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Signal Update |
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Current
Signal Performance as of
Signal
Type |
Trade
Date |
Return
since issued |
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World |
U.S. |
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Nasdaq
100
(QQQQ)
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Russell
2000
(IWM)
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S&P
500
(SPY)
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Market Update |
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The respite
was of short duration and this week stock markets resumed their
plunge to new lows. The week opened on a bullish note with Fed
Chairman Ben Bernanke comments in support of a second economic
stimulus package providing most of the impetus. As a result,
markets kept the rally which began a week earlier intact by
surging on Monday, albeit in generally lower volume. The S&P
500
led the pack with a 4.8% gain. Most of these gains were erased
on Tuesday on the back of a batch of mixed earnings reports.
Any remaining talk of a rally came to an abrupt end on Wednesday
when the S&P 500 led the way down with a 7% loss. Again, the
losses were triggered by poor earnings news from the likes of
AT&T, Boeing and Wachovia. Still, the biggest losers continued
to be commodity stocks which suffered from reduced forecasts
associated with a more and more obvious global recession. The
same fears pushed oil down to below $67 and energy companies
got hammered in the process. Thursday's small gains were gone
at the open on Friday as Wall Street initially followed the
sell-offs of major overseas markets, only to move well off the
session lows by the closing bell. In the end, the only winner
seemed to be the U.S. dollar which jumped 4.9% during the week.
In another bad week for stocks, the S&P 500 (SPY), Russell 2000
(IWM) and Nasdaq 100 (QQQQ) respectively lost 6.62%, 9.64% and
8.64%. All 3 ETFs remain located below both their 50-day and
200-day exponential moving averages (EMAs) as all 3 closed at
new bear market lows.
For its part, our World portfolio posted an
8.23% loss this week. The portfolio
consists of the 5 top-ranked world ETFs as of October 10, which
marked the beginning of the current 4-week holding period. Please
note that since we now have an active Cash
signal, the World approach calls for selling
your holdings if you follow the "Long Only"
or "Long and Short" strategy. Only if you follow
the "Buy and Rebalance" strategy should you
remain invested in the top 5 ETFs, as the strategy calls for
staying invested at all times. Please go to the "Our
Service"
page for all the details.
Our current Cash
signal remains in effect.
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Trend Timing School |
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Market
valuation
Being in the depths of one of the worst bear market declines
in the last hundred years, it is not surprising to find investment
gurus and pundits who are willing to call a bottom or double
bottom (triple maybe?). Many were calling a bottom in July as
well. We are always reminded that people calling bottoms or
tops violate the cardinal rule of forecasting: give a price
or a date, never both. But seriously, from a technical analysis
standpoint, recent market action has exploded most metrics and
blown away any remaining support. Some of the frequently cited
indicators to justify this as a bottom include volatility (fear)
at record highs, terrible bullish versus bearish sentiment,
the put/call ratio and the NYSE short interest at 5 year highs.
We all agree that, if nothing else, markets are oversold and
a rebound rally would make sense. Tell that to the markets.
We have written before about "Overbought
and oversold indicators" and their weakness as market timing
indicators.
What is more surprising is that calls that the market has become
undervalued or outright cheap have been coming from the fundamental
analysis corner. Even the "Oracle of Omaha", Warren Buffett,
has chimed in with an op-ed piece recently published in the
New York Times (read
it here) in which he boldly declares that U.S. equities
are a bargain right now and that he is buying. In his defense,
he is not talking about the short term direction of the markets
but their very long term potential. He writes: "Equities will
almost certainly outperform cash over the next decade, probably
by a substantial degree." Well, this was not the case in the
previous decade and several other decades in stock market history.
From October 1998 to September 2008, the S&P 500
returned a total of 14.5%, which did not keep up with inflation.
Does this mean that Warren Buffett is wrong? No, but the fact
that his Berkshire Hathaway Inc. (BRK-A) returned an impressive
125% over the same 10 years also points out the flaw in his
recommendation to the investing public. While he frequently
says that individual investors should stick with the broad market
averages because they don't have the time or skills to research
individual companies, the way he has achieved superior returns
is specifically by targeting individual opportunities, not betting
on the market as a whole.
