For the past 12 years, the range bound equity market has been testing the patience and confidence of two generations of investors. This is about to change as the market appears poised to grind higher. Fueled by strong capital inflows, reasonable valuations and strong technical underpinnings, loathed equities will regain their luster as the asset class du jour.
MARKET SENTIMENT INDICATORS: Negative
Bulls have retreated to 43% from 55% and outnumber bears by 1.5 to 1. All indicators except S&P put/call ratio and short interest ratios are now bearish. The VIX & VXN and have receded to normal levels. The spread in corporate yields between top & medium grade issues, portends for more bullishness. More likely, high grade corporates appear to be over-bought and overpriced with the high quality index trading about 50 basis points below its historical mean.
TECHNICAL INDICATORS: Positive
Over 77% of all stocks are above their 200 day moving averages. All major market indices are comfortably above their 50 & 200 day moving averages. Broader based indices such as the NYSE composite and the Russell 2000 confirm the market’s overall strength. With tech stocks leading the way the NASDAQ is trading at 11½ year highs. The Advance/Decline line confirms the market’s underlying strength as well. The NYSE A/D ratio is 2.25-1. The NASDAQ is currently at 1.46-1. The only major missing ingredient is volume. NYSE trading volume is 20% below last year, while NASDAQ is 12% lower than a year ago. This is a head scratcher and cause for concern. It appears to show a lack of conviction, which we read as positive since we expect that change is likely to be to higher volume, providing future support for higher valuations.
LIQUIDITY INDICATORS: Positive
Market participants came back from the holidays with their checkbooks in tow. Over $66 billion flowed into the equities market in the last month. Individual investors have joined the party, investing over $19 billion into equity funds. Corporate inflows were a stellar $45 billion net of new stock issuance. In the last four weeks announced buybacks have exceeded $43 billion led by telecom stalwarts AT&T at $9 billion, Comcast at $6.5 billion and Time Warner at $4 billion. Also there have been nearly $11 billion in mergers and acquisitions lead by Oracle (ORCL), Eastman Chemical (EMN), Thomas & Betts (TNB) and Amgen (AMGN).
There were over 17 IPO’s totaling over $7.3 billion and insiders were net sellers of $1.6 billion in the last month. However, the insider sell/ buy ratio is neutral at 12-1 sells to buys.
VALUATION INDICATORS: Positive
Equities still look compelling versus other alternatives. The 6.4% in earnings yield is very favorable compared to 4.3% on high quality corporate bonds. In addition, earnings are expected to grow over 8% this year. Absolute valuations appear reasonable as the market rates at near parity to its estimated replacement value ex-financials. Historical valuations also appear reasonable, as the S&P trades a very modest 7% premium to GDP and a slight discount to its long term PE ratio. Our 12 month DCF model forecasts 8% further upside to an S&P500 at 1472. The total return potential of 10% for equities compares favorably to 4% for corporate bonds and 2% on government bond.
EARNINGS MOMENTUM: Negative
This indicator is plagued by difficult year over year comparisons and slowing EPS growth. The positive to negative surprise ratio is 2.33, below the 3.0 level needed for a positive indication. Earnings revisions for 2012 and 2013 are both negative at 0.67 and 0.75 although this is slightly improved from last month’s levels. EPS growth for the fourth quarter 2011 has slowed to about 6%, down from over 15% growth in the third quarter. With quarter over quarter growth turning negative, this trend is expected to continue for the next two quarters before it turns up again for the second half of 2012. The three leading sectors for EPS surprise are Construction +46.5%, Industrial Products +18.3%, and Computers and Technology up 17.1% year over year.
MONETARY POLICY: Barely Positive
Year over year M2 growth is 9.6% while money velocity (MV) declined by 6.6%, resulting in a still positive 3% increase. This provides a mildly positive 21 basis point bump for our excess liquidity indicator. A pick up in money velocity could have a leveraged affect on GDP growth. Thus an increase in business and consumer confidence is likely to lead to greater money velocity and eventually better earnings growth later this year.
The slope of the yield curve is still a positive 200 basis points. This supports favorable monetary conditions. The spread between government and junk bonds has declined to 495 basis points, close to the historical norm. The aberration in the bond market is clearly in Treasuries as nearly all maturities provide negative real returns. The bond market does not seem to price in any sustained growth at present.
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