Markets Not Oversold Enough
(June 24, 2011)
Dear Subscribers and Readers,
Just as the market seemed on the verge of a melt-down yesterday morning, it came roaring back in the afternoon—with both the Dow Industrials and the S&P 500 closing near their highs for the day. While the market managed to avoid a more severe decline (no doubt aided by more short-term plugs for the Greek sovereign debt crisis), there still needs to be clear, sustained demand for global equities before the market can power high from current levels. With the longer-term problem of the European sovereign debt crisis unresolved—and with emerging market countries' central banks still tightening (India isn't shy about slowing down its economy to clamp down on inflation)—we maintain that this summer would be a tough time for equities.
Note that the IEA's release of 60 million barrels of crude oil (half of which is located in the U.S.) is equivalent to a form of liquidity relief for the markets. At the very least—assuming crude oil prices stay the same—this would provide approximately US$6 billion of liquidity (60 million barrels multiplied by $100 a barrel). Assuming crude oil prices decline by an average of $5 a barrel, this is equivalent to $45 to $50 billion of liquidity relief for the global markets and economy this summer (80 million barrels a day of demand x $5 a barrel x 90 days). This is a roundabout way of “quantitative easing” without raising commodity prices—and the timing is perfect given the imminent expiration of the Fed's QE2 policy in less than a week. While this will provide some much-needed relief, it still does not do much for the overall U.S. liquidity picture. One measure is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly. As of the close yesterday, it is still near its cyclical bull market low, despite the correction over the last couple of months, as shown in the following chart:
Note that we have updated the numbers as of Thursday 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 been consistently declining since February 2009. The ratio temporarily bottomed at the end of April 2010, with the ratio rising by 4.00% from the end of April 2010 to the end of August 2010 (from 32.59% to 36.59%). However, with the stock market rally since the end of last summer, this ratio sits near a cyclical bull market low of 30.16% as of yesterday at the close. More important, it has declined too far, too fast, and is very low compared to its readings over the last three years. The low reading in this liquidity indicator suggests that the market's upside is limited and that market conditions should remain tough this summer.
I now want to address the steady rise in leverage within the stock market, as exemplified by the amount of margin debt outstanding. Since the February 2009 bottom, total margin debt outstanding has increased by 78%, and has retraced about 72% of its peak-to-trough decline from July 2007 to February 2009. Total margin debt outstanding decreased by $5.2 billion last month $355.7 billion. Despite last month's decline, it remains near its highest level since month-end February 2008 (right before the Bear Stearns collapse):
Margin debt outstanding remains extremely elevated—and given the lack of oversold conditions in our liquidity indicators and weak technicals that we've covered over the last several months, we advise our subscribers to be cautious about the market action this summer.
Finally—our valuation indicators still don't suggest the market has reached a sustainable bottom yet. This is exemplified by Morningstar's aggregate valuation, a 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 just under its fair value, as suggested by its current ratio of 0.97 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). Note that 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. Moreover, as shown in the following chart, courtesy of Morningstar, this ratio is still about 7% above where it hit a significant bottom last summer:
Morningstar's proprietary valuation indicator suggests that the stock market is just below its fair value. More important, subscribers should note that – given the trend of corporate earnings over the last two years – 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 declined dramatically – suggesting that valuations may be stretched, especially given the still-unresolved European sovereign debt crisis. In other words, Morningstar's proprietary valuation indicator suggests that while a correction isn't imminent, the market will likely remain tough this summer.
Henry To, CFA, CAIA