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Every Picture Tells a Story: Market Charts Looking Good

November 14, 2011

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key points

With so much focus on the macro, I thought an update on the micro would be welcome.
Several measures of sentiment, valuation and technical conditions show the market to be in pretty good shape.
Macro headwinds persist, but the expectations bar has arguably been set low enough to be easily hurdled.

My and my research colleagues' reports this year have been heavily macro-oriented, for obvious reasons, given massive macro headwinds with which the markets and economy have been contending. However, in my report of two weeks ago, I veered into the future, with a more optimistic assessment of what could go right with the US economy.

Today, I want to look short-term again, but go back to basics with an update on some of the classic fundamentals that typically drive markets. It's been a while since I wrote about sentiment, valuation, earnings and the market's technical condition. Since charts often tell the most accurate story, this report is filled with them. I'll start with sentiment.

But before I get to that …

… we all know it's been a wild ride so far this year. As I write this, the S&P 500 Index® is flat on the year, having suffered a near-bear market drop of more than 19% from the April 29 high to the October 3 low, and since rallying 15%. It's no wonder investors are frustrated—last week alone saw a remarkable swing, with the Dow Jones Industrial Average losing nearly 400 points Wednesday but then recovering nearly all of that in the subsequent two trading days.

Sentiment charts

The first sentiment chart below is the well-watched Crowd Sentiment Poll put out by Ned Davis Research. Although optimism did rise along with the recent rally, it remains in the "extreme pessimism" zone—a zone in which the market has historically had nearly 10% annualized returns since 1995.

Sentiment's Improved But Still Pessimistic

The next chart is a more direct way to measure investor sentiment and shows the dramatic outflows from stock mutual funds this year versus the inflows into fixed income funds. Over the past five years, individual investors have redeemed more than $400 billion of domestic equity funds while contributing more than $800 billion to (low- or no-yielding) fixed income funds. That swing, of more than $1.2 trillion since early 2007 is, by far, an all-time record change in preference of bonds over stocks, according to Doug Kass, writing for RealMoney.com.

Investor Have Greatly Favored Bonds Over Stocks

Source: FactSet, Investment Company Institute, as of September 30, 2011.

Finally, we can look at hedge-fund sentiment via their net equity exposure, which, as you can see below, is near the low last seen at the market's March 2009 bottom. Add to that the fact that pension funds' exposure has been fixed income-skewed and you get a recipe for some reversion to the mean toward stocks.

Hedge Funds Have Not Chased Rally

Source: ISI Group, as of November 9, 2011.

Valuation charts

Most classic valuation measures include earnings in the denominator (the "E" in P/E, or price/earnings, ratio). So let's start with earnings since we're well into third-quarter reporting season.

Source: Thomson Reuters, as of November 14, 2011.

With more than 90% of companies having reported, S&P 500 earnings are up nearly 18% year-over-year—well better than what was expected a couple of months ago when recession fears were rampant.

As for valuation on those earnings, to some degree it's a function of the period one is measuring. One of my preferred longer-term valuation metrics incorporates five-year normalized earnings (four-and-a-half years of historic earnings and two quarters of forecasted earnings). On that basis, the market is trading at 18.2 times earnings versus a median of 17.1 since the late 1940s (the period through which we have data).

Five-Year Normalized P/E a Little Rich

Source: FactSet, The Leuthold Group, as of November 4, 2011.

But let's look at arguably the most popular valuation metric, which incorporates prospective 12-month earnings. On this basis, the market is dirt cheap at a multiple of 12.4 versus a median of 16.8 since 1990 (the period through which we have data).

Forward P/E Dirt Cheap

Source: FactSet, Standard & Poor's, as of November 11, 2011. P/Es based on forward 12-month operating earnings.

One final valuation tool I find interesting is to compare the broad environment of today versus the first time the S&P 500 crossed the price at which it's presently trading.

Source: FactSet, Federal Reserve, Standard & Poor's, The Leuthold Group. Jan. 6, 1999, represents the first time the S&P 500 hit 1,264 (actual closing price was 1272). Bond yield represented by 10-year US Treasury bond.

Indeed, the S&P 500 has made no headway in nearly 13 years, but the same can't be said for the economy, valuation (using five-year normalized earnings) or interest rates. The market was overvalued back in 1999, but based on this analysis, it's quite undervalued today.

Technical charts

Lastly I want to highlight two interesting technical situations I noticed last week thanks to sentimenTrader.com. The first surrounds the Arms Index, also known as the TRIN. It measures the amount of volume in declining stocks versus volume in advancing stocks. A very high number means selling volume is exceptionally lopsided.

Huge Surge in TRIN Shows Lopsided Selling Pressure

Source: FactSet, as of November 11, 2011.

During last Wednesday's big decline, the TRIN closed above 6. That's only happened eight times in the past 60 years, and one month later, the S&P 500 was up every time, by an average of 6.0%. Three months later it was up every time except one, by an average of 10.3%, with the one loss a meager -0.1%. What it shows is that we experienced some climactic selling pressure last week, a good sign.

The final technical chart brings in volatility. On Friday, the market experienced the 17th time in the past three months that the S&P 500 SPY (exchange-traded fund trading the S&P 500) gapped by more than +/- 1% at the open and then didn't close that gap during the day. This means that the S&P didn't reverse enough to "kiss" the previous day's close. As you can see in the chart below, this level of "unclosed gap" behavior has been seen only four other times since the early-1990s. All occurred while the market was forming a major bottom.

Source: www.sentimentrader.com, as of November 11, 2011.

In sum …

… this is but a smattering of charts highlighting the present sentiment/valuation/technical condition of the market. Frankly, depending on your bias (bullish or bearish) you could probably find charts to support your case. Even my valuation examples tell multiple stories (no pun intended).

The net for me is I continue to think the expectations bar is set pretty low and that hurdling it won't be hard. There's a lot of money on the sidelines as we head into year-end and some of that is under increasing performance pressure. The market isn't out of the woods, especially as it relates to the eurozone debt crisis, but we think rallies may be more likely than corrections in the near term.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

MacroSnap

Tuesday, November 15, 2011

Schwab Market Report -- Bullish