Trader’s Narrative

Guest post by Wayne Whaley, CTA

Valuation is a funny bird because we are forced to use trailing information to attempt to estimate whether the market is fairly priced relative to future information (earnings) and there is substantial guesswork involved.

This allows analysts a great deal of flexibility to mode the statistics to serve one’s agenda. I read an article published on Oct 23rd in a prominent online finance page that stated that the bulls should be disturbed to buy the stock market at 136 times earnings. That article prompted me do the following mental gymnastics.

What we do know for a fact:

So using the trailing 12 months earnings of $7.51 for the four quarters that we have full earnings for and the S&P 500 value as I type of 1050.0, we have a market trading at a P/E of (1050.0 divided by 7.51) 139.8 times earnings.

If I read their website correctly, Standard and Poor’s estimates that with 37% of companies 09 third quarter earnings in, that the 3rd quarter estimate is $13.14. This would take the trailing 12 month earnings to $10.92 at the end of the third quarter and put the current P/E at 1050/10.92 = 96.1 times trailing earnings.

But the big change comes at the end of the year. We will drop the -$23.25 during the height of banking crisis and add some number likely to come in between 10 and 15. To avoid picking numbers to serve our purpose, let’s be conservative and assume $10 a share for the fourth quarter. This would take earnings for 2009 to (7.52+13.51+13.14+10) = $44.17. With the S&P 500 at 1050, that would give us a conservative estimate of P/E for 2009 of 1050/44.17 = 23.77, a tad bit below the current +100.

A P/E of 23.77 is above the historic norm of 19, but inverts to an earnings yield equivalent of 4.2% which is equivalent to the current return of the 30 year bond and higher than any other return on the shorter end of the yield curve.

This is justified by a more detailed look at earnings vs. interest rates. I use an average interest rate (AIR) which is the average of the 3 Month T-bill, 5 Year T-Note and 30 Year T-Bond. Since 1970, whenever the AIR is below 5.0, the average P/E has been 29.

So without a great deal of imagination, one can put together a strong case for stocks being at least fairly valued at 1050. If you were brave enough, you could argue that stocks are even cheap when compared to returns on alternative investments. Of course, you can argue that the market is selling at 140 times earnings as well.

Personally, for the reasons above, my suggestion is to not rely to much on valuation as a timing tool and focus more on what the tape is telling you.

Let’s face it, this market has been driven by technicals not by any real fundamental health. So what happens when the same folks leave and take their rationale with them, fundamental investors may not be as keen to support the bids.

The recent softening in bids shouldn’t be a surprise. On October 15th the S&P 500 briefly traded 20.81% above its long term moving average. Now, it is only 14% above it. It was back on September 16th that the S&P 500 index first reached the 20% Maginot Line. Between then and now we had 4 other instances where price briefly pierced minutely above the 20% barrier only to be pushed back. Compared to historical precedence, this is part for the course.

As I presented in the detailed historical research report (What Happens This Far Above The 200 Moving Average?), usually when price moves this much away from its long term trend it has been unable to continue at the same pace. That’s what we’re seeing today as the S&P 500 is now below where it was trading on September 16th.

In this short video you can see the headwinds arrayed against the S&P 500. Both by the breaking of the uptrend line from March 2009 and the approaching downtrend line from the top of the bear market (October 2007):

One of the most important sectors, the Philadelphia Banking Index (BKX) has broken this uptrend line. We are also seeing some serious breadth (advance decline) weakness which is never really good but especially bad news while the market is so near a top.

Two institutional money managers have turned negative on the market recently. Jeremy Grantham of GMO Partners and Bill Gross of PIMCO. Click here for details on Grantham’s reasoning and to download his full quarterly report. Gross goes further than Grantham saying: “almost all assets appear to be overvalued on a long-term basis”. You can read his full commentary here.

For those who like to look at fundamental data like the quaint P/E ratio, here is a very long term chart, courtesy of Prof. Shiller:

As you can see, a lot of air was let out of the bubble. But, to mix metaphors, the pendulum didn’t swing back enough. During previous important market lows, the P/E ratio has fallen to much humbler depths. Thanks to the 60% rally from the March lows, we are once again back above the long term average. Which is unsettling, especially when you remember that Shiller uses a 10 year smoothing of the earnings data to iron out short term noise.

October’s P/E earnings, according to Shiller’s methodology is about 20 - well above the long term historical average of 16. Normally, a P/E ratio of 20 corresponds to economic expansion in its 5th year, not a major recession like the one we’re experiencing now. So understandably, Prof. Shiller is skeptical of the recovery in the equity market making the inevitable comparison to the aftermath of the 1929 crash and saying that “it can’t be trusted to continue”.

And turning our attention momentarily to the options markets, the equity only ISE sentiment index came in today at 191. Which means that while the equity market had a negative day with red all over the monitor, retail option traders tenaciously clung to hope and bought almost twice as many calls.

And if all that wasn’t spooky enough for you, to coincide with Halloween this year we have the 80th anniversary of the Great Crash of 1929. Boo!

No, there is no free lunch. But for my US readers, there is a free trading magazine subscription in their future.. For a limited time, you can get a complimentary subscription to SFO magazine (Stocks, Futures, and Options).

