Trader’s Narrative

This morning the Labor Department issued its report on employment conditions for September. The consensus estimate among analysts was -170,000 but the data came in at -263,000. This was worse than last month’s 216,000 job losses and even worse than most pessimistic estimates.

Here’s a long term chart of the nonfarm payroll data going back to the 1960’s:

TrimTabs had the lowest estimate at -358,000. They based this on the continuing decline in income and employment taxes withheld from paychecks. As well the TrimTabs Online Job Postings Index continues to be flat.

The weakness in the economy is reflected in the real-time Aruoba-Diebold-Scotti business conditions index which we looked at yesterday. The most recent data shows an adjustment downwards, taking the ADS index to -0.927 (from around -0.20).

The trend is once again down, which implies a contracting economy. This wouldn’t be a big deal had the ADS first spiked above zero as it has many times before recovering from a negative economic shock. But we didn’t see that this time as the ADS was barely able to return to zero before falling back into the negative.

Yesterday we looked at what happens when the S&P 500 is this far above its long term moving average. If you haven’t yet read that, click on the previous link and read it first because then what follows will make much more sense.

As you’d expect, when the stock market is stretched 20% or more above its 200 day moving average, it has a hard time continuing such a heady move. Instead, we find that the market pauses or retreats in the short term (1 to 3 months). But as Barry pointed out in the comments, there is a difference to how the market behaves in a bear market rally and a real secular bull market. With that in mind let’s analyze the data further.

If you looked at the historical data table that I showed outlining the previous extremes you probably noticed that 4 out of the 13 instances occur very close together in late 1982 and early 1983. This was, of course, the launch pad of the super bull market. The S&P 500 closed at 102.84 on August 10th 1982 and never looked back.

So naturally, there is a cluster of data points (chart below) as the market went on a rampage. This also explains why the 6 month period returns are so inordinately high:

That’s a lot of red marks! Between January 1st, 1980 and June 30th, 1983 there were 28 days when the S&P 500 was above its 200 day moving average by at least 19.5%.

If you look at the chart carefully, you’ll notice something remarkable. Even in such a super-strong bull market, this simple indicator is still able to identify short term tops in the market. But in the intermediate term, the market simply ignored any and all overbought signals. And eventually, by May 1983, they were’nt even able to mark a teeny bit of a correction. After all, in a strong bull market, ‘overbought’ is meaningless.

The question then is, are we about to see something similar? That is, do bull market rules apply? will this most recent extreme be simply the first of many? will the stock market simply ignore each and every one as it goes on yet another rampage the way it did in 1982?

No one knows of course. But personally, I think such a scenario to be highly improbable. It just wouldn’t make sense to expect a repeat of the 1982 experience. For one, we do not have the volume to fuel such a move. Second, and most importantly, we do not have the valuation.

I know, I know, fundamental analysis is for chumps. But I’m not talking about trying to game next quarters earnings estimate. I’m referring to the aggregate valuation of the market. Something for which we have much evidence to indicate excellent predictive value in the long term. For details, I refer you to Shiller’s excellent book: “Irrational Exuberance“.

Let’s pretend to ignore that the market has never rallied 60% in 6 months before. Let’s also ignore that never before has it performed even remotely close to that when the unemployment rate was this high. And ignore that corporate insiders are selling like lemmings. That sentiment is way too optimistic. That 95% of issues closed above their 200 day moving average (and 93% above their 50 day moving average). Even if we brush all of that and more under the rug, we can’t ignore how expensive the market is here:

• the trailing P/E (for operating earnings) is 26
• at the onset of the bear market in October 2007, it was 19
• the trailing Price Earnings ratio is 184 (reported earnings)
• on October 2007 it was merely 23 (in October 1987 it was just 20)
• the price to dividend ratio (click for chart) is at 53
• on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16
• based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years
• on October 2007 the forward est P/E was 14 (same as on Oct 1987)
• Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)
• based on recent Tobin’s Q analysis, the market is 40% overvalued

While the market is a forward discounting mechanism, there is a limit to how much and how far ahead it can do so. Arguably, at these prices, the stock market is discounting the next 3 years operating earnings (2012). Historically, the market faces strong headwinds when P/E reaches 25. The average 1 year return at that valuation (or higher) is -0.3%. (All valuation data sourced from David Rosenberg’s invaluable research at Gluskin Sheff).

All of the above leads me to conclude that the most apt script is the one we’ve seen before many times in the aftermath of secular bear markets. While the performance of the stock market since March has been more than impressive, the stage is not otherwise set for the launch of a secular bull market.

We have yet to see convincing data flow that the economy is improving. At least not as much as the jump in equity prices since the spring low would suggest. However, a specialized index which has an 82% correlation to US GDP over the past 10 years is way ahead of the S&P 500 index:

Source: Bloomberg

The Strategas Bellwether Index suggests that the stock market has identified an imminent economic turnaround. It includes 15 large caps stocks which are sensitive to economic activity:

• Apple (AAPL)
• Advanced Micro Devices (AMD)
• American Express (AXP)
• Computer Sciences Corp. (CSC)
• Walt Disney (DIS)
• Dover Corp. (DOV)
• General Electric (GE)
• Halliburton (HAL)
• Hewlett-Packard (HPQ)
• Motorola (MOT)
• Monster Worldwide (MWW)
• News Corp. (NWS)
• Sprint Nextel (S)
• Schlumberger (SLB)
• Tellabs (TLAB)

This is yet technical argument for a strong underlying market and economy. The S&P 500 is approximately 60% higher today than in early March 2009. The Strategas Bellwether Index is even higher, about to take out its 2007 highs. The question now is, will fundamentals catch up to this level of valuation? and if so, when?

The danger, of course, is that with so much good news already priced in, in the here and now, what if we do not see the perfect scenario develop going forward? Since the market is all about expectations, it could get ugly (again).

Source: Tom Toles

As Homer Simpson would say: “It’s funny ’cause it’s true.”

• Refinance Boom is Over
• Unemployment in Past Recessions
• Duration Of Unemployment - A Really Scary Chart
• The US Consumer Rediscovers Frugality

This bear market we’ve just had (is it over?) has been one fit for superlatives. So why not its inevitable counter-rally (or is it a bull market?).

The chart below is from economist David Rosenberg who now plies his trade at Gluskin & Sheff. In it he points out that what we’ve seen since the spring of this year is the Sharpest Equity Market Rally Ever in the Context of Pricing Out of the Recession:
(Click to see a larger graph open in a new window)

That’s a 54% rise from March 9th 2009 to September 11th, 2009. The closest rally in comparison is 44% in 1929-1933.

Is this recession over? No one really knows. But the sharpest rally ever from within a recession is just one more notch in the belt of this bat$hit insane market.

I, for one, look forward to becoming a curmudgeon and poking my grand kids with my walnut walking stick as I regale them with tales from the bear markets of 2000 and 2008.