Saturday, December 26, 2015

Reitmeister/Zacks 2015

[12/26/15] The best part of the 2016 investment landscape is that it looks just like last year. This means we can use the lessons learned from 2015 to carve out extra stock market profits.

And the worst part is... it will look just like last year. That means limited gains for the main indices and spells of nasty volatility.

Gladly I think the pros beat the cons in this scenario... because where else are you going to put your money???

Cash is still trash.

The 33 year bond rally is over as rates will likely rise from here.

Real estate will lose luster as rising rates put pressure on home prices as well.

So the stock market still offers the best place to find outperformance. That is not necessarily true if you are just an index or mutual fund investor as your returns will likely be in the low single digits.

Instead this is the year of the stock picker. Meaning the average stock is going virtually nowhere. However, if you stack the odds in your favor by selecting the kind of stocks that are proven to outperform, then you will enjoy attractive returns.

In the rest of the article I will cover these topics to get you in the best position to prosper in the year ahead:

1) Why Still Bullish?

2) Predictions

3) Potential Pitfalls

4) How to Stack the Odds in Your Favor

Why Still Bullish?

A long term bull market stays in place until one of two things happens:

A) Recession looms on the horizon awakening the next bear.

B) Valuations get stretched (Ex. The bear market that started in 2000)

As for a recession looming on the horizon, that just doesn't add up as the US economy continues to grow at a +2% clip. I know that doesn't get your engines revving, but it is a consistent pace that makes this one of the longest expansions and bull markets in history.

I appreciate that on average there has been a recession every 5-6 years. But that is often because the boom times are too good leading to excesses that bring to life the next contraction. The beauty of this Muddle Through 2% growth is that there are no excesses or bubbles at this time. So no serious fear of an imminent recession.

Now let's address the other side of the coin...valuation. I know folks who point to a historical average PE of 15 in order to say that this market is getting stretched given the trailing PE of 17.7. However, there is much more to the story.

First, the market looks forward. In this case we should be looking at the PE based upon estimates for the coming year, which are in the neighborhood of $126 per share for the S&P 500. That creates a PE of 16.3 at this time.

Second, PEs in the latter stages of bull markets typically move higher given the confidence folks have in a positive outcome. So a PE of 17-18 is more standard at this stage of the game.

Lastly, and most importantly, is the relationship stocks have with Treasury rates. In general, the earnings yield for stocks is 3% higher than the 10 year Treasury. So let's do that math.

Earnings yield is the inverse of PE. So you need to divide the $126 in expected earnings for the S&P 500 by its recent closing price to come out with an earnings yield of 6.1%. Whereas the 10 year Treasury is only providing a meager 2.2% yield for investors. Given this historical relationship, there is still ample upside for stocks. ( What if rates keep rising? More on that topic in the "Potential Pitfalls" section below).

2016 Predictions

This bull market has already rallied more than 200% since it began in March 2009. Thus, the easy money has been made, which explains the basically breakeven performance in 2015. Unfortunately the results for 2016 are not looking much better.

In some of my recent commentaries I have shared the following equation to predict future stock market returns. Here it is again:

GDP growth + dividends + inflation

The first two items get you to around +4%. Inflation is the bigger mystery. Let's call it 1%. So all together we are looking at around 5% gains from the stock market in 2016.

10% is not out of the question if GDP and earnings growth escalate from current levels. Unfortunately another 0% showing is just as possible.

Weighing out all the possibilities, I expect the S&P 500 to end the 2016 campaign a notch higher between 2150 to 2200.

Potential Pitfalls

The outlook shared above is based upon the information in hand. As things evolve it may get better...or may get worse. So let me now prepare you for 2 potential hazards out there.

1) Recession: The average expansion period for the US economy lasts for 63 months before the next recession arrives. Gladly history does not repeat itself like clockwork as right now we are in month 82 of this growth phase.

Again, the #1 cause of bear markets is a recession. So as this expansion gets longer in the tooth, we all need to be on active watch for any signs of contraction. When that happens, it is time to lighten the load and get prepared for the next bear market.

