Where is this market heading?
Now that we are in the midst of a market correction: what next? Where do we go from here? For the answer to this let’s take a look at the charts to see what our GMM model is telling us. Now this might get technical, so bare with me for a few moments:
This chart dates back to May 2008 to provide us with pre-market meltdown and recovery context. Let’s go through each of the indicators to provide some colour.
In purple the GMM is presently at 1.28 – at or above the highs from before the massive market selloff. This indicator is based on trailing financial statements dated as at early October, 2009. In our model, this indicator acts as a proxy for the forward gross profit growth rate over the ensuing twelve month period. In short: as at February 5, 2010 the market is pricing in a 28% increase in gross profits for the period between October 2009 and October 2010.
The LQA/LTM indicator in light blue shows us the current rolling run rate of gross profits dated as at the average date of the trailing financials, which as of today means early October, 2009. This chart shows that at the end of the third calendar quarter of 2009, aggregate gross profits in the Caseridge TechSys Index declined by 1.45%. To clarify, this means that annualized gross profits as at the end of the third quarter of 2009 were about 1.5% lower than in the preceding twelve month period.
The NQA GMM indicator in dark blue is a forward looking indicator that is based on consensus analyst estimates for gross profits and gross margins in the “next quarter”; and which is annualized for the purposes of our model. This indicator is at 1.02 as at February 5th. This means that the market is fully pricing in the results of the analysts’ consensus estimates for the next quarter, and then some.
With that elaboration out of the way, the current jitteriness in the markets is a function of the high implied gross profit growth rates priced in to the market relative to the declining gross profits in the trailing quarter. In order for a sustainable market advance, the GMM multiple needs to decline from the present value of 1.28 to something closer to or below the 1.20 level. This doesn’t necessarily imply a market decline – it could result from higher gross profits and gross profit growth rates in the December quarter. Should this be the case, the gross profit growth rate (in light blue in the chart above) will turn positive and over the course of the year we will likely see gross profit growth rates in excess of 10%. As these growth rates increase as financial results are released, the GMM should decline, even if the market stabilizes or valuations improve. For this to happen, gross profit growth rates need to exceed the growth in enterprise valuations. Further, once the fourth quarter is released and the analysts focus their revisions on the first and second quarters of 2010, we should see a further decline in the NQA GMM index to below 1.00. We believe that anything below 0.95 would present some strong buying opportunities.
In the final analysis, this market will move as the combination of gross profits and gross margins is revealed. The market will begin to advance on a sustainable basis if the GMM declines to below 1.20 as a result of strong gross profit growth rates. We expect that this will begin once the average age of the trailing financials moves from October to December. If it doesn’t, then we’re in for some further declines.
Disclosure: No stocks mentioned