A Random Assortment of Technical, Liquidity, and Valuation Indicators
(October 21, 2010)
Dear Subscribers and Readers,
What a difference a few days make! Over the last few days, both the Richmond Fed and Philadelphia Fed presidents have made statements arguing against an additional quantitative easing policy. The Kansas City and Minneapolis Fed presidents have also questioned the wisdom of an additional round of asset purchases. With the Republicans posed to take the House on November 2nd (Intrade.com is pricing in a 87.9% chance of the Republicans taking the House), and with Ron Paul (who is not exactly a fan of the Federal Reserve or Bernanke) predicted to become chairman of the sub-committee responsible for overseeing the Federal Reserve, Chairman Bernanke may be increasingly reluctant to embark on a new round of quantitative easing until there are clear warning signs of the U.S. economy slipping back into a deflationary spiral and/or a recession. Moreover, both the Chinese and the Japanese have recently allowed their respective currencies to rise—which means that the Fed does not have to worry about a stronger dollar—and thus the case for QE2 is further weakened. With the markets likely having priced in an announcement of QE2 at the conclusion of the November 3rd meeting, any hesitation by the Fed could lead to another correction in the stock market. For now, there is a strong case for remaining 50% long in our DJIA Timing System. We will now discuss other indicators arguing for a range-bound market (if not a correction) going into Thanksgiving, and possibly Christmas.
Over the last several weeks, short-term negative divergences have been developing, although long-term technical conditions remain decent. These short-term negative divergences have persisted—thus leaving the market vulnerable to a short-term correction. As discussed in earlier commentaries, the recent action of the NYSE Common Stock Only Advance/Decline Line still isn't confirming the strength in the NYSE Composite, as shown in the following chart:
While the NYSE Composite is now challenging its late April levels, both the NYSE CSO A/D Line and the NYSE CSO A/D Volume Line are still significantly lower than their late April levels. These short-term negative divergences, combined with a short-term overbought condition, makes the market vulnerable to a correction—and at the very least, a range-bound period that could last into Christmas.
In addition, our liquidity indicators are still weak—and thus isn't too supportive for a year-end rally, especially given the uncertainty surrounding Federal Reserve policy. For example, the amount of “investable cash on the sidelines” versus the S&P 500's market cap – has continued to decline, as shown in the following chart:
Note that we have updated the numbers as of Wednesday evening. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has consistently hit new lows since February 2009. The ratio bottomed at the end of April, with the ratio rising by 4.47% from the end of April to the end of August (from 32.30% to 36.77%). However, with the best rally in a decade in September, and with the ongoing rally this month, this ratio has declined to 33.03% as of Wednesday evening. Moreover, this ratio has come down too far, too fast, and remains low compared to its readings over the last two years. As such, this liquidity indicator is does not indicate a year-end rally.
From a valuation standpoint, I would say the stock market is likely trading at around “fair value” right now. One valuation factor that I regularly track – Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is now right at fair value, as suggested by its current ratio of 1.00 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). As shown in the following chart, courtesy of Morningstar, this ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001), and as high as 1.14 on December 31, 2004:
As mentioned, Morningstar's proprietary valuation indicator suggests that the stock market is more or less, trading at “fair value.” Subscribers should note that – given the trend of corporate earnings over the last 12 months – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom. In addition, the weighted cost of capital has already declined dramatically – suggesting that valuations may be a little bit stretched, especially if the Federal Reserve forgoes “QE2” at the conclusion of the next Fed meeting. In other words, Morningstar's proprietary valuation indicator provides further evidence that the market will be range-bound going into Christmas.
Henry To, CFA