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Did Correction Fix the Valuation Problems? image

Friday's expiration-enhanced dance to the downside, which came on the heels of the Thursday's Fed-induced reversal, left investors wondering if the market wasn't ready to roll over and retest the recent lows again. The bears could be heard telling anyone willing to listen that since the "V-Bottom" has failed to materialize this time around, a more protracted bottoming process should be expected and that a series of rallies and retests would be the norm in the coming months.

The type of discouraging action seen on Friday also begs the question, is it over? Until the market reversed after the Fed announcement on Thursday, those in the bull camp had been fairly pleased with the movement seen in stocks over the past couple of weeks and our heroes in horns argued that stocks were in rally mode. But then the action suddenly became very weak again. Ughh.

S&P 500 - Daily

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One of the best ways to determine if the recent correction has run its course is to do a check of the valuation indicators. You see, what is oftentimes lost in the emotion of a waterfall decline is the fact that lower prices have a tendency to "cure" overvaluation issues.

All Better Now?

Cutting to the chase, the answer to the question of whether or not the 11.2% decline seen in August "fixed" the valuation issues facing the stock market is, no.

For more detail, let's run down the traditional valuation indicators:

Price-to-Earnings Ratio (P/E): While there are many ways to look at the traditional price-to-earnings ratio, we prefer to review the median P/E of the S&P 500 relative to its history from the post WWII era. And although this reading has retreated a bit from its recent high in the 22 zone, August's level of 20.8 is still well above historical average of 16.8 and nearly double the "undervalued" level of around 12. In fact, the current reading is higher than any time prior to the "bubble period" that began in the late 1990's. And yes, that includes the reading seen prior to the 1987 crash event. Thus, it is easy to say that stocks remain overvalued from a P/E perspective.

Price-to-Dividend Ratio (P/D): The same story applies to the P/D ratio as the current reading is indeed lower than it was a couple months back and the decline in the ratio created by the pullback in stock prices was not significant. In addition, the current reading of 47.25 on the S&P's P/D remains WELL above ANY level seen prior to the bubble period. For example, the P/D was around 37 prior to the 1987 crash and hovered around 35 during the mid-1970's. And with the 50-year average at 39.9, it is hard to argue that the current reading is undervalued. So, again, the P/D suggests stocks remain expensive.

Price-to-Book Value Ratio (P/B): It is essentially the exact same story when looking at the price-to-book value indicators. While the ratio has pulled back a bit, the current level is definitely elevated compared to historical readings and well above the levels seen in 1987. The good news is that the P/B has pulled back close to the average reading seen since 1978. But, once again, you cannot say that valuations are now "fixed."

Other Price-to-XXX Ratios: In looking at other absolute valuation indicators such as price-to-sales and price-to-cash flow, the song remains the same. In short, while the indicators have seen "some" improvement, the levels remain elevated and are above all other readings seen prior to 2000. So, again...

Relative Valuation Indicators: However, when comparing the valuation of the S&P 500 to the "relative" valuation indicators, which look at current pricing relative to interest rates, stocks remain undervalued. In other words, there are really no strong alternative investments that produce a yield at this time.

The Bottom Line

The key takeaway here is that the recent correction has NOT cured the market's valuation issues from a big-picture standpoint. However, as has been the case for some time now, stocks remain a decent play from a relative valuation perspective.

In addition, the argument CAN be made that the market did become oversold enough and sentiment did become negative enough to justify a meaningful rally. Thus, if one looks at the calendar, they can argue that as long as the "bottoming process" doesn't turn into another leg lower during the seasonally weak September/October period, then investors might see the traditional year-end rally unfold into the end of the year.

But, it is important to recognize that short of a big improvement in earnings or a much larger price decline, the upside likely remains limited due to absolute valuation issues. And as such, some caution continues to be warranted.

Publishing Note: I am traveling this week with a very hectic schedule. As such, I will publish morning missives as time and energy levels permit.

The Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: Closed
    Hong Kong: -0.75%
    Shanghai: +1.91%
    London: +0.83%
    Germany: -0.03%
    France: +1.17%
    Italy: +0.95%
    Spain: +0.51%

Crude Oil Futures: +$0.81 to $45.89

Gold: -$5.40 at $1132.40

Dollar: lower against the yen, higher vs. euro and pound

10-Year Bond Yield: Currently trading at 2.175%

Stock Indices in U.S. (relative to fair value):
    S&P 500: +11.02
    Dow Jones Industrial Average: +141
    NASDAQ Composite: +33

Thought For The Day:

"It is not only what we do, but also what we do not do, for which we are accountable." -Moliere

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Fed/Global Central Bank Policy
      2. The State of China's Economy
      3. The State of the U.S. Economy

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Neutral
(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1935
  • Key Near-Term Resistance Zone(s): 1990-2000

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Neutral
  • Price Thrust Indicator: Neutral
  • Volume Thrust Indicator(NASDAQ): Neutral
  • Breadth Thrust Indicator (NASDAQ): Neutral
  • Intermediate-Term Bull/Bear Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Moderately Negative

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Neutral
          - Intermediate-Term: Oversold
  • Market Sentiment: Our primary sentiment model is Positive .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Moderately Negative

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research


Indicator Explanations

Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.

Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.

Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.


Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning, an advisor representative of CONCERT Wealth Management Inc. (CONCERT), is founder of Heritage Capital Advisors LLC, a legal business entity doing business as Heritage Capital Research (Heritage). Advisory services are offered through CONCERT Wealth Management, Inc., a registered investment advisor. For a complete description of investment risks, fees and services review the CONCERT firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting Heritage or CONCERT.

Mr. Moenning is also the owner of Heritage Capital Management (HCM) a state-registered investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Neither HCM, Heritage, or CONCERT is registered as a broker-dealer.

Employees and affiliates of Heritage and HCM may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.