Zacks Confidential – Charts vs. Fundamentals; Do they Agree?

We made it through the election, a devastating hurricane, avoided the fiscal cliff (for now) and an uncertain Q4 earnings season.  The market seems to be in a state of limbo, but still seems resilient.  Stocks have now reached an inflection point and the question is where the next move will be. 

Even if the fundamental backdrop is stable enough to support U.S. equity prices, it’s the technical formations that will help predict the market’s next steps with greater accuracy.

Algorithms control 80% of the market’s volume and many of them are based on technical formations.  There are also millions of high powered traders that base their decision making solely on charts.

In this article I am going to look at the big fundamental and technical trends to see if they agree and if the market has the strength to break through these multi-year highs.  I’ll also explore just how high (or low) the market can go over the next quarter and beyond.

The Fundamental Backdrop

It’s no secret that economic growth is anemic.  “Stall speed, snail’s pace, lackluster” and even “non-existent” have been the adjectives used to describe the state of our economy. 

Holiday retail sales growth was modest and month over month increases have been very low compared to past expansion periods. ISM manufacturing and services PMI is just above the expansion mark and durable goods orders just began to increase after almost six months of contraction.

The good news is that job growth has been steady, but also unimpressive when compared to the past. Consumer confidence and spending habits, while not exceptionally strong, are stable enough to reveal consumers’ fiscal health and positivity.

One of the main drivers of the consumers’ stability is the housing market’s stabilization and (moderate) recovery.  In late January, the S&P Case Shiller index showed that the average home price roughly 5% over the last year (4.5% for the 10-City Composite and 5.5% for the 20-City Composite). 

{Trading Housing

There are several ways to play the housing recovery; my favorite derivative trade is the mortgage market.  Specifically, we are buying PennyMac Mortgage (PMT).  PennyMac is a Zacks Rank #1 stock and has a unique angle as it is a REIT formed in the late 2000s to take advantage of residential mortgage-related opportunities; everything from mortgage loans, mortgage servicing rights and mortgage-backed securities.

PMT invests in both newly originated prime-quality mortgage loans in addition to mortgage loans which may be distressed and acquired at discounts to their unpaid principal balances.

Rates are to remain low for the next couple years at least.  This environment is good for homebuyers and refinances alike.  Extremely high rent rates throughout many major metro areas are also pushing would-be home buyers over the edge to buy.

PennyMac throws off a 9.00% yield and trades at just 8.3% trailing earnings, which makes it attractive and perhaps less susceptible to market weakness.

I have a target of $27.50 on the stock over the next month or so.

As a bonus, I’d also look at Ryland Group (RYL) as a buy as well; it’s a Zacks Rank #2 and one of the less expensive homebuilders.}

Europe’s moderate recession and its ramifications have been factored in and China’s slowing growth (which magically seems to keep on going) has been accounted for as well.

Earnings season is just about over and 64% of companies in the S&P 500 beat their estimates.  This may sound good, but year over year EPS growth is only about 2.3%, back out financials and that reading is flat; revenues are actually lower.  But remember that this is no secret; every trader and analyst is aware of this and yet the market holds. 

If people were truly afraid of a market correction or devastating correction in equities, gold would be outperforming stocks or at least stable; it’s been anything but!  In fact, even with the U.S. monetizing its debt and the Euro/USD at 52 week highs, gold has been diving compared to the S&P!

Even during the recent month’s stall, gold has been dropping…This is a clear “risk on” sign.

It’s OK to be OK

It’s not ho-hum boring data that makes the markets correct.  A plethora of major unknowns, fear of bubbles bursting and big news or economic surprises that have usually caused the worst market disasters. 

Everyone is talking about just how “not-great” things are, which means that everyone is aware of the risks the we face and barring a major disaster that makes serious headlines, investors are OK with the present environment.

Also keep in mind that other than QE infinity, there are no real “bubbles” to speak of that have been the major drivers of the appreciation in U.S. equities.  At least not like the dot-com, housing, credit or commodity bubbles of the last decade or so.

This feeling of acceptance can be further rationalized by several key indicators.

1.    While the S&P 500’s p/e multiple is not the cheapest, it is still cheaper than the 2007 and 2000 highs previously.  As long as earnings growth is stable (which it’s barely there) stocks still seem semi-attractive.  In fact, the market’s multiple is 50% of what it was in 2000 and roughly 70% of what it was in 2007.

2.    The U.S. equity market is the most attractive thing out there.  Foreign markets are waning, Bonds are yielding next to nothing and even junk corporate debt is only offering 4-5%!

The big, smart money can lever themselves up with cheap money and not only buy stocks, but purchase companies which in turn fuels the markets as well.

I’m not saying we won’t see small corrections along the way, but right now, given the data that we have in hand and the risks that we know; markets want to move higher over the next 1-4 months.  The fundamental outlook is strong enough to hold stock prices up.  This became even more apparent when Goldman reduced its earnings outlook for the current quarter and almost at the same time J.P. Morgan lowered its GDP forecasts and the market didn’t even flinch.

I believe it will take an event to get more buyers into the market and I think the charts know what that event needs to be.