2) Treasury Bond Rates: As shared earlier, there is an important historical relationship between Treasury bond rates and the valuation of the stock market. Right now that is still very favorable for stocks as bond rates are near historic lows.

However, in December the Fed raised rates for the first time since 2006. This has pushed up the rates on some short term bonds, but amazingly the 10 year Treasury rate is actually a notch lower than before the announcement.

Why?

Because the Fed has promised to exercise great caution in making future rate hike decisions. In fact, the Fed members have already predicted that the Funds Rate will likely be between 1.25% and 1.5% at the end of 2016. Add virtually no inflation on top of that and there is no current reason for the 10 year rate to move markedly higher. And thus stocks are still attractive.

If the Fed moves faster than expected, or inflation kicks up, then yes 10 year Treasury rates will rise. I believe stocks will do fine if rates just float up to around 3%. Above that level and it will start to call into question the relative value of stocks versus bonds, which would spark a correction even if other economic indicators are positive. So be sure to keep tabs on how this progresses over time.

[12/4/15] December 31st Stock Market Prediction

The S&P 500 started the year at 2059...and that is likely where it will end.

Why?

The similarities with the breakeven finish in 2011 are becoming quite apparent.

•  Big gains in the two years prior: 45.5% return in 2009 and 2010 very similar to the outsized 50.5% return spanning 2013 and 2014. It is fairly normal for the market to rest after such exhausting runs higher.

•  Positive returns to start the year. Then collapse in August only to crawl back towards breakeven by year end.

Yes, I previously expected stocks to take another shot at the record highs of 2135 to finish the year. However, as time wears on the commonality of this year with 2011 is becoming all too evident.

[11/30/15] Starting now the investment media will be very focused on the state of holiday shopping activity. My strong recommendation is to not waste your time reading these commentaries.

Why?

Because the metrics are too focused on sales at brick and mortar retailers. Yet we can all appreciate why year after year more sales move online. And because of that, more sales occur closer to Christmas instead of the weekend after Thanksgiving.

Last year fell into the same trap where the early signs pointed to retail weakness. In the end, it was another strong year of growth and this one will be exactly the same. That is because of the sound logic of this equation:

Higher employment/ income + energy savings + no inflation + stronger consumer sentiment readings = stronger retail sales.

That equation gives me supreme confidence to look past these retail articles knowing that all will be well in the end.

[Monday, 11/16/15] Friday the 13th lived up to its name. You may not see it as much in the return of the S&P 500 at –1.12%. Yet when you witness the –1.54% haunting of the Nasdaq and the –3.81% chain saw massacre of the retail sector, then you appreciate just how scary the day truly was.

The main reason for recent pain is the continued poor earnings announcements from big name retailers. Nordstrom and JC Penney were the latest boogeymen to join WalMart and Macy's. However, the weak retail earnings this past week just doesn't pass the sniff test. Meaning that virtually no time in history did this equation make sense...

5% unemployment + no inflation + strong dollar + AMAZING savings from cheap energy + improving consumer sentiment = lower retail sales

Unfortunately the above conclusion is what some investors are coming to believe. As if the US consumer is hunkering down for bad times ahead. This simply does not compute.

Yes, retail sales can be lumpy month to month (or even quarter to quarter). And yes, more traditional retailers are feeling the pinch from their online rivals. But NO is the response to those who think the consumer is hurting or that this spells a looming recession. That was apparent in both the Retail Sales and Consumer Sentiment reports Friday morning.

So I say "Thank You!" to my fellow investors for creating this prime dip from recent highs. It gave me a great opportunity to add shares of a 3X long ETF to get back to fully invested on Friday.

Odds are Santa Claus is coming to town with a good chance of making new highs before the year is out. Even if we just make it back to 2100 that is a good enough reason to add shares now.

[11/4/15]  Stocks started off Tuesday back under 2100. It seemed like folks finally wanted to take some profits with a consolidation period to follow.

Then investors said "Nah...let's keep going higher" .

The Tuesday close puts us a scant 1.2% away from the old highs at 2135. Given the recent market action it seems a forgone conclusion that we will soon traverse those heights. What happens next appears the greater mystery.

