The Market Might Be Running Out Of Steam

Includes: SPY
by: Kurtis Hemmerling

The market as tracked by the S&P 500 (NYSEARCA:SPY) is up over 21% since October 1st of last year. Is this a buyer's market? While I remain a cautious bull, there are a few warning signs that investors should keep their eyes on that are not directly related to Europe's woes or the price of gold.

Market Sentiment

Market sentiment can often serve as a contrarian indicator. According to the most recent AAII survey, the bullish sentiment is at 43.7% and bearish sentiment lies at 27.5%. The market is marginally more bullish than the long-term average by about 4.7% and less bearish by 2.5%.

These current numbers are not extreme, but when you see bullish sentiment rise above 60% it may indicate that many investors are fully invested and are now trying to "wish an upside." This often serves as a contrarian indicator. Remember that it is buying pressure that drives prices up and not a cheerleading team.

Buying Pressure

When volume is drying up, one has to wonder if the trend will continue. Look at the S&P 500 chart below.

In the first instance you can see decreasing volume while prices are dropping. After a short consolidation a new upward trend begins. In the second example we see a short upwards trend with volume tapering off - which is divergence. Will a new downtrend begin? Possibly, but it may also be highlighting mass indecision as prices are toying with new highs. As so many are calling for a pullback, the market might be waiting for a directional clue before tipping its hand.

Another technique compares volume on up days versus down days to see where the net volume lies. By this measure we have strong market accumulation since August where volume multiplied by up days is far greater than volume multiplied by down days. The abnormal amount of up days since mid-December is coloring the data though.

Corporate Earnings

Another method to determine potential market drivers is to look at forecast earnings. If strong earnings growth is expected and earnings are consistently revised upwards, share prices will usually trend upwards as well.

One of the many new market-timing tools developed at Portfolio123 utilizes the trailing two quarters and the forward two quarters of EPS in the S&P 500 to plot the earnings trend. I find this more useful than simply using current year EPS figures that factor in a year's worth of growth during the month of January causing a spike in the reading. The chart below is a smoother representation of our earnings past and future forecast.

The market earnings trend is still trending upwards, as this one year chart shows, but I wish the momentum or strength of earnings growth was stronger since August (mid chart). Growth is inching up at a snail's pace now.

What Makes Up the S&P 500
To add a little more perspective in S&P 500 index prices and earnings, we need to consider the top 10 holdings of the S&P 500:

Apple Inc.


Exxon Mobil Corp


Microsoft Corp


Intl Business Machines Corp


Chevron Corp


General Electric Co


Procter & Gamble


AT&T Inc


Johnson & Johnson


Wells Fargo & Co


These top 10 holdings make up 20% of the S&P 500, with Apple alone making up 4%.
  • Over the last 4 quarters, Apple has delivered some amazing triple-digit earnings growth numbers (year over year). Share prices are up over 53% over the trailing 12 months.
  • Microsoft is up a whopping 22% over the past 12 months, as it has strengthened its earnings over the past couple of years and sits with a low PE of 11.5.
  • IBM is up almost 24% over the past year with 4 quarters in a row of double digit earnings growth (year over year).

Apple, along with other companies, are lending a lot of strength into the earnings and index values. Of course not all the companies listed above achieved this sort of growth - some are marginally higher or lower than the S&P 500 average. You can use an equal weight index to see what the average stock performance is instead of cap-weighting and the equal weight index is somewhat higher as smaller companies such as Eastman Chemicals (NYSE:EMN) and Advanced Micro Devices (NASDAQ:AMD) have runup recently.

What is my point here? Don't limit yourself to tracking one index. Try to see what equal-weighted, cap-weighted, small cap, mid cap and large cap indexes are all doing. Take the picture as a whole since each index has its strengths and weakness and one chart can hide pertinent information.

FED Market Valuation

Some value the market by comparing the earnings yield of the S&P 500 to bond yields. The closer bond yields are to market earnings yields the less desirable buying equity is supposed to be. If we use the current years S&P 500 EPS estimate of $103.86 and divide that by the index value of 1370 we arrive at a forecast earnings yield of 7.58% for 2012. Stacked next to a 10 year T-Note yield of 1.93% we can conclude that the market provides stronger excess returns by 5.65% based on earnings yields.

However, I don't like this approach. I want to know when to get in and out of the market based on the market not based on bond yields, the price of corn, or how much return I can get investing in baseball cards. This relative valuation system might continue to show good relative value even if the market falls by 20% because bond yields are so low.

Total yield and market risk would provide a more absolute picture than guessing which of the two investments might carry less risk. The FED model reminds me of the Dogs of the Dow system where you buy the highest yield.

Bottom Line

The market has risen nicely for many months now. The S&P 500 is encountering some stiff resistance at the 1360 - 1380 range while volume is drying up. Other signals such as sentiment and earning trends are fairly "blah," neither giving us a compelling reason to buy nor sell.

While I am still a long-term bull, I have a nagging suspicion that one day soon we will hear a negative report and trading opportunists will take this as a signal to temporarily drive prices down hard. Load up your ammo to buy when the time is right.

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

Additional disclosure: I may intra-day trade any of the above stocks in the next 72 hours but currently have no plans to do so. A market shock could change my mind though.