Posted | by David Moenning |
Is There Any Upside From Here? image

With the S&P 500 closing Friday up 35.9% from the March 23 low, the key questions in my mind are simple. First, how high is too high? And is there any upside from here?

The reason I ask these question is because it appears there is a ginormous chasm between the stock market's recovery and that of the economy. Yes, the economy is turning the corner. But as we discussed last week, the hill the economy must climb in order to return to where things stood in January is long and steep. In fact, Fed Chair Jay Powell lamented last week that recovery could take years. As such, a "quick fix" doesn't look to be in the cards.

Now compare this to the S&P 500, which sits just 10.2% from its all-time high. Or the NASDAQ 100 Index that closed Friday up 10.66% on the year. See what I mean?

Logic would seem to dictate that one of these two views is wrong. Either the economy is going to recover very quickly, which would justify current stock prices. Or stock prices have gone too far when considering the amount of time it will take the economy to recover.

However, it is important to keep in mind that the stock market has its own kind of logic. And oftentimes it isn't exactly, well, logical.

The Narrative

The current narrative is that Ms. Market is looking ahead. Moving on, if you will, beyond the current economic and earnings debacle, which was self-inflicted, and ahead to what things will look like in 2021.

The chart below makes this point pretty well. This is a graph of the consensus estimates for S&P 500 operating earnings for each calendar year going back to 2014 and forward to 2021.


View Chart Online
Source: Ned Davis Research Group

As you can see, in most calendar years, analyst estimates start out a bit on the high side and then are reduced over time. Except for 2018 and 2020, that is. Of course, 2018 estimates had to be revised upward as the year went on due to the tax cuts. And then we all know that 2020 is going to be rough. Just look at that dashed teal line!

As analysts began to look at 2020, the estimated operating earnings for the S&P 500 was north of $185. And as of June 4th, it stands at 109.71 - a drop of about 41%. Ouch.

And if the stock market were "logical" it might be trading in line with where the earnings were in 2014, 2016, or 2017 - which I've highlighted with a yellow box. To review, the S&P closed 2014 at around 2058, 2016 at about 2284, and 2017 around 2700. So, with earnings for 2020 down at these levels, wouldn't it be logical for the S&P to be trading somewhere around where those years ended? After all, the earnings are expected to be about the same.

How The Game Is Being Played

But hang on, that's not how the game is being played. No, since we stopped the economy on purpose, the market is looking past the "artificial" decline in earnings and ahead to 2121's earnings. And analysts currently expect the S&P to earn $161.80 next year.

So, if we take $161.80 and multiply it by 22 (the current Operating Earnings P/E and the multiple range seen in mid-2016 through most of 2018), we get 3560. Which is 17.05% higher than where the S&P closed on Friday. Thus, it would appear that there might be some serious upside still available!

Assuming the S&P 500 companies earn $161.80, of course. And that investors are willing to pay 22 times those earnings. Remember, sometimes they pay a lot more. And other times a LOT less.

To make this point, I offer the chart below - the S&P's Price-to-Operating Earnings Ratio going back to 1990ish.


View Chart Online
Source: Ned Davis Research Group

As you can see, putting a 22 multiple on earnings isn't exactly conservative. Sure, 22 isn't as high as the heady times seen in the late 90's or as the market bottomed from the Great Financial Crisis in 2009. But it ain't cheap either. Especially when there might be some question as to whether those earnings actually show up.

So again, I ask, how high is too high?

My Take

Here's my take on the situation. If the economy is going to recover faster than expected, a 22 multiple is probably about right. And the joyride to the upside can surely continue as traders discount better days ahead.

But... If the economy doesn't recover like a race horse and instead acts more like a plow horse (hat tip to Brian Wesbury at First Trust for the horse analogy), there might be some "discussion" about the appropriate level of earnings as well as the proper multiple to put on those earnings.

And to clarify, that "discussion" involves a little something called "price discovery," which in this case will likely include some downside testing.

The bottom line is this is going to be interesting. Stay tuned!

Weekly Market Model Review

Each week we do a disciplined, deep dive into our key market indicators and models. The overall goal of this exercise is to (a) remove emotion from the investment process, (b) stay "in tune" with the primary market cycles, and (c) remain cognizant of the risk/reward environment.

The Major Market Models

We start with six of our favorite long-term market models. These models are designed to help determine the "state" of the overall market.