My money rides on a well overdue consolidation period around the old highs followed by a final push to new heights before the new year. 2150 for sure. Maybe all the way up to 2200 if Santa is feeling especially giving this holiday season.

For those of you waiting for some magical dip to get back into the market, I ask rhetorically "How is that strategy working for you?"

[10/26/15] Correction...I Meant Choice #3

In my last commentary I speculated whether stocks were truly ready to breakout higher above the 200 day average at 2060. Thus, I showed these 3 choices and suspected that #2 was the most likely:

1)  Pullback lower in the range like 2000.

2)  Consolidate just under this level building up energy to break above in the near future.

3)  Break above immediately.

In hindsight #3 is the obvious selection. Helping to fuel the breakout on Friday was a cocktail with three strong ingredients.

First, impressive tech earnings from AMZN, GOOGL and MSFT was a welcome surprise. Second, PMI Manufacturing Flash Index showed an unexpected improvement in the recently beleaguered manufacturing space. Third, news of a rate cut in China to help stimulate their growth was icing on the cake.

The S&P 500 may pull back closer to 2060 next week in a modest round of profit taking. But the improving fundamental landscape points to more time being spent above the 200 day moving average than below.

(we'll see if he's right this time :)

[10/23/15] Some better earnings reports rolled in Thursday. Investors rejoiced by sending stocks up towards the 200 day moving average at 2060. Since this is the first such attempt to cross that important level of resistance, it failed.

What is unclear is the next step. Here are the 3 most logical choices:

  1) Pullback lower in the range like 2000.

  2) Consolidate just under this level building up energy to break above in the near future.

  3) Break above immediately.

I vote for #2 as the most likely option. Why?

The market action Thursday gave me some clues. It was an odd session in that the S&P and most other large cap indices were raging higher while the small caps lagged far behind. This often says that investors are not ready for risk taking...and thus not really ready to bolt higher.

Also most technical indicators say that the market is overbought at these levels after bouncing all the way from 1870 in short order. So I think a consolidation is in order under the 200 day. Then perhaps a successful breakout occurs on the second or third attempt to get above.

[it turned out the answer was #3.  The S&P 500 gained 22.66 to 2075.17.]

[10/15/15] The signs for stocks to head lower keep mounting. Here are the new ones that appeared on the scene Wednesday:

•  Chinese inflation data points to continued economic weakness. In particular, a 5.9% year over year drop in their Producer Prices is a serious red flag as robustly growing economies typically have healthy inflation.

•  The September US Retail Sales report came in relatively soft across the board with only modest pockets of strength on the discretionary side. Overall consumers are not truly spending much of their energy savings in other places.

•  The nation's largest retailer, WalMart lowered guidance which chopped 10% from the share price and hurt their retailing peers.

•  The Atlanta Fed's GDPNow Tracker has Q3 GDP estimate of just +0.9%. Not a recession...but certainly headed in the wrong direction after +3.9% in Q2.

•  The Fed's Beige Book showed more regions with decelerating growth than in the past. Weakness in the factory sector was most notable.

Add it all up and you understand why stocks closed back under 2000 for the first time in five sessions. Of course, traders can depart from a focus on the fundamentals as they did with the recent bounce from the lows. However, it is rarely wise to be disconnected from those facts for long.

Until the fundamentals start looking up, then investors should expect stocks to have a predominantly downward trajectory.

[10/10/15]  Was THAT the Bottom? By: Kevin Cook

After a "flashy" 13% correction, the stock market just established a strong "W" bottom and retook S&P 2000.

But was that the bottom? And did you miss your last chance to buy stocks on sale before a classic fourth quarter rally?

I think not. I believe that the four-letter word of markets - FEAR - will make a big comeback very soon and that it will create another great buying opportunity, maybe even bigger than the one in late September.

Here are my 3 reasons why October will probably still be scary...

1) Earnings Recession Confirmed

The S&P is set to log its second consecutive quarter of negative year-over-year earnings "growth." We know the Energy sector is a big culprit here. But the Tech sector has been getting shaky too as expectations come back down to earth.

