Market Indicators & Strategy Report December 31, 2015
January 4, 2016 By Senior AnalystMMI Ends 2015 In Bear Country- Unhappy New Year?
Our Major Market Indicators closed the year stuck in a bearish range for the fourth straight week. The market hit a short term peak in early November (but early December for the NASDAQ) and since then the indexes have given ground through year-end. Since November 3rd the S&P 500 is down (3.4%) and the DJIA is down (3.08%), while since December 2nd the NASDAQ is down (3.27%) and the small cap Russell 2000 has been even worse, down (5.74%). The MMI entered bearish territory starting with our report dated December 6th, which corresponds with market close on December 4th. MMI ended this past week at 36.33, its lowest score since we began publishing this data some 20 months ago in May of 2014. A reminder: the MMI index is not considered an arbiter for the next week's performance, but rather a longer term outlook of the forward nine to twelve months.
The chart below shows the performance of the significant indexes since their recent top - November 3rd for two of them and December 2nd for the other two. Again, the Major Market Indicators fell into a bearish score starting the first week of December. Given that this week is the lowest score of the recent string of bearish weeks, we believe the MMI are throwing up a yellow caution flag to investors.
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Below, the weekly graph of our Major Market Indicators shows the trend since May of 2014 through December 31, 2015.
MARKET SENTIMENT INDICATORS: Neutral
The market sentiment indicators score neutral this past week as bullish and bearish indicators offset each other. Since we use a mostly contrarian judgment on sentiment; a bullish behavior by market participants registers as bearish, and vice versa. In terms of bearish indicators, the Volatility indicators (VIX and VXN) stood at week's end at 18.21 and 19.63, which added one bearish point to our score; we score VIX/VXN at greater than 20 as bullish. The ARMS index on the NYSE and NASDAQ (0.98 and 1.40) also were bearish. The AAII (American Association of Individual Investors) survey of investors registered a ratio of bullish to bearish attitudes of 1.06, also a bearish reading. Finally, the Consensus Index and the Market Vane Index registered 61% and 60.0% respectively, all bearish indicators.
On the bullish side of the ledger, the Put-Call ratios are both registering bullish scores. The CBOE Put/Call ended the week at 73/100, while the Put-Call on the S&P 100 was also bullish at 127/100. The confidence index, the index of high-grade bonds yield vs. intermediate grade bonds yield (3.69%/5.15%) produces a ratio of 71.7%; we score any spread under 75.0% as bullish. Also, the short ratio on both the NYSE and the NASDAQ were bullish, at 4.30 and 4.83 days to cover respectively. These 6 indicators were the bullish contributors for this week. The chart below from Citigroup indicates their reading of sentiment is back in the "panic mode" levels previously seen in late summer.
TECHNICAL INDICATORS: Bearish
Our technical indicators scored 1 out of 15 indicator points bullish this week, so the technical picture is overwhelmingly bearish. The volume ratios we track were all bearish. The advance/decline volume ratio on the NYSE and NASDAQ closed at 0.65 and 0.65 respectively. The ratio of the number of issues advancing vs. declining for the week on both the NYSE and NASDAQ was 0.54 and 0.50 respectively, and again this too was bearish. The 10 day moving average of up vs. down stocks on those two exchanges was also bearish on both counts: The10-day moving average of the NYSE scored bearish at 0.94 and the 10-day moving average of the NASDAQ was bullish at 1.38. Finally, the ratio of new highs to new lows was 1.06, and this too was bearish.
We also score a number of indexes vs. their 200 day moving average. Only one of these indexes was trading above its 200 day moving average at year end: the NASDAQ composite closed the year at 5007.41, or 0.51% above its 200 day moving average of 4982.21, the lone bullish reading in our technical indicators. The remaining indexes we track were all bearish, sitting below their 200 day moving average, by the following percentages: The S&P 500 (0.83%), the Dow Jones Industrial Average (0.62%), the NYSE Composite (4.58%), the Russell 1000 equal weight ETF (EWRI) (4.78%), and the Russell 2000 equal weight ETF (EWRS) (8.02%).LIQUIDITY INDICATORS: Bearish
Our liquidity indicators are bearish. Money market funds balances are 11.4% of the market cap of equities, which provides buying power to support stock prices, a bullish score. On the other hand, customer credit balances at brokerages stood at only 28.5% of margin debt at last reading (November 2015), a low level and a bearish score. In a sharp sell-off, customers either have to post more cash to bring their margin account above the minimum maintenance threshold, or margined stocks will be sold to meet the cash call. This low cash level implies increased risk of customers having to meet margin calls with stock sales rather than posting more cash.
