by Jared A Levy
The most prolific sages and philosophers would find it almost impossible to predict the equity markets’ random walk over the next six months given the circumstances. Unfortunately for them, they didn’t have access to modern research and tools…
I joke, but there is no doubt that taking an intermediate forward view of this market is a daunting task.
Professional investors have come to grips with the fact that there is no certainty, only probability. The most practical way for the average investor to find direction is to organize and weigh out the forces that are pushing and pulling on this marketplace and find the most probable route that the markets will take and with that gauge risk and investment allocations accordingly.
The Big Picture
Global economic uncertainly is punctuated by the fragile state of the Euro-zone which I equate to a cancer that is metastasizing constantly. New “tumors” are discovered regularly and the powers that be seem to be treating the symptoms as opposed to the cause and finding a cure (which many say would be a breakup of the Euro currency).
The headlines that emerge on a daily basis are having profound effects on the equity markets, which I suspect will continue for the coming months. While all seems to be copasetic at present, I think it would be prudent to expect further deterioration and contagion to spread. Because of this, I would remain cautious to the upside and only buy on the short dips of three to five percent or more from current levels.
Economic data remains mixed here in the US and abroad and a still shaky consumer is saving less, spending more with incomes stagnant. Some experts viewed this recent data as positive; to me this is a sign of inflationary pressures that are not being epitomized well in the numbers. If you combine this with a lack of bullish price catalysts in the housing market, I think it’s safe to say that the consumer and their spending on non-discretionary items will remain muted for the next quarter or two.
This is evidenced by the weakness in Amazon and Best Buy’s earnings reports (among other retailers) which fell short of expectations. I also took notice that the Russell 2000 small caps have had a far weaker earnings’ season when compared to their big multinational brethren in the Dow and S&P 500. This tells me that small business, which is the growth and job incubator for the US is still struggling while big business is still benefiting from our weak dollar, which overstates their earnings results, skewing readings.
Who is Buying?
The recent rally in the stock market can be rationalized in several ways. When you examine the relative value, cash flow and decent results that the average large company has posted and combine that with the moderate growth outlook, stock prices don’t seem that high.
If you examine the chart below, you will note that the price to earnings ratio of the S&P 500 remains at historically low levels even with the recent run-up. Furthermore, the future earnings outlook remains extremely conservative, which lowers the bar for most companies to clear and opens the door for would-be buyers.
To give you an idea of just how low earnings expectations are, there is only a 6% difference in the current P/E multiple of the S&P and the predictions for a year from now!
S&P 500 P/E Chart – Trailing and future – Courtesy of Bloomberg
This low valuation is supported by the fact that companies are generating historically high amounts of free-cash flow, which is mainly due to cost cutting. The theory there could be that when economic data begins to perk up, these war-chests of cash can be put to work on quick expansion and hiring, leading to a quicker recovery.
Another reason for the most recent run-up was short covering. Short interest was at a 5 year high (with the exception of December 2010 and May 2011) recently with traders expecting a big drop. They got it, but then an immediate reversal, forcing many to cover and buy back shares accelerating the rally
Technical Analysis
The S&P remains in never-never land in terms of a clear trend. The recent breakout above the 200 day moving average was short lived. Although we have cleared out of the most recent channel of 1,220 and 1,120, the market must hold above the 1,220 level in order to begin building in a true bullish trend.
The coming weeks will be critical. The 38.2% Fibonacci level of 1,243 will be the first support from here. If we fall below that, then acceleration back down to 1,220 will be swift.
Your cue to buy will if the S&P moves lower to 1,220 and bounces. This will not only indicate strength, but allow you to pick up shares a bit cheaper than at present.
What do you buy now?
With the “Santa Clause Rally” and “January effect” knocking on our door, I would first focus on stocks that are fairly valued and cater to either the upper end consumer or provide basics to the masses at affordable prices. Those are the two areas where we are seeing strength.
Tiffany & Co. (TIF) remains above its 50 and 200 day moving averages and has technical support at around $73, which would be the level I would buy.
At the other end of the spectrum I would be adding Walmart (WMT) to my portfolio at or below the $53.50 level. I may be boring, but it throws off a nice yield and will reduce your portfolio’s volatility.
Another stock that has shown strength in earnings and has bullish techincals is IBM. Big Blue continues to reinvent themselves and remains firmly in a bullish trend. They are breaking new ground and giving serious attention, money and research to cloud services and middleware, both of which are growing at a breakneck pace. Like the others, buy on the pullack between $180 and $175.
Because of relative valuation and for the sake of volatility reduction, I would also begin to add the S&P 500 ETF (SPY) to the portfolio using a systematic investment technique, buying small quantities on the selloffs to gain price advantage and build a position.
Obviously I’m moderately bullish, but I would keep some power dry going into the first quarter of 2012. Global economies still face challenges and you can bet there will be “gotchas” from time to time.
Hopefully they won’t be on the scale of what we saw here in 08’ and 09’ but I wouldn’t rule that out.