The way I see it, this earnings season has to be strong and significantly beat all those lowered expectations to support stocks. But we won't have a solid idea of that for another 2-3 weeks. And that means, in the short-term, investors will be more likely to sell any bad news around S&P 2000 than buy it.

Fear is definitely under the surface with regard to earnings surprises. 

2) Economy on Recession Watch

After the recent drop in the ISM Manufacturing survey to the 50 line - the pivot for expansion vs. contraction - many large investors have raised their "recession probability" for the US economy. I bumped my own estimate to better than a 25% chance of recession in the next 3-9 months.

And the decline in US job growth the past couple of months isn't helping the case that our economy is able to weather the fallout from faltering global growth in China, Europe and Emerging Markets. Just like the earnings recession, the market hasn't waited to "price-in" this bad news.

But we just rallied back over S&P 2000 despite this worse news - fueled by a big rebound in the beaten down Energy and Materials sectors - and I don't believe there is much room for error now.

The positive sentiment appears to be coming from 4 areas combined:

1) The Fed is still very cautious about hiking interest rates amidst global turmoil

2) Pushing out the rate hike "lift-off" weakens the US dollar and helps exporters

3) Oil may have bottomed and that boosts the prospects for a big part of the economy

4) US equity markets are still the "cleanest dirty shirt" in a world awash in liquidity

These are nice reasons for a relief rally off the nice "W" bottom. But they don't argue for strong improvement in the fundamental picture. And based on EPS estimates for next year of $120 for the index, we are back to trading at nearly 17 times forward projections.

That's rich in an earnings recession. And ripe for more profit-taking and fear.

3) The Charts Are a Mess

The market weather forecast is simple right now: cloudy with a chance of chaos. And you can see this in lots of index charts and indicators that I watch. The S&P, Dow, Nasdaq, and NYSE Composite have all rallied back over their 50-day averages, which is great, but the 200-day lines loom further above.

And the sector rotation has been violent as fund managers appear to be moving out of growth stocks and into areas of value and safety. That’s not typically bullish.

More importantly, the major indexes are still below the areas where they broke down from in August. What was support all year will likely turn into resistance now. On August 12, with the S&P still near 2100, I wrote an article about how we finally had a catalyst for the market to roll over into a correction just like 2011.

That catalyst was the Chinese yuan devaluation. In August, I also laid out how the current correction was likely to evolve very much like the one in 2011, with lots of violent rallies off of support that needed to be tested several times.

S&P 1900 now looks a lot like S&P 1100 was back then. And Market Timers have profited from those violent swings, catching the turn in the final days of September for the ride back up to 2000.

The Way Out of This Correction

So now with a double-bottom around S&P 1870, and the "W" correction that I was looking for instead of the typical "V", one might argue that the fear, and thus the correction, are both over. But recession worry among economists and big fund managers is the highest it's been in four years.

While that fear may be misplaced, it can still drive new waves of selling in stocks.

And the really big difference between 2015 and 2011 is valuations. There are still some hefty profits and excess to be wrung out of certain areas of the market.

So while I am busy trading the swings between S&P 1900 and 2000 to pocket some extra money until Mr. Market is done fooling with everyone, I am waiting for the signal on one last fear-driven trip to 1900, or lower.

Bottom line: Down there somewhere, my "capitulation" indicators will give me the green light to buy stocks and leveraged ETFs with both hands for a fourth-quarter rally.

After the Rally

Looking further ahead, a bear market is surely looming over the horizon. The current bull has already outlived the average lifespan by nearly two years. The question is not if but when it will hit with full force.

[10/2/15] I Am NOT Buying This Bounce

At 10am ET on Thursday investors were served notice that the odds of recession have increased. That came in the form of a paltry 50.2 reading for US ISM Mfg. This extends nearly a year long decline from the peaks in the high 50's to this level that borders on an outright contraction.

There is no relief in the key components as New Orders is at the lowest level since August 2012. Add that with Backlogs at a meager 41.5 and it says that the group is running on vapors.