Tipping the balance to the bearish was our cumulative market liquidity calculation for the trailing four weeks. Total flows into the market as calculated are registering a bearish inflow. Mutual funds (including ETFs) have seen net outflows over the past four weeks, with a net ($19.39) billion withdrawn from the market for the four weeks. We should point out that the most recent week's flow reported by Lipper this past Wednesday was a positive $10.0 billion. Other activities in the liquidity flows we track were slow this month, reflecting year-end doldrums. In the corporate acquisition market we count only the cash component of M&A deals as announced. The sum of that figure for these four weeks was $9.04 billion. The only really big deal we saw was Newell's announced acquisition of Jarden Holdings, for which we calculate $4.4 billion as the cash component.
Announced stock buybacks contributed another $25.9 billion to our liquidity calculation in terms of total buyback authorizations announced. The most significant buyback announcements were made by Boeing ($14.0 billion), AIG ($3.0 billion), Ameriprise Financial ($2.5 billion), and Moody's Corp ($1.0 billion). Stock buybacks have been and continue to be an important source of liquidity to the market.
IPO activity has slowed even more these last four weeks. $4.5 billion of new market capitalization was added to the market for the trailing four weeks. The only significant new issue was Atlassian (TICKER: TEAM) at $4.4 billion.
The chart below shows the number of IPOs priced over the past eighteen months. December's IPO pricing activity has fallen off the table, coincident with the pullback in index returns and the usual year-end vacation period.
Secondary stocks offerings have slowed, with only $0.9 billion in the trailing four weeks. Note that we exclude sales by large shareholders (private equity) which do not increase the total number of shares outstanding. Insider selling pulled $1.51 billion of net cash out of the equity markets in the past four weeks, down sharply from the $7.8 billion of the prior month.
We track cash inflows to domestically focused equity hedge funds on a monthly basis. We calculate cash inflows to domestically focused equity hedge funds at approximately $1.06 billion in November. Given the relative secrecy of hedge funds this calculation will always be a rough approximation, but we are applying our methodology on a consistent basis, month-to-month.
Overall, we count up a positive net inflow of liquidity into the domestic market of approximately $9.63 billion for the past four weeks, which is not enough to warrant a bullish score. We require at least $20.0 billion of calculated positive liquidity to warrant a bullish score, so therefore the liquidity calculation is bearish. We double weight this calculation in our MMI scoring. Combined with the other factors above we arrive at a bearish view on liquidity.VALUATION INDICATORS: Neutral
Our valuation indicators rank at a neutral level this week. Our fair value target for the S&P 500 is 2294, representing a 12.2% upside from the close on December 31st. That upside potential is a bullish indicator in our calculation. The target uses a 19.4x multiple applied to 2015's estimated operating earnings of 118.12. Our fair value target multiple is arrived at using an intermediate grade bond yield rather than the ten year Treasury bond, due to the artificiality created by Quantitative Easing. The S&P 500 is trading at 17.2 times the trailing four quarters operating earnings (through the third quarter of 2015), compared to an historical norm of 15.5 times operating earnings. On forward-four-quarters earnings, the S&P 500 is priced at 16.66 times earnings, while it is now trading at 17.3x 2015E and 16.1x 2016E. The upside to the fair value target is sufficient to rate bullish. So too is the ratio of the S&P's earnings yield vs. the Single-A 10-year bond yield, 1.43x.
We score the target for the S&P 500 a second time, with a more conservative price target discounted 10% from the prior target. We require a minimum of a 10% upside from the current index price to this second target in order to score the indicator as bullish. The resulting target, 2064, produces a prospective vs. the week's close of only 0.99%. Since this is less than a 10% potential gain, it scores bearish.
There are other bearish indicators. Compared to GDP the market is at a 34% premium. Small cap stocks, as judged by comparing the T Rowe Price New Horizons Fund to the S&P 500 are not cheap, at a 1.60 times ratio. However, they look a lot cheaper if we substitute the P/E of the Russell 2000 - 1.30x, or the equal-weighted Russell 2000 ETF - 0.95x.
We estimate the total domestic market capitalization is trading at 88.5% of replacement cost of the asset base of non-farm, non-financial corporate businesses. By this metric, our version of Tobin's q, stocks are cheap. Since this is less than 100% of replacement cost we score this a bullish indicator.
Overall, valuation indicators are neutral, with bullish indicators equal to bearish indicators.EARNINGS MOMENTUM INDICATORS: Bearish
The MMI score for earnings momentum is bearish this week. The earnings season for the third quarter 2015 (which is over 99% complete) positive to negative ratio of earnings surprises is 2.95x, a bearish score (we set a high bar for this indicator; since the earnings game system is set up to naturally encourage companies to "beat the street" we require a ratio of greater than 3.0:1 for this indicator to score bullish).