Still, just out of curiosity, we decided to take a look at market
valuation. When it comes to fundamental valuation metrics, there
is probably none better or more widely followed than the ratio
of price and earnings, or P/E for short. It directly measures
the valuation of a company through the ratio of its market value,
as expressed by the price of a share of its stock, over profitability
as conveyed by its earnings per share (EPS). Just as P/E is
applicable to gage individual company valuation, it can be applied
to broad market indexes as the aggregate of their component
companies. The reason the P/E ratio is sometimes called the
"multiple" is because it represents the multiple dollar amount
investors are willing to pay for $1 of current earnings. In
the most recently published numbers for the S&P 500 as of September
30, 2008, the multiple was at 22.50 for 12 months trailing earnings.
To place this in proper historical perspective we offer Chart
1 below which shows the S&P 500 P/E ratio for the last
some seventy years. Through thick and thin, bulls and bears,
expansions and recessions, not to mention manias and depressions,
the reading has mostly fluctuated between undervalued levels
around 10 to overvalued at 20 or above. The long term average
P/E is at 15.8. The chart also reveals that the excesses of
the 2000 stock market bubble, which pushed the S&P 500 P/E as
high as 46, were not completely corrected as they never even
returned to the historical averages. Most unbiased observers
would say that the latest reading of 22.5 is not cheap.
Chart
1: S&P 500 P/E ratio history, 1936 - 2008
Source: Standard & Poor's
Another view of market valuation is presented in Chart
2 below. Based on historical S&P 500 earnings, the
3 light background price lines plot the range of possible valuations
from over-, to fair and undervalued (P/E ratios of 20, 15 and
10 respectively). Overlaid is the actual S&P 500 price in bold.
Despite what anyone might tell you, at the current earnings
levels, the S&P 500 at 900 still represents a P/E of 17.4, above
the historical average. The problem with the worsening recession
is that earnings have topped out, and judging from the most
recent quarterly results, they have started a decline that is
sure to last until the economy rebounds. The more earnings drop,
the more prices must fall to bring P/E back to historical averages.
Chart 2: S&P 500 relative to its valuation range
Another interesting (and frightening) observation on this historical
data is that it is not unreasonable to expect P/E readings to
return to an undervalued level at sometime in the future. At
current earnings levels a P/E of 10 would place the S&P 500
at 517. No telling what reduced earnings (which always go hand
in hand with recessions) could do to that number!
We are not saying this is not a bottom, it could well be one,
but the P/E data clearly shows that even after the 44% drop
from the top, the S&P 500 is still overvalued by historical
averages. It is worth mentioning that the only periods of true
market undervaluation on the chart occurred in the early 1950s
and during the late 1970s/early 1980s, both at the tail end
of secular bear markets which lasted 20 and 16 years respectively.
Trend timing does not seek to spot bottoms or tops, as no one
can do so accurately and consistently. Instead, our trend following
approach requires that the markets first form a new trend before
it can be detected. In case you are tempted to believe a bottom
caller's rationale and pull the buy trigger, always remember
that during a secular bear market down is the path of least
resistance and that a meltdown is always possible.
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FAQ of the Week |
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Question:
How do I invest in the U.S. dollar?
Since we currently have a Cash
signal in force, cash is where our money is. We discussed cash
alternatives such as money market and bond funds in the Weekly
Update "Money market funds versus bond funds",
but another possibility is to invest directly in the strength
of the U.S. dollar. Against all logic, despite dismal and rapidly
deteriorating fundamentals, the U.S. dollar has been rallying
against most other currencies, and many experts anticipate this
trend to continue for some time.
UUP
, the PowerShares DB US Dollar Index Bullish fund is an ETF
which seeks to match the daily changes in dollar valuation against
a basket of foreign currencies. When the U.S. dollar goes up,
UUP goes up. In fact, it has gained an astonishing 17% over
the last 3 months while most everything else has crumbled in
value. Note that we are not making any forecasts, and frankly
have no clue as to how long and how high the U.S. dollar rally
will go.
Warm wishes and until next week.
The TimingCube
Staff
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