For those about to say that manufacturing only represents 15-20% of the US economy...you are missing the point. This group is typically the leading indicator for the rest of the economy. So, if manufacturing is heading south, typically other groups are soon to follow.

I wasted no time in selling 5 stocks in the Reitmeister Trading Alert following this announcement. This has my portfolio now standing at -10% net short the market. Yes...net short.

This is NOT a guarantee that a recession and bear market are on the way. However, the odds of this happening have increased and likely stocks will head lower to reprice this new level of risk.

Plain and simple, the more the odds move towards recession and bear market the more defensive you should get. If and when the fundamental outlook switches back to more bullish evidence, then quickly glide back in that direction.

Just like the chant at football games. Now is the time for DEFENSE!

[9/28/15] Why This Isn't the Bottom

Kevin Cook here for Steve...

Stocks took a pounding Monday as the Healthcare sector acted like it wanted to steal the Energy sector's title as Most-Hated. That's what happens when the strongest stocks of the bull market suddenly surrender to political headwinds. There are lots of profits -- and lots of margin calls -- to get wrung out of the exuberance.

And the odds are good that we haven't seen the worst yet. Last Wednesday, I presented a "top ten" list to Zacks insiders of the catalysts for new lows in this correction. I'll share the Cliff's Notes of my 4 most controversial negative catalysts...

1) Recession fear & "valuation re-set" brings 14X next year's $125 EPS = S&P 1750

2) Flash Correction of Aug 24 is "a crime that the market will return to the scene of"

3) Q3 earnings decline of 6% is not yet priced-in to market until S&P 1875

4) Buybacks have exceeded free cash-flow for first time since 2009.

Bottom line: While I am nibbling on select stocks that look like great bargains right now, I am still mighty cautious given how far this correction can extend. So I am saving lots of dry powder. My bet is that a great big "buyable" low is coming to an October near you.

[9/14/15] Stocks Should Have Collapsed Friday!

Why?

Consumer Sentiment shockingly plunged to the lowest level in a year. Often consumer indices like sentiment and confidence are the canary in the coal mine of what happens with consumer behavior ahead. The chain reaction works like this: Typically the lower the sentiment, the lower their future purchasing activity, the lower the GDP reading, the lower stock prices head.

Reity, so why didn't stocks collapse on this news?

Right now Wall Street is far too fixated on the odds of a Fed rate increase. This weak consumer data adds to the majority belief that the Fed will sit on their hands longer before raising rates which is considered a short term positive for stocks. However, it is TOTALLY missing the point.

Way too much emphasis is being put on Thursday's Fed announcement. Truly I think it will only affect stocks for a couple days at most. What really matters is the health of economic activity here and around the globe (especially China) and what that means for GDP, corporate earnings and stock prices in the future.

So yes, I will be the one of the few investment commentators barely talking about the Fed leading up to the 9/17 announcement. However, I bet that I am 100% right in not making a mountain out of this mole hill. Instead the key is to stay focused on the economic indicators which certainly took a step backwards on Friday.

[9/2/15] As shared in my commentary yesterday, the key Chinese and US manufacturing data would deal the hand for stocks Tuesday morning. Unfortunately it was a royal flush of bad news.

First, we find that both measures of Chinese manufacturing results came in under expectations and under last month's mark, and overall trending in the wrong direction. This got followed up by US manufacturing stats that were barely in expansion territory. Not surprisingly investors took the hint and got back in a selling mood with a nearly 3% decline for the S&P.

Unfortunately I think this sets us up for a potential retest of the recent lows at 1870. That support level may hold. Or perhaps we push all the way down to the October 2014 lows of 1820 to scare everyone senseless before a meaningful bounce occurs.

That kind of retreat should provide enough pain until we see whether there is any reality to the soft economic data. Quite likely this is another false scare as we have endured many times throughout the 6+ year bull market with higher highs as the result. But just in case the fundamentals deteriorate further, then a dose more caution in your portfolio makes sense at this time because the market goes down a lot faster than it goes up.

[8/26/15] Those looking for a healthy bounce on Tuesday had the rug pulled out on them after a promising start to the session. Fret not, this is pretty typical behavior for a market trying to find bottom.

