as the European Central Bank's final purchasing managers index (PMI) for August came in at 45.1 -- down from a preliminary 45.3. Europe's PMI has been below 50 for 13 straight months (readings below 50 in this diffusion index signal contraction). Following the foreign weakness theme, China continues below expectations on factory orders and the Shanghai Index trades at a 35% discount to 2011 highs.
Investor enthusiasm, individual and professional, causes me to get concerned when compared to the slowing in earnings growth. Rather than see the aforementioned for what it is, markets have rallied on hope. That is, "hoping" the ECB will signal a willingness to kick off its bond-buying plan and hope that the U.S. Fed will countenance additional quantitative easing at the mid-September FOMC meeting. Regardless of the news, hope has become a panacea; at least for investors. Even so, buoying stocks with borrowed money is a very slippery slope.
At least for now, markets have shifted into a much lower gear. On 8/1/12, the S&P 500 crossed up through 1,400 for the first time since the beginning of May. Over a month later, the S&P 500 has been unable to build on that advantage, and may have missed its chance to top the 2012 year-to-date high of 1,419 recorded on April 2. As trading ended on 8/31/12 (heading into the holiday weekend), the S&P 500 closed under its 20-day moving average. Sure, it was only one point below but that hasn't happened since late July. It was during this time that policy hopes were building once more though they packed little punch. Adding to an already challenging landscape, earnings are not rising to support current stock prices.
In the years since the market bottom in March 2009, investors have been inundated with a cacophony of bad news. Major negative events and trends include collapses in multiple European sovereign debt markets, a notable slowdown in emerging-economy growth, and breathtaking domestic budget deficits as a result of the recession, tax cuts, and unchecked federal spending. Even the silver linings have a touch of gray and now, at least domestically, we are on the verge of another dilemma; the "fiscal cliff."
With so many headlines and market moving events, it might be worth turning off the noise to consider the following. In 2008, S&P 500 earnings from continuing operations were $49.49; for 2012, which is two-thirds done, the forecast is $103.50. The change in earnings between 2008 and 2012 is 109%. At the market bottom in March 2009, the S&P 500 hit 676; on 8/28/12, the S&P 500 was trading at 1,410. On a percentage basis, the change between the market trough and the 8/28/12 level is that same 109%. In other words, when earnings go up, stocks follow. Unfortunately, the reverse order of this axiom can't be ignored.
Comparing all this to various stages of bull markets, one might conclude that today's rally has seen its better days. In the final stage of a bull market, margins are capped, revenue growth is sluggish to nonexistent, and earnings are no longer growing. Ironically, stocks tend to keep rising during such stages; usually for all the wrong reasons. Individual investors, notoriously late to the party, finally succumb to their emotional greed and Institutional investors also need to match or beat the market; they abandon any lingering bearish feelings. More often than not, these are the times that inner bear voices shouldn't be ignored. Other signs of the late-stage bull include a burst in M&A activity and attempts to return value to shareholders via dividend hikes and share buybacks. While these M&A and financial structure hallmarks are present, bullish capitulation by individuals and professionals has not yet occurred.
At this point of uncertainty, using P/Es might help us better discern an otherwise cryptic market message. If we can agree that earnings growth has slowed, and stocks have continued to rise, it only makes sense that P/Es expand. Usually P/Es are well behaved during the early and middle stages of a bull market. After an initial P/E spike, as stock prices race ahead of actual earnings, P/Es tend to decline in the middle stages from early bull market levels. P/Es then rise in the later stages, often ending with multiples that simply cannot sustain. It is this phase in which earnings go from stable to deteriorating to negative. Nevertheless, investors rarely concede - blinded by euphoria - that the party is over and subsequently keep bidding stocks higher until the bear bites.
With that somewhat circumlocutory information as a backdrop, I can now focus on our main concern; the current bull market, which began in 2009. At 39 months old, I compared this with the last seven bull markets; they averaged 43 months. From a duration perspective, the current bull market is looking long in the tooth. On the other hand, this bull has room to run if we focus solely on the P/E trend.
Thus far in 2012, P/Es have averaged 14.6 in 1Q12, 13.8 in 2Q12, and 14.3 in the third quarter to date. But the market has been rising since mid-May, while earnings growth has steadily declined. Using Standard & Poor's estimates, 1Q12 EPS grew in the mid-single-digits (year-over-year); second-quarter EPS inched up 2.2%; and 3Q12 is forecast for the first negative comp (-1.1%) since 2009. The fourth quarter is set for a big finish, with earnings forecast to rise 13% year-over- year. Post-World War II bull market averages show a 550-basis-point premium over opening P/Es at the bull market close. From the March 2009 opening P/E of 13.1-times, that would suggest a bull-ending P/E of 18.6. On the other hand, the 2003-2007 bull ended at a lower P/E than where it began. We would be wary of a bear market long before the current market starts trading at 18-times. In my opinion, it would be worth keeping an eye both on index prices and on S&P 500 earnings.
In this low volume environment, the market's message becomes harder to discern. But light volume during a price advance can be foretelling of a reversal in trend. Other factors weighing in on the continuing rally include; a presidential election looming, European uncertainty, employment situation and capitulation by individual and professional investors fearful of missing what might already be gone. The S&P500 trades more than 6% above the 200-day SMA; that number has not been tested since June 2012 - in my opinion, a reversion to the mean is a more likely scenario than a vote in favor of a continued rally.
Our technical indicators also provide some solid clues that the current bull is growing tired. To better quantify this, it is helpful to apply some measure of risk-on versus risk-off. For risk-on, we tend to focus on consumer discretionary, commodities and the Aussie Dollar. Risk-off typically favors safe-havens like consumer staples and treasuries. At the moment, risk-on has the upper hand but we note the recent decline in the Aussie Dollar and a rising slope on consumer staples. These are early signals of a risk-off trade. Furthermore, new 52-week highs are declining and breadth is not increasing at a convincing rate. Treasuries confirm the risk-off trade with yields trapped in the 1.60% area; treasuries seem to be in favor of additional quantitative easing. For the current rally to continue, something has to give; the best case for stocks is rising treasury yields. Emerging markets are struggling and transportation stocks are testing their 2012 lows. Our basis for a short-term bearish outlook appears justified at this point.
Should the market carry its summer momentum into fall and 2013, we will consider taking more risk off the table. That's because, so far, earnings are not rising to support the pop in stocks - they have done this relentlessly since 2009. As investors return from summer break, stocks will need a lot more volume and conviction to move the market higher and that will be easier said than done.
There are no guarantees. But if the stock prices and earnings continue moving apart, the 2009-12 bull market could be reaching its end. More stimulus appears imminent and history tells us that stocks could get another boost; don't fight the Fed. However, in my opinion, this is not a time to bet the farm. Our moderate portfolios now hold upwards of 30% cash and our commodities exposure to Gold and Agriculture are growing to maximum tolerances. Some consumer staples and utilities have declined thus increasing opportunity for yield; assuming a risk-off trade materializes, those declines can quickly be erased.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services.
