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Market Notes: Are We There Yet? -- May 16

May 16, 2013

4:00pm ET: It looks as if yesterday's internals didn't lie because we got our expected pullback today. The question is whether or not today's drop is a one day event or if we're in for more downside. Judging from today's leadership to the downside by the Transports (DTX), tomorrow could start off on the wrong footing but we may not stay in negative territory for long. The volatility index (VIX) should have made a bigger move up today considering the negativity didn't react much indicating that the bulls are still in control. Also, the sharp reversal to the upside going into the close indicates short-covering. This shows us the bears are afraid to hold short positions for any length of time.

So is there an upper limit to this market? Some stock pundits like Peter Lynch believe in the "Rule of 20" which states that a market equilibrium P/E ratio should equal 20 minus the inflation rate (given by the CPI). Using the latest inflation figure of 1.1 would imply an equilibrium P/E ratio of approximately 18.9 times earnings. Calculating the upper bound of the market depends on which earnings multiple you use: the trailing 12 month, the 12 month forward estimate, or some sort of average value. Using $86 as the trailing earnings level on the S&P (from Standard & Poors) and $114.5 as the forward estimate (from Factset Research) gives us a range in the SPX from a low of 1625 to a high of 2165. I'm not an expert on this topic but if we're to assume the trailing earnings number, then the market is already overextended. On the other hand, if we're to assume the forward earnings figure, then the market has a long way to go before it corrects. A lot of this will depend on when the Fed decides to start raising interest rates which many feel could be by the end of this year.

The moral of the story? Be vigilant and don't become too complacent. There's still half of the month left for the "Sell in May" scenario to unfold. Beware of the Bear!

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