Let me walk you through the psychology of what happened on Tuesday. Yes, in 4 short sessions the market shed a full 10%. That is a devastating drop in such a short period of time. As you can imagine, this ferocious drop rattled the nerves of many investors who were too paralyzed to sell in the midst of the initial rampage.

Now they get served up a healthy bounce which allowed them to save some face as they head for the exits. This helps to clear out much of the selling pressure allowing buyers to soon gain the upper hand.

This doesn't mean that stocks just go straight up from here. Indeed there is likely to be more volatility in the near term. However, my sense is that these thwarted bounces from Monday and Tuesday are a healthy part of the bottoming process that paves the way for future gains.

[8/24/15] Does That Sound Reasonable?

The headlines read: "Market is Selling Off on Global Growth Fears" .

Scary stuff indeed. But scare tactics is all the media is good at. Unfortunately they are not good at helping investors make money.

When you dig below the surface you find that the US economy is humming along just fine. Even Europe is on the rebound. So all we are talking about is concerns about China.

OK, I'll admit that China is an issue worth watching given how much their growth has meant to the world economy the past several years. But do you think for a second that their government is done throwing stimulus at their economy? One quick glance at recent history and you will discover that they are not short on will power, creativity or the cash to restart growth.

And do you believe that there is good reason for stocks to fall further than the current 10% losses in the States and 20% in Europe on this one catalyst alone?

If a further sell off sounds reasonable to you, then please dump your stocks so I can buy them on the cheap.

If you agree with me that enough is enough already, then hold on with expectations for a bounce coming soon.

[7/12/15 Mitch Zacks] If you had just one word to describe the market so far in 2015, it might be: volatile. And, this can be concerning. Regardless, for all the market machinations, performance essentially finished flat eking out a 0.7% (S&P 500) gain. So, what do we think will happen next?

At first glance, the economic backdrop might raise eyebrows: a second estimate of U.S. GDP shows contraction of -0.7% in Q1 and incoming data point to a tepid rebound in Q2, perhaps +2%. Additionally, if you consider uninspiring domestic growth, an escalating Greece situation, the wild China stock ride and imminent U.S. rate hike(s), you might conclude the odds are stacked against a strong finish in 2015.

And, you may be right. But these factors are not enough to turn bearish for these four reasons:

1. Markets Tend to Do Well in Rising Rate Environments – the last three rate hike cycles have corresponded with strong market performance. In 1994 – 1995, the Fed raised rates 7 times and the S&P 500 annualized 18% in that period; in 1999 – 2000, there were 6 hikes and the S&P 500 annualized 5%; from 2004 – 2006, 17 rate hikes and 16% annualized on the S&P. It makes sense why this occurs: if the Fed is raising rates, it’s because the economy has underlying strength! Stocks tend to do well when that’s the case.

2. We Expect GDP Growth to Average 3% Over the Next Four Quarters – we expect earnings to recover and for the economy to expand at a moderate, but reasonable, pace. This should push unemployment down to 5.1% by the end of Q4 with core inflation, based on Personal Consumption Expenditures [PCE], creeping up to 2% by 2017. Not too hot, not too cold. With multiple expansion that has come with Fed easing the last six years, we think the market should move more in-line with earnings growth versus seeing P/Es climb much further. That could mean single digit S&P 500 growth in the next year or two.

3. Greece is a False Fear, Creating a Wall of Worry Markets Love to Climb – the Greece story is now over two years old, which means the market has had plenty of time to price-in the worst. Even if there is a “Grexit,” we think it’s probably only capable of inciting a bit of short-term volatility. All this talk of the European banking system collapsing or systemic issues surfacing (if Greece leaves) are over-reactions in my view. False fears are almost always tailwinds for stocks.

4. Global Growth Should Continue Apace – in spite of Europe’s Greece dealings, the region should see growth in the range of 1% - 2% this year, which is more than it has grown in a few years. Having Europe back in the plus-column is good for global GDP, and I think the U.S. and China will hold up in spite of the jitters that appear to be surfacing. China is willing to ease and the U.S. should recover in the back half like we did in 2014.