Once again, there are two changes to report on the Primary Cycle board this week. First the Leading Indicators Model improved from neutral to positive. Next, NDR's Risk/Reward model flipped to positive. In addition, my "Desert Island " model looks like it will flash a long-term buy signal as well this week. So, with three buy signals and three neutral signals, I'll continue to rate the board (and the overall market picture) as moderately positive. While I remain concerned about the chasm between the stock market's recovery and the economy's, I cannot argue with the indicators.


* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability - NOT INDIVIDUAL INVESTMENT ADVICE.
View My Favorite Market Models Online

The State of the Fundamental Backdrop

Next, we review the market's fundamental factors in the areas of interest rates, the economy, inflation, and valuations.

There are no changes to the Fundamental Factors board this week. As I have stated previously, I believe both the Economic and Earnings Composite models remain artificially high due to the fact that many of the component indicators update either monthly or quarterly and have not had time to reflect the sudden halt to economic activity caused by the coronavirus. However, based on the market's reaction to the Fed's support, we might want to give the Monetary Model double - or even triple weight here.


* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability - NOT INDIVIDUAL INVESTMENT ADVICE.
View Fundamental Indicator Board Online

The State of the Trend

After looking at the big-picture models and the fundamental backdrop, I like to look at the state of the trend. This board of indicators is designed to tell us about the overall technical health of the current trend.

After the recent joyride to the upside, (as in the best run over a 50-day period in history), a pullback/pause/correction shouldn't come as a surprise. And since Thursday's rout was one of the largest in stock market history on a percentage basis, it is natural to see the shorter-term indicators on the price trend board turn red. The key here is if the bulls will be able to "break on through to the other side" (hat tip to The Doors) and continue to move higher after a period of consolidation or if the bears will be able to do some additional downside price exploration. I'll be watching the key technical levels for clues this week.


NOT INDIVIDUAL INVESTMENT ADVICE.
View Trend Indicator Board Online

The State of Internal Momentum

Next, we analyze the "oomph" behind the current trend via our group of market momentum indicators/models.

While the Momentum Board gave up a little ground last week, the preponderance of green on the board remains positive. As such, the plan is to give the bulls the benefit of any doubt here.


* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability - NOT INDIVIDUAL INVESTMENT ADVICE.
View Momentum Indicator Board Online

Early Warning Signals

Once we have identified the current environment, the state of the trend, and the degree of momentum behind the move, we then review the potential for a counter-trend move to begin. This batch of indicators is designed to suggest when the table is set for the trend to "go the other way."

The Early Warning board did a pretty good job of warning us that a pause was due. At this stage, the board is beginning to suggest that the bulls may regain control of the ball. However, I for one would like to see the bears consolidate in a sideways fashion for a spell here.


* Source: Ned Davis Research (NDR) as of the date of publication. Historical returns are hypothetical average annual performances calculated by NDR. Past performances do not guarantee future results or profitability - NOT INDIVIDUAL INVESTMENT ADVICE.
View Early Warning Indicator Board Online

Thought For The Day:

A lifetime of investment research has taught me to become more and more humble about making predictions --Sir John Templeton

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

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research

Disclosures

At the time of publication, Mr. Moenning held long positions in the following securities mentioned: IWM, MDY - Note that positions may change at any time.


Leading Indicators Model: A group of indicators that have historically shown tendencies to lead the market at major turning points.

Intermediate-Term Market Model: A composite model (model of models) focused on trend and momentum indicators which has been designed to provide identify intermediate-term trading opportunities.

Risk/Reward Model: A model-of-models intended to provide an overall view of the state of the risk/reward environment. The model includes tape, monetary, and sentiment indicators as well as 7 big-picture market model readings.

Desert Island Model: If I was stranded on a desert island with access to only one market model to manage money with, this would be the model. The model is a comprehensive model-of-models comprised of trend, momentum, mean reversion, economic, monetary, sentiment, and factor-based indicators/models.

External Factors Model: A model-of-models designed to provide a reading on the "macro state" of the market environment. The model is comprised of indicators/models in the areas of various index yields, industrial production, investors sentiment, and historic volatility.

Short-Term Trend-and-Breadth Signal 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 NDR's 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.

Channel Breakout System Explained: The short-term and intermediate-term Channel Breakout Systems are modified versions of the Donchian Channel indicator. According to Wikipedia, "The Donchian channel is an indicator used in market trading developed by Richard Donchian. It is formed by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the channel for the period chosen."

Intermediate-Term Trend-and-Breadth Signal Explained: This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 45-day smoothing and the All-Cap Equal Weighted Equity Series is above its 45-day smoothing, the equity index has gained at a rate of +17.6% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +6.5% per year. And when both are below, the equity index has lost -1.3% per year.