Third quarter 2015 earnings are currently estimated at a growth rate of negative (1.5%) compared to (1.3%) on November 30th. This worsened expectation vs. the prior month's estimate is judged bearish in our scoring. Earnings expectations the full years 2015 and 2016 continue to decline: 2015E earnings are now projected by the street at a negative growth rate of (0.6%) vs. (0.3%) at the end of November. 2016 estimates also have come down to a growth rate 7.6% growth vs. 7.8% at the end of October. A positive change in earnings expectations is bullish, but a flat or negative change in expectations is bearish. We rely on FactSet for these specific estimates.
On a PEG ratio (P/E to growth rate) basis S&P earnings still looks this side of cheap, at a PEG of only 2.28 times, compared to a longer term average of 2.58. Looking at small cap stocks, the Russell 2000 trailing P/E ex: negative earnings were 22.3x at 11/30/15, vs. a five year eps growth rate of 10.80%, implying a PEG ratio of 2.06 times.
Thus, overall earnings momentum now scores bearish since only one out of our six indicators scored bullish.
The earnings outlook would look better, if not for the Energy sector, and it would look worse, if not for stock buybacks. According to Thompson Reuters I/B/E/S if we exclude the Energy sector, the growth rate for S&P earnings for Q3:15 would increase to a positive 6.3%, and for Q4:15 the growth rate would increase to +1.9%. The point is, the Energy sector has thrown index earnings into the red, but ex:Energy earnings are estimated to grow in positive territory this year. Then, over two-thirds, 68.9%, of S&P 500 companies reported a lower share count for Q3:15 vs. Q3:14. In fact 22.7% of the index members reported at least a 4% lower share count year-over-year (the seventh consecutive quarter for this), while 9.6% of the index members reported at least a 4% higher share count.
Expectations for 2016 earnings growth have declined over the course of the year, which is not a big surprise. Notably, early in this year the Energy sector was estimated to have a big bounce-back year in 2016 on the assumption oil prices would rebound. These expectations have evaporated. The Energy sector is now forecast to show a decline of earnings of (8.4%) in 2016. FactSet reports all the other sectors are still forecasting positive growth in 2016, with materials up 1.2%. Is it reasonable to expect energy sector profits to continue to decline yet the whole materials sector recovering significantly?MONETARY POLICY: Bullish
The Federal Reserve finally pulled the trigger. The money masters in the Eccles building raised their Fed Funds target interest rate by a quarter point this past month, to a new range of 0.25% to 0.50%. The effective rate was 0.35% at the end of the year. When the Fed made this announcement, it seemed to imply another four rate hikes in 2016. That's still not a very high Fed Funds rate in an absolute sense, though it would lend support to pushing up the rest of the yield curve. However, they may face a lot of pushback against further action based on perceived weakness in our economy as well as knock-on effects to the rest of the world.
Our excess liquidity indicator is bullish at 18.5 basis points. This means the Fed is providing 0.185% more liquidity than the current nominal GDP growth rate. This figure takes into account the decreased velocity of money in recent periods. We arrive at this figure by subtracting the annual percent change in velocity from the year over year percent change in M2 money supply. Then we subtract the most recent quarter's year-over-year percentage change in nominal GDP. We score this amount of excess liquidity as bullish.
The Treasury yield curve is accommodative to growth. The spread between the ten-year and one-year rates is about 1.60%, a positively sloped yield curve, and we score this bullish.
Junk bonds yields remain elevated. Using the HYG fund as a proxy, the yield-to-maturity of that fund stood at 7.80% this week and the spread vs. 10 year Treasuries stands at 5.55%, and this is bullish, since we judge anything over 4.0% as wide enough to rate bullish.
As shown below, forward inflation expectations remain well below 2.0%. This would appear to indicate the bond market, which we believe is collectively smarter than any one of us, is forecasting a low inflation environment, which runs counter to the hawkish talk about raising rates. This makes us wonder why the Federal Reserve is anxious to raise rates by the end of the year. We note that the ten-year breakeven rate has risen from its recent bottom, but has not yet violated its downward trend.
In summary, our MMI score sits in bearish territory at the end of last week. Monetary policy indicators scored bullish, while technical, liquidity and earnings momentum indicators score bearish while market sentiment and valuation indicators are neutral. Since this is the fourth week in a row for a bearish reading, caution in protective strategies are encouraged.
Singular Research Analyst and Market Strategist
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.