What do the Charts Say?

First off, the Russell 2000 tends to lead and break away from the S&P when sentiment is positive and be the canary in the coalmine when markets are skittish.

It’s sort of my confidence checker because if folks are flocking to small caps, they are usually not feeling defensive.

At present, the Russell is making not only at all time highs, but pulling away (positively) from the S&P 500’s returns.  This is represented by the distance between the Russell in green and the S&P in red.  

Notice how they were much closer in the mid 2000’s leading up to the crash and how the Russell actually lagged the S&P in the late 90’s.   This breakaway and performance of the Russell 2000 is a key part of my overall bullish thesis for the next couple months. 

 

 

Near Term trends

To get an idea of what’s going to happen over the next couple weeks, let’s take a look at the S&P 500 itself, first on a daily basis. 

In the daily chart below you see the market’s cycles going back to the end of 2011.  Since then it has established a 4 month up, 2 month down rotation, giving back roughly 30-50% of each bullish move on the retracements.  What is interesting to note is the pattern that emerges after each cycle.  The cycles were +23%, -11%, +16.5%, -9%, +13% is the current trend.

Basically, each rally is roughly 24% smaller than the last and if we keep this same pattern (as markets often do) then we don’t have much left in this recent rally (from 1343).  If the last rally was 16.5% and lasted 4 months, then we need to pay attention.  The current rally is almost 4 months long and if we take 76% of 16.5%, we get 12.54% as my anticipated length of the current rally).

Volume has been trailing off and market internals are losing momentum at these levels.  All this data tells me that the short term rally may have worn out its welcome.  The only reason we have not sank yet is the fact that we are dancing with multi-year highs, which is helping create this “stickiness” around the 1500 area, but I don’t see it holding for long.

The Bigger Technical Picture

Things start to get really interesting when you back up and look at a monthly, 20 year chart of the S&P.  Here is where the big trends are and the secrets into the next move higher.

It looks somewhat similar to our daily chart, but with one difference.  Instead of making a series of higher highs, the S&P has been in a big channel or sideways pattern since the mid-90’s. 

You can see how each rally (black trend lines) has gotten less pronounced and how the most recent rally starting in 2009, took quite a bit of volatility before reaching our current levels.  This choppiness can be attributed to the headlines we have had to endure and break through as well as the great recession lingering fresh in our minds.  But those dips and subsequent rallies over the past few years have been tests for this market and bode well for the resiliency of this rally.

The two tops that were formed in 2000 and 2007 are resistance and looking at volume dissipated like it has over the last year it looks like a triple top may be created, but this time it’s different.  I don’t see this triple top sending the market back down to the bottom of the large channel.

Those peaks and valleys over the last 4 years were all pivots around Fibonacci levels (dotted horizontal lines above).  The S&P has been following the Fib patterns exactly, testing each level and overcoming it.  Let’s not forget the biggest difference here; the market is being driven by lackluster earnings, no bubbles and an anemic global economy.  

What Comes Next?

As these patterns play out, I do see the market correcting to the 23.6% Fibonacci daily level of 1,418, perhaps down to the 200 day moving average of 1,393 in the worst case scenario.  As long as markets hold above the 23.6% monthly Fibonacci level of 1360, we will be moving higher from there.

The near term fundamentals seem stable with the biggest risk being our debt ceiling and budget issues here in the U.S.  Normal issues are what will give us the 6.5% correction.  Any other serious new risks would add to that, but I see that has highly unlikely in the next 2 quarters. 

The charts are pointing to a near term pullback of about 100 points in the S&P –6.5% or so, but the longer term trends point to another leg higher, breaking through the 13 year resistance level of 1552 and even through 1576.

These are very big trends playing out here; if I were a betting man I would say it’s much more probable that we hit 1420 before 1576.

{Trading the Turbulence

Most stocks will be susceptible to a market downturn, but I did find a couple that fared extremely well in the correction from September to November last year.  One of them also has a slight defensive quality to it and stands to benefit from the drop in commodity prices over the last several months:

Ingredion (INGR) (formerly Corn Product International)is a Zacks Rank #3 stock that you probably never heard of. The company turns corn, tapioca, wheat, potatoes and other raw materials into a myriad of ingredients for the food, beverage, brewing and pharmaceutical industries as well as numerous industrial sectors.

Their products are used by our customers to provide everything from sweetness, taste and texture to immune system support, fat replacement and adhesive strength.  They help make foods and beverages taste better, baby powders and cosmetics smooth to the touch, cereals and crackers crisper, breads brown evenly, IV solutions for patients in need, ingredients for the pharmaceutical industry, and much more.

It’s even more digestible when they are trading at just 11 times earnings with net income growth that usually commands multiples in the low 20s. 

Take a look at how the stock fared from September to November last year and you’ll see why I believe INGR is a defensive stock with growth potential.  

 

I see shares approaching the $69 level over the next couple months.}

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Jared Levy is one of the most highly sought after traders in the world. That is why you will frequently see him appear on CNBC, Fox and Bloomberg providing his timely insights to other investors. You can discover more of his insights and recommendations through his two portfolio recommendation services:

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