Cycle Composite Projections: The cycle composite combines the 1-year Seasonal, 4-year Presidential, and 10-year Decennial cycles. The indicator reading shown uses the cycle projection for the upcoming week.

Trading Mode Indicator: This indicator attempts to identify whether the current trading environment is "trending" or "mean reverting." The indicator takes the composite reading of the Efficiency Ratio, the Average Correlation Coefficient, and Trend Strength models.

Volume Relationship Models: These models review the relationship between "supply" and "demand" volume over the short- and intermediate-term time frames.

Price Thrust Model 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 +5.26% per year.

Volume Thrust Model 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 -15.269% per year.

Breadth Thrust Model 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.

Short-Term Overbought/sold Indicator: This indicator is the current reading of the 14,1,3 stochastic oscillator. When the oscillator is above 80 and the %K is above the %D, the indicator gives an overbought reading. Conversely, when the oscillator is below 20 and %K is below its %D, the indicator is oversold.

Intermediate-Term Overbought/sold Indicator: This indicator is a 40-day RSI reading. When above 57.5, the indicator is considered overbought and wnen below 45 it is oversold.

Mean Reversion Model: This is a diffusion model consisting of five indicators that can produce buy and sell signals based on overbought/sold conditions.

VIX Indicator: This indicators looks at the current reading of the VIX relative to standard deviation bands. When the indicator reaches an extreme reading in either direction, it is an indication that a market trend could reverse in the near-term.

Short-Term Sentiment Indicator: This is a model-of-models composed of 18 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a short-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Intermediate-Term Sentiment Indicator: This is a model-of-models composed of 7 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a intermediate-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Long-Term Sentiment Indicator: This is a model-of-models composed of 6 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a long-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Absolute Monetary Model Explained: The popular cliche, "Don't fight the Fed" is really a testament to the profound impact that interest rates and Fed policy have on the market. It is a proven fact that monetary conditions are one of the most powerful influences on the direction of stock prices. The Absolute Monetary Model looks at the current level of interest rates relative to historical levels and Fed policy.

Relative Monetary Model Explained: The "relative" monetary model looks at monetary indicators relative to recent levels as well as rates of change and Fed Policy.

Economic Model Explained: During the middle of bull and bear markets, understanding the overall health of the economy and how it impacts the stock market is one of the few truly logical aspects of the stock market. When our Economic model sports a "positive" reading, history (beginning in 1965) shows that stocks enjoy returns in excess of 21% per year. Yet, when the model's reading falls into the "negative" zone, the S&P has lost nearly -25% per year. However, it is vital to understand that there are times when good economic news is actually bad for stocks and vice versa. Thus, the Economic model can help investors stay in tune with where we are in the overall economic cycle.

Inflation Model Explained: They say that "the tape tells all." However, one of the best "big picture" indicators of what the market is expected to do next is inflation. Simply put, since 1962, when the model indicates that inflationary pressures are strong, stocks have lost ground. Yet, when inflationary pressures are low, the S&P 500 has gained ground at a rate in excess of 13%. The bottom line is inflation is one of the primary drivers of stock market returns.

Valuation Model Explained: If you want to get analysts really riled up, you need only to begin a discussion of market valuation. While the question of whether stocks are overvalued or undervalued appears to be a simple one, the subject is actually extremely complex. To simplify the subject dramatically, investors must first determine if they should focus on relative valuation (which include the current level of interest rates) or absolute valuation measures (the more traditional readings of Price/Earnings, Price/Dividend, and Price/Book Value). We believe that it is important to recognize that environments change. And as such, the market's focus and corresponding view of valuations are likely to change as well. Thus, we depend on our Valuation Models to help us keep our eye on the ball.


Disclosures

NOT INVESTMENT ADVICE. The opinions and forecasts expressed herein are those of Mr. David Moenning and Heritage Capital Research and may not actually come to pass. The 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 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.

Mr. Moenning of Heritage Capital Research is an investment adviser representative of Eastsound Capital Advisors, LLC, a registered investment advisor. The adviser may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Individualized responses to persons that involve either the effecting of transaction in securities, or the rendering of personalized investment advice for compensation, will not be made without registration or exemption.

Mr. Moenning and Heritage Capital Research may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

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.

The author neither endorses nor warrants the content of this site, any embedded advertisement, or any linked resource. The author or his managed funds may hold either long or short positions in the referenced securities. Republication rights must be expressly granted by author in writing.

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.