Chasing The S&P? Here Are The Parameters

by: Emmet Kodesh

The S&P hit 1773 at 10 a.m. Wednesday, nearly surpassing its intraday high of 1775 on October 29. Traders who did not buy during correction week, October 7-11 have been looking for an entry point and wondering whether to wait for a few red days or just plunge into the QE-powered current. Looking at the S&P's (NYSEARCA:SPY) profile and the boundaries of its channel offers perspective in an environment driven by political turmoil and policies of unprecedented liquidity.

The trading since October 17 may have made some people forget that only a month ago, October 8-9 saw intraday lows at 1646. Confidence and thirst to wring gains from an environment of crushed yields (the 10-year was at 2.64% Wednesday and has been wobbling between 2.48-2.70% since late September) have led players to push cash into equities. The S&P is up 7.72% in 21 trading days. That is delightful and unsustainable.

Since the May 22 FOMC meeting that ended with the initiation of taper talk it has been plain that not only events but narratives have major impact on the year's markets. The next meeting is not until December 17-18 but the one last week showed again that various Regional Fed Presidents can move markets by speculating about times to taper: first it was possible, then it was premature, and so the markets moved. It is very unlikely that tapering will occur: it would boost yields and crimp if not crush asset classes, but taper talk is a way to keep indices from getting too frothy.

There are many economic, political and geopolitical tensions that quickly could create entry points so let us consider the S&P channel which reflects QE-assisted markets in an economically challenged context. The massaged markets display a notably consistent 12-month pattern of rises and declines that can assist your tactical trading.

During the year since early November 2012, the S&P shows seven corrections of 4-5% within a context of consistently higher highs and higher lows. Variations from the norm are important. Note that the current surge from October 8-9 presents the steepest growth profile. The possibility that we are riding for a fall is underscored by the fact that in each of the last two pairs of troughs, April 18 -June 24 and August 27 - October 9, the second trough in each pair came closer to its previous bottom than was the case in the previous six months of the 12-month trend. Thus, the June 24 close at 1573 was closer to the 1542 on April 18 and the October 8-9 intraday low of 1646 closer to the August 27 low of 1631 than had been the case earlier in the rise. That may suggest that the markets are increasingly overbought.

The S&P gained 23% January - October and, the Bloomberg article linked here states that in 82% of the last 85 years, when the index is up 10% or more through October, the mean gain during the last two months is 8%. That would make for a powerful year. It also reports that 447 of the index's component companies are green for the year. It also is impressive but in the near term cautionary that 80% of the S&P have out shot their 50-day MA. Everyone wants to join the party: it is at such times that hilarity gets out of hand and revelers can strike their heads on doorposts.

Equity valuations have increased 18% this year to 16.7 while the GDP, an exaggerated measure of economic growth (government salaries and perks consume rather than boost economic basics) is +1.5%. David Pearl at Epoch Investment Partners (previous link) noted that the markets are strong but the economy "is not that great," a kind way of alluding to a host of structural problems.

While the Bloomberg piece notes that the S&P's PE is still below the 15-year average of 19.3, Doug Short recently took a broader and more cautious perspective. He notes that the TTM (trailing twelve month) P/E often is an inadequate predictor of market health because in overbought markets earnings fall faster than price. The earnings miss by Whole Food Markets (WFM) reported November 6 may be signs that a dip is due before what seems to be setting up as a near-record year, one of the best since 1933. CBS (NYSE:CBS), for example, had earnings rise 33% Y/o/Y. While an S&P P/E about 18 is a bit below the average for the past 15 years, it is 20% above the average since the 1870s, Short writes.

Building on the work of Graham and Dodd, Robert Shiller proposed his cyclically adjusted (for inflation) P/E 10-year or CAPE ratio. The historical average is 16.5 and the index now is about 24 above the regression trend. We are not as far above it as in 1929 (33) or the tech bubble (44) but the CAPE suggests the index is overbought which also is shown by reading the effects of QE and taper talk. Add that to the steepness and extent of the current rise and it seems doubtful that the indices can push strongly to New Year's without blowing off some steam in another of this year's 4-5% "corrections" (a strict definition of correction is 10% or greater).

The lower line of the current S&P up-channel could fall to 1680 without breaking the trend of higher lows. If that occurred, it would be a 5.08% drop. Regarding the top line of the channel, the highs of May 22, August 5 and September 18 point us to 1755: by a well-established and carefully modulated trend, we currently have overshot the mark. However, by the more sprightly standards of tops earlier in this twelve-month period, those from December 18, 2012 through March 14, April 11 and May 22, 2013 we are headed for S&P 1810 or better.

I have striven to identify strong companies not just for the present but mid to long-term. It is useful to distinguish between companies you trade mainly for gains and those you wish to hold for their intrinsic merits and core socio-economic positioning. Your time horizon tells you when and how much you should trim the latter to bank gains. Note: trimming for its own sake as a defensive strategy can hurt those not pressed by time. For example, those who bought Starbucks (NASDAQ:SBUX), TJX (NYSE:TJX) or Whole Food Markets five years ago and trimmed occasionally to avoid being "greedy" have missed some spectacular accretions of 100 - 130%.

Takeaways: Look for a couple of consecutive red days and buy some of the strongest companies you have been watching. In addition to those mentioned above, I have discussed the merits of Dunkin' Brands (NASDAQ:DNKN), Disney (NYSE:DIS), and Boeing (NYSE:BA), strong but pricey, United Tech (NYSE:UTX) and British Petroleum (NYSE:BP). Macy's (NYSE:M) just had an impressive earnings beat and rides the season and good metrics. Among PMs (precious metals), First Majestic (NYSE:AG) and Endeavour (NYSE:EXK) have had excellent YTD and 3Q results with production of silver, gold and base metals rising 53% - 158%. Their prices now are inviting, suppressed more than usual by a vote in the Mexican Senate to move toward a 7.5% tax on mining sales and a .05% tax on gross revenues of gold and silver. I mention both companies in this piece, among others.

The last year suggests that a drop of 4-5%, toward S&P 1700 would be a strong buying situation unless occasioned by a major domestic or geopolitical convulsion. In that case, continued watchfulness or increase of cash is a cautious strategy. Barring such a major event, it is difficult to see the next four - five weeks passing without a drop of 40 or more points and also difficult to see the year not finishing with additional gains: that would extend an established and consistent trend upheld by government policy. With traders filled with skeptical hopes, the gains may continue for some time.

Disclosure: I am long AG, DNKN, SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.