Is the Market Cheap? Does It Matter?

Includes: DIA, QQQ, SPY
by: Roger Nusbaum

A reader left a comment that gave a reasonable "I hear ya but..." approach regarding the 200 day moving average. It seems three out of four timing indicators that Phil DeMuth and Ben Stein use say the S&P 500 is now undervalued.

(Let me be clear: I don't know anything about what Stein and DeMuth are saying. If anything, I am relaying the reader's comment and choose to believe the reader has his facts straight.)

I have written about this sort of thing before. The Fed Model is an example of the type of market valuation process the reader is talking about.

All indicators of all types have flaws. If you are going to to rely on an indicator, you have to know its flaws in order to make an intelligent decision based on it.

First, let's stipulate that Stein and DeMuth's indicators are correct and the market is cheap. OK, when will it go up? Will it get cheaper? What about being cheap will lead to a move in the market? Is cheap important right now? Do the risks that made it cheap in the first place outweigh the cheapness?

Every model along these lines I have ever seen can stay cheap or expensive for years - the market continues to move up while expensive, or down when cheap.

My take on the 200 DMA is that the dynamics of the market are communicating the health of demand. Quite simply, if demand is healthy the market stands a better chance of doing well, regardless of how cheap it is. The drawback is that occasionally it will breach the 200 DMA in one direction for only a couple of days and then go right back - which is a reason why I don't make big bets all at once but just start with a tweak.

The way I look at it, valuation models/indicators rely on too many "shoulds." I don't find anything forward-looking when armed with the knowledge that stocks are cheap. Additionally, "Is demand healthy - yes or no?" is a much simpler concept and where possible I think simpler is better.