A Summary Of The Bull And Bear Arguments For The S&P 500

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Includes: DIA, QQQ, SPY
by: Jeremy Robson

The market is presently giving off mixed signals. The top in August was 1373, so at present it is 9.7% off its best level. However from the September bottom of 1074 it has risen 15.4%. As the picture is so clouded at the moment, I thought it would be helpful to summarize the bull and bear arguments

The bull case

Valuation

The 12 month forward p/e for the S&P500 is around 11.5 by most analysts forecasts. With the long term average around 15, the market is presently 30% undervalued. This implies an upside move to over 1600; a new all time high for the markets! The TTM p/e is at 13.4 against an average of 16, so this confirms the forward p/e picture.

The macro view

The economic picture is also supportive. Both ISMs are above 50, new unemployment claims are falling steadily and most analysts are predicting 4th quarter GDP growth of around 3%. The Christmas retail sales are presently reading better than forecast. Railroad traffic is continuing to expand.

The micro view

Company balance sheets are at their strongest for many years. U.S. corporations presently hold over $2.1 trillion in cash. Profit margins have just hit a record high in the 3rd quarter at 8.9% of income. Companies are therefore coping well with the slow growth economy and will continue to produce earnings growth going forward.

Monetary and fiscal policy

The Federal Reserve has told the market that it will keep interest at the zero rate band until 2013. They have clearly shown that they will support markets and if the bear market does return we will have QE3 to snuff out any major down move. Fiscal policy, although not supportive, will not be tightened before the presidential elections

World View

China's inflation rate is starting to moderate and this will lead to policy easing, supporting growth in Asia. The pressure on any house price decline in China will reduce as policy tightening is reversed, leading to a soft landing for the economy.

The same picture of inflation easing and looser monetary policy is emerging in India and Brazil.

The policy makers in Europe are making slow but steady progress in solving their problems. A crisis is unlikely but a recession will be the result of the present move to austerity. Seventy percent of the U.S. economy is service sector-oriented, so any contagion from Europe will not lead the economy here into recession. The banking system in America is only now levered around 15 times and has been recapitalised and will be able to withstand any crises in the European banking system.

Technical outlook

The market recently made a higher low around 1150. Once it has made a higher high above 1290, the bull market will have returned and the period between April and September will mark a correction in an ongoing bull market. Seasonality is in the Bulls favor; the Santa rally will be followed by the January effect. December has shown an average positive 1.73% gain and January a 1% average gain since 1970. The chance of a higher high is therefore good. Investors presently have over $2 trillion in cash on the sidelines. Some of this cash will soon be invested in the markets.

The Bear case

Valuation

The p/e10 is presently at 20.1 against an average of 16.4 and the Tobin Q is at 1.01 against an average of .7. The market is therefore overvalued by 15.5% and 30.7% by these two measures. The downside targets are between 800-1000 for the S&P 500, if these valuations return to their average. On the 7th September 2011, a Dow theory sell signal was confirmed. Dow signals have a 79% success rate. The average downside move from a sell signal is 34%. This implies a downside target of 825. This confirms the overvaluation picture produced by the Tobin Q model.

The macro view

All of the ESMs and PMIs reached a peak in April of 2011. They are all now steadily deteriorating. They are presently not negative but it is only a matter of time before the trend formed over the last 8 months moves them into recession territory. The present reduction in the new claims data is a temporary effect due to Christmas and will be reversed in January. The savings rate has fallen to 3.2% as consumers continue to spend. This is not a sustainable trend and retail sales will shortly turn down again, as savers exhaust their savings. The ECRI recently issued a recession call and so far they have never been wrong.

The Micro view

Companies are holding so much cash as they fear a resumption of the financial crisis. This cash will not therefore be used for investment and will stay in cash, producing no positive effect. The present record profit margins are unsustainable. Profit margins are a mean reverting statistic and will soon return to their long term average around 6% of income. Earnings growth is about to stall.

Fiscal and monetary policy

Fiscal policy is on hold before the presidential elections in November 2012. This means no more stimulus, any extensions to payroll tax and extended unemployment benefits are likely to come with balancing cuts elsewhere. Monetary policy including QE3 will not be effective if not accompanied by fiscal stimulus. On its own, monetary policy will not be effective enough.

World View

China has finished tightening but will be unable to ease as inflation and house price gains will keep its fiscal position neutral. Almost 50% of China's growth is presently investment; this is clearly not sustainable. As the investment effect is reduced, growth in China is likely to fall to the 6% range. Europe is in recession and it accounts for 28% of world GDP. This will further effect Chinese exports and slow its economy. Sovereign debt yields in many European countries have moved to unsustainable levels. Confidence in the U.S. will slowly be eroded by world events. This erosion of confidence will start to show in service sector growth (the recent service sector ISM for November fell from 52.9 to 52) and lead the U.S. into recession.

Technical outlook

The S&P 500 produced a double top at 1370 and has declined for over 8 months, producing lower highs in October, November and so far in December. The position remains bearish until the market makes a higher high.

This post is intended to summarize the present position. Personally I like to look at both bull and bear perspectives so that I can make a decision on the most likely outcome. I recommend that you look particulaly at the oppposite perspective to your own to see if it changes your opinion. I hope that you have found it useful. I have a post here on my medium tem outlook and a blog here with a short term view. i would also suggest this post by J Hussman.

Disclosure: Short S&P 500 & Dax futures, long RWM.

Disclaimer: This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.