It takes less than a minute to sign up and you need to provide some basic information. But as I mentioned, you need to be a resident of the US (because you need to provide a US address). Enjoy!

Jeremy Grantham declares most of the easy money made in his latest quarterly letter from GMO. I respect Grantham as one of the few ‘elder statesmen’ of the stock market because he approaches it with an impressive amount of perspective and discipline. No doubt, a result of having survived many market cycles.

He was one of the few who warned that the bubble was everywhere in 2007 and then surprising to many who were accustomed to his jeremiads against the market, he turned bullish in March 2009: Reinvesting When Terrified.

Here are a few choice excerpts from his latest missive on the US equity market:

Fair value on the S&P is now about 860 … This places today’s market at almost 25% overpriced

Having reinvested back in March to be almost neutral in equities, we have recently taken just a few chips off the table and recommend that anyone who was neutral weighted in equities or even overweighted (lucky you!) do the same.

Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets

As many have already done before him, Grantham compares the spring rally to the ‘last hurrah’ which saw the Dow Jones counter rally in the aftermath of the 1929 crash:

As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great job of driving equity markets and speculation higher.

Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profi t margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment.

But, like Doug Kass of Seabreeze Partners, Grantham doesn’t believe that we break the 666 low on the S&P 500 but that it will last as a long term inflection point. Turning to other markets, Grantham continues to favor emerging markets, even as their valuation pushes against his own value instinct. Finally, he finishes off with an special comment on the question of redesigning the financial system in the aftermath of the 2008 meltdown. The whole thing is longer than his usual quarterly updates but well worth the read.

Follow this link to download GMO latest quarterly letter. If that doesn’t work, you can also find it in the Free Trading Resource section in the Reports & Articles folder.

No, there is no free lunch. But for my US readers, there is a free trading magazine subscription in their future.. For a limited time, you can get a complimentary subscription to SFO magazine (Stocks, Futures, and Options).

It takes less than a minute to sign up and you need to provide some basic information. But as I mentioned, you need to be a resident of the US (because you need to provide a US address). Enjoy!

While the bulls flex their muscles day after day, it is daunting for those who believe that the economy is not on sound footing and that the latest earning season is not about to suddenly provide a cornucopia of better than expected earnings - especially since expectations have been ratcheting up so much recently.

More and more, this is a technically driven market, decoupled from such mundane things as P/E or the economy or any type of anchor we may think is rational to attach to it. We just ricocheted off the S&P 500 index’s 50 day moving average. If you recall back in June and July it was the 200 day moving average which buttressed the index before turning up itself.

But arguing with the market is about as useful as standing in front of a runaway train and doing a PowerPoint on why it should stop in its tracks. Remember that bears have always had the most lucid and convincing arguments.

I’ve been guilty of comparing this spring rally to the 2003 cyclical bull market. If you’ll indulge me once more, here is yet another point of similarity.

The percentage of S&P 500 components which trade above their 50 day moving average fell through the floor to hit the basement in the summer of 2002. Those were dark days indeed. Then even as the S&P 500 index went lower, this metric did not - suggesting that less and less individual stocks were participating in the continuing bear market:

The first sign that things had changed was the almost unanimous involvement of the components in the ensuing rally. In June 2003, out of the 500 stocks in the index, 471 of them closed higher than their intermediate moving average. Then it started to show a remarkable resilience as each subsequent low in this metric was higher than the previous one.

Here is the recent chart of the percentage of stocks above their 50 day moving average, showing a remarkably similar script:

A caveat is that we are starting to see some speculative fever getting stoked in the options pit. But even this is not extreme enough (yet). The market resilience continues with few signs of abating.

Last week I presented a historical study of what happens when the S&P 500 is this far away from its 200 day moving average. If you missed it, click the link to check it out in full.

According to the study, when the stock market has trended enough to set off this indicator, it has trouble continuing its heady ways in the months that follow. The average 6 month return is -5%.

If you look at the data carefully, it becomes apparent that certain date ranges contain a lot of repeated instances where the S&P 500 index is 20% or more above its long term moving average. We’ve just traversed one of these periods from September 16th to the 22nd. Between those dates there were 5 consecutive days were the S&P 500 was at this threshold (or very very close).

The last time this occurred was at the end of July 1997. But the best example was of tenacity in this indicator was in late 1982, just as the great generational super bull market was launched. Although the expected consequence of such an overbought condition is for the market to hit a wall, or at least to pause, during the start of the great bull market, this was not the case. While it continuously flashed red, the stock market continued to climb higher and higher, acting very out of character.

So the question is whether what we are seeing is a repeat of that atypical market action. In other words, do bull market rules apply?

Although there is no way for me or anyone else to prove it definitively one way or another, I highly doubt that what we are witnessing is the dawn of another rare secular bull market based on one variable: valuation.

I mentioned a lot of ratios, statistics and data before but putting all those numbers aside, here is a simple chart which sums up the strange voyage we have taken, from fully priced perfection to panic induced forced liquidation and back again:

That doesn’t look like a great launch pad for the next generational bull market. Heck, even bonds are priced for perfection. At best, we are going through a cyclical bull market - otherwise known as a bear market rally.