Earnings Season Heats Up
(April 10, 2011)
Dear Subscribers and Readers,
Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;
12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;
13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.
Earnings season kicks off this week with Alcoa reporting on Monday after the close, JP Morgan on Wednesday, Google and SuperValu on Thursday, and Bank of America, Charles Schwab, and Mattel on Friday. 11 components in the S&P 500 are reporting this week. Next week starts the avalanche, with 113, 182, and 112 of the S&P 500 components reporting over the subsequent three-week period, respectively. This represents 81% of the companies in the S&P 500, and about 83% of the S&P 500 market capitalization. Not surprisingly, on a YTD basis, the best performing S&P 500 sector has been energy (+17%), followed by Industrials (+9%). The worst performing sector has been Utilities (+3%), with Information Technology, Consumer Staples, and Financials all closely behind (about +4%).
As I am typing this, the S&P 500 futures is up 3.0 points. Valuations remain decent. As we mentioned in last weekend's commentary, Morningstar's aggregate valuation is just slightly overvalued—remaining the same as last week's reading at 1.04. As discussed, this ratio is still about 6% below where it was immediately before the market experienced its last major correction in late April 2010. Moreover, “traditional” valuation indicators such as the NTM (Next 12 Months) P/E ratio and the LTM (Last 12 Months) P/B ratio are both at recent levels at 13.6 and 2.4, respectively (as shown in the following exhibit courtesy Goldman Sachs):
Of course, not everything is looking up. For example—as shown in the following exhibit (again, courtesy Goldman Sachs)—the S&P 500 profit margins is now at a structural high (the data isn't shown here but one would need to go back to the 1950s to see higher margins).
More important, subscribers should keep in mind that these structurally high profit margins were a result of 1) the steep yield curve as orchestrated by the Federal Reserve—and which is coming to an end, and 2) the structural “labor arbitrage” by S&P 500 companies to China and India—which by many accounts may also be coming to an end as China starts to face manufacturing labor shortages. Of course, there is still no lack of labor supply domestically, but US employment is starting to catch up—and with energy and commodity inflation heating up, profit margins may start to compress over the next 12 months. This will definitely have an impact on valuations.
Meanwhile, our technical indicators are still deteriorating! For example, the action in Lowry's Buying Power Index vs. its Selling Pressure Index is now at its most ominous since the beginning of the cyclical bull market in early March 2009. The NYSE Common Stock Only Advance/Decline Volume line is also not confirming the new highs in the major market indices. A similar story exists in the NYSE CSO McClellan Summation Index and new 52-week highs vs. 52-week lows. Finally, our liquidity indicators still indicate a tendency towards tightening—especially in light of the 25 basis point hike by the European Central Bank last week. Sure, the Federal Reserve's QE2 policy is still intact, but it is likely to “stand pat” once it expires at the end of June. Japan, meanwhile, has flooded its banking system with liquidity since the March 11 earthquake, after following a relatively “non-activist” monetary policy for the last several years. From the end of February to the end of March 2011, the year-over-year increase in the Japanese monetary base increased from 5.6% to 16.9%, as shown in the following chart:
While this latest increase is encouraging, subscribers should note that both the Japanese government and the Bank of Japan have indicated that no further monetary easing is needed (e.g. monetization of debt to pay for the rebuilding). In other words, the latest easing is probably just sufficient to cover short-term liquidity needs by the Japanese banking system—and may not be sufficiently high enough to sustain a more robust recovery. Given all-around global tightening, subscribers should continue to be cautious. Indeed, while the Dow Industrials and the S&P 500 could continue to make new highs in the face of deteriorating technicals, it also means the market is increasingly vulnerable to a deeper-than-expected correction. We are going out on a limb: Should the Dow Industrials and S&P 500 continue to rally (preferable to the 12,750 to 13,250 range) on dismal upside breadth and/or volume, there's a good chance we will go short in our DJIA Timing System.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:
For the week ending April 8, 2011, the Dow Industrials rose 3.33 points, while the Dow Transports declined a whopping 142.17 points. Given the incredible run in crude oil prices, it is not surprising to see the Dow Transports reversing nearly the entire gain from the week prior. Nonetheless, the non-confirmation of the new highs in the Dow Industrials by the Dow Transports, is still disturbing, especially in light of the further deterioration in our technical indicators. Combined with weakening global liquidity conditions and geopolitical risks in the Middle East, we expect the market to correct sooner rather than later. We remain neutral in our DJIA Timing System, and may shift to a 50% short position should the Dow Industrials rally further on weak upside breadth/volume.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The four-week moving average of these sentiment indicators increased from a reading of 16.3% to 18.1% for the week ending April 8, 2011. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1998 to the present:
After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA has declined by 12.7% to 18.1% last week. At the same time, the 10-week MA just made a four-year high seven weeks ago. Both readings remain overbought. Although there may be more upside for this sentiment indicator, and for the market over the short-run, we still believe the market is highly vulnerable to a deeper-than-expected correction. We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the Dow Industrials rally to the 12,750 to 13,250 range.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
The 20 DMA increased from 110.3 to 114.1 last week, and has stabilized in the three weeks and is now only moderately oversold. Meanwhile, the 50 DMA is approaching neutral levels. Given the oversold condition in the 20 DMA, there may be more upside in both sentiment and the market in the foreseeable future, especially since valuation levels remain decent. However, should the market rally further this week, we will likely go 50% short in our DJIA Timing System.
Conclusion: The cyclical bull markets in all major market indices last week, along with decent valuations and relatively neutral sentiment indicators, suggest more upside in the stock market for the foreseeable future. Earnings reports may also be well received in the beginning, but the deterioration in our technical indicators cannot be ignored, especially given the age of the bull market and declining global liquidity indicators. Moreover, the recent easing by the Bank of Japan may not be sufficient to sustain an increase in Japanese asset prices or the Japanese economy. In the meantime, we remain neutral in our DJIA Timing System and will likely go 50% short if the market rally further on weak upside breadth/volume. Subscribers please stay tuned.
Henry To, CFA, CAIA