The Bottom Line for Investors

With the Fed tightening, modest corporate earnings growth, and a further decline in the equity risk premium, we expect the S&P 500 to notch up +4% to finish the year. While 4% isn’t the kind of return we’ve become accustomed to as of late, it still beats what you can get from U.S. Treasuries, or much of what can be attained in fixed income markets. And, the outlook for equities beyond 2015 remains positive with the possibility of upside surprises in my view. For the long-term growth investor, equities likely remain the best asset class for now.

[7/11/15 Weekend Wisdom] Stocks have rallied over +200% from the depths set in March 2009. That includes a healthy 13.7% gain for the S&P last year. Unfortunately this year things seem to be stalling out. That begs the question:

How high will stocks go?

I will explore that topic by first looking at the best case scenario. Then the worst case. And for good measure, I will give my prognostication of how it will all play out.

Hey Goldilocks! Best Case Scenario

Plain and simple the bull market will stay in place until one of two things happens:

1) Recession appears on the horizon.

2) Stocks become ridiculously overvalued and the bubble needs to be burst (like in 2000).

Right now the US economic data shows no signs of a recession in the air. Yes, Q1 was modestly in negative territory, but that was due to transitory factors like bad weather. Economists are in strong agreement that we will return to 2-3% GDP growth ahead. So no problems here.

And yes, stocks are getting pretty fairly valued these days. However, history shows that most bull rallies don't end until way past fair value...what you might call "fully valued". That could be at a PE of 18-20. Whereas the S&P is only trading at 16X next year's earnings estimates.

So the best case scenario is that the economy returns to a healthy 2-3% growth pace. That, plus the aforementioned PE expansion, should lead to the market making new highs once again in 2015. And if the economy keeps expanding in 2016...then stocks will progress even higher.

Long story short, you should stay fully invested in this market until a recession appears imminent or stocks become bubblicious.

 Look Out Below! Worst Case Scenario

The previous section provided the two main elements (recession and valuation) that would lead to the worst case scenario and full blown bear market. Note that the average bear rips out 34% from stock market valuations. That is actually a good scenario if you see it coming and get short in time to profit from the move with shorts and inverse ETFs.

However, there is one more thing that could be the harbinger of the next bear. That would be a dramatic rise in interest rates.

At first it would be good for stocks as investors would lose more money in bonds and switch to stocks as a more attractive alternative. Yet the higher rates go, the more it calls into question the true value of stocks.

Note that the inverse of the PE ratio is another important valuation metric called the "Earnings Yield". Right now that stands at 6.3% (given $130 in estimated EPS for the S&P 500 next year). That 6.3% earnings yield is still very attractive versus the current 2.3% yield on 10 year Treasuries as the average historical spread of these investments is 3%.

So now imagine that there is a whiff of inflation in the air. Or our politicians botch up our debt situation. Or the Fed raises rates too fast...any of which could get the 10 year back towards 3.5% or higher. Now stocks won't look so attractive leading to a stiff decline.

I do not fear any of these nasty scenarios playing out any time soon. In fact, even the Fed has made it clear that the slope of rate increases will be slow and steady as not to disrupt the economy. But good to know all the potential signs that would lead to the next bear market.

And My Crystal Ball Says...

The best outcome for 2015 is that stocks start trading up to 18X next year's earnings estimates. That would give us a target of 2340. Yet, this year has too many question marks abounding:

1) What happens with Greece and ripple effects to the rest of the European economy?

2) Is China's stock market decline a sign of a looming recession there, which would harm worldwide economic growth?

3) QE in other nations is devaluing their currencies...which makes the US dollar more expensive...which hurts US exporters. Will this situation worsen?

These question marks have limited the upside for US stocks this year. Unfortunately I think that will continue a while longer. As such, I predict that 2150 to 2200 is as high as US stocks will get this year.

If these 3 lingering issues get resolved in a positive fashion, and the US economy keeps rolling along, then indeed 2340+ should be in the cards next year. So that says it is best to stay long the market until there are more pressing reasons to believe that a bear market is on the horizon.

