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Executive Summary:

With recent data showing the initial rebound in economic activity to be waning, the unprecedented level of support from the Fed and Washington takes on added importance. As such, the battle between the "real economy" and expectations for recovery is likely to continue. And so far at least, a "modern monetary theory" approach appears to be winning out. So, as I've been saying, I'm of the mind that investors should avoid "fighting the Fed" and stay seated on the bull train.

My Take on the State of the Fundamental Backdrop...

There is one change to report on the Fundamental Factors board this week as our Earnings composite slipped into the red. On the surface, this would seem to be a negative. However, in this case, where the economy - and in turn, earnings growth - was intentionally stopped and started within a short period of time, we have to recognize that our earnings models are lagging indicators.

The bottom line is I will argue that stocks initially dove on the expectations of an earnings collapse but have since moved on to discounting better days ahead. The question, of course, is if the anticipated improvement in the earnings will arrive in the time frame expected.

* 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

Below is the indicator that turned the Earnings composite negative. The top clip is the S&P 500 with the indicator's buy and sell signals. The bottom clip is a six-week moving average of the S&P's earnings per share.

S&P 500 Earnings Per Share

View Chart Online
Source: Ned Davis Research Group

The indicator and buy/sell strategy was developed by Ned Davis Research Group and is based on the directional movement of earnings. A sell signal is triggered when the moving average of EPS falls by 10% from its high, which just occurred. And buy signals happen with the moving average moves up from its low by 1.5%

A review of the hypothetical record shows that this approach has been pretty good historically. For example, since late 1979, the S&P has hypothetically gained at a rate of 11.84% per year when on buy signals and lost ground at a rate of -5.9% when on sell signals (compare to the S&P's return of +8.9% over the same period).

My take is this indicator represents a strong approach to managing the downside risks associated with periods of falling earnings. When earnings are starting to fall, history shows that it's a good idea to play some defense. And then when earnings begin to rise, it's time to jump back on the bull bandwagon. Well, except for periods where the economy was shut down for a couple months to keep people healthy, that is.

So, since the current situation is unique and has never really happened before, I am taking the recent sell signal with a fairly large grain of salt.

Thought For The Day:

A fanatic is one who can't change his mind and won't change the subject. - Winston Churchill

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: none - Note that positions may change at any time.

Fundamental Models Explained

Monetary Composite: 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 Monetary Composite is a combination of two proprietary monetary models developed by Ned Davis Research. The first is comprised of 14 indicators and is plotted as a composite and the second is made up of eight monetary-related indicators including money supply, and the bond and commodities markets.

Economic Composite: 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. The economic composite is a series of three models designed to indicate the current state of the economy.

Earnings Composite: A series of four models designed to indicate the overall health of corporate earnings. The first model is based on the slope of the smoothed S&P 500 earnings per share. The second model looks at the drivers of earnings and includes indicators such as U.S. industrial production, the CRB Spot Raw Industrial Material Price Index, the Treasury yield curve, Institute for Supply Management (ISM) indices, corporate bond credit spreads, unemployment claims, and the trend in analyst earnings estimate revisions for the S&P 500. The third model is designed to indicate the likely trend in the earnings per share reported for the S&P 500 Index. This model uses a variety of macro variables to indicate whether current conditions are favorable for strong, moderate, or weak growth in S&P 500 earnings. The fourth model the median 12-month percent change in the one-year analyst forecast out of the 500 components of the index.

Inflation Model: From an historical perspective, one of the best "big picture" indicators of what the market is expected to do next is inflation. The Inflation model is designed to identify cyclical changes in the rate of inflation. The model consists of 22 individual indicators primarily measuring various rates of change of such indicators as commodity prices, the Consumer Price Index (CPI), producer prices, and industrial production.

Valuation Composite: 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. The Valuation composite consists of five valuation indicators/models developed by Ned Davis Research. The first valuation indicator reviews the S&P 500 Price-to-Earnings GAAP Ratio relative to normal, expensive, and bargain valuation zones. The second model measures the S&P 500’s Median P/E ratio, representing the median P/E of the 500 stocks in the index. The third model measures the Median P/E ratio of a multi-cap stock index. The fourth indicator is the P/E ratio of the Value Line Index. The fifth model is a composite of 7 indicators designed to reflect stock market valuations based on how various valuation indicators compare to their latest 10-year historical ranges.

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.

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