Note that I am by no means a perma-bull. When the facts change, then so too will my outlook. In fact, if any of the bear market conditions discussed above emerge, you can bet that I start shorting the market with both fists. Putting my head in the sand, allowing a 30-40% mauling of my portfolio or yours, is just not in my DNA.

[6/30/15] I find the decline of US stocks Monday to be laughable with a strong bounce soon to follow.

Why?

Because Greece is a false boogeyman for the US investor as it has virtually nothing to do with the health of our economy or corporate earnings and thus should have no ill effect on stock prices.

But Reity, if that is the case, then why did stocks tumble on Monday?

It is healthy for markets to correct in order to wring out excesses and investor complacency. So even though this was not the most logical catalyst for this cleansing process, it will serve that end just the same.

When investors soon wake to the reality that Greece has nothing to with their US stock investment decisions, then the market will rebound mightily. It also helps that the strong support of the 200 day moving average is just below the Monday close at 2053.

[6/19/15] Stocks have been bottled up all year in the narrowest of trading ranges. So Thursday's rally has us within striking distance of the all-time high at 2134.

Are we ready to breakout? Or is this another failed attempt?

Given all the failed breakouts in 2015, it's hard not to give credence to that notion. However, there are some good reasons to believe a breakout is soon on the way. Here are the key points:

• We are still in the midst of a long term bull market
• Economic data is improving
• The Fed has promised to "do no harm"
• There is no other good place for investors to put their money.

Add it all up and the odds are increasing that stocks may be ready for a breakout higher. My guess is to 2200 before the next consolidation. So it makes sense to get back towards 100% long stocks at this time if you have not done so already.

[6/4/15] Strike 3: Correction is Out!

Yes, I was one of the many investment commentators who became more defensive when the economic data recently got soft. Especially how the strong dollar was hurting the manufacturing sector. I thought best to be cautious until there was more clarity on the issue.

Well the clarity is in and the idea of a correction is out.

Strike 1: ISM Manufacturing on Monday rose to 52.8 with the New Orders index pointing to more gains ahead.

Strike 2: ADP Employment on Wednesday showed continuation of solid employment gains with 201,000 jobs added.

Strike 3: ISM Services, also on Wednesday, displayed a strong 55.7 result with New Orders even better at 57.9.

I am back to 100% long after a long time in a more defensive posture. 100% long does not mean the same as it did in the past. That is because I am not truly "uber-bullish".

Actually I think the most likely outcome for stocks this year is sideways. The second most likely result is to move modestly higher. If that is the landscape, then being 100% long with a diversified group of quality Zacks Ranked stocks is the best way to generate outperformance.

[5/11/15] The S&P rallied +1.3% on Friday because some call this a "Goldilocks" employment report. Not too hot to make the Fed feel comfortable in raising rates. Not too cold to worry investors that economic growth is stalling out.

I am not impressed!

Let's look under the hood on this employment report. 223K was a meager 3K higher than estimates. HOWEVER, the past month was revised lower by 41,000 and thus the average of the past two months is well under trend.

Even more depressing was employment in the manufacturing sector where there this is the 3rd straight lackluster report. And hours worked was down which is often a precursor to layoffs. You can blame the strong dollar for this situation.

Long story short, I am not getting sucked into Friday's rally. I will stay defensive for now at just 45% long the market...the most defensive I have been in a long time. And will remain so until either manufacturing data improves or the dollar weakens (which would help manufacturing in time).

[4/30/15] The anemic +0.2% showing for Q1 GDP on Wednesday morning was a clear warning sign to get more defensive. So just before the open I told Reitmeister Trading Alert members to buy a large position in the Smallcap 3X Bear ETF (TZA) to profit from the likely ride lower.

So far that was the right call as the small cap index fell nearly three times more than the large cap oriented S&P 500. And those profits will swell if I am correct that stocks break under 2100 and test the 100 day moving average at 2067. Maybe even lower if the ISM Manufacturing report on Friday stinks up the joint.

Just to be clear, the long term bull market is still in place. This is just a range bound kind of year like we endured in 2011 which hopefully paves the way for better gains in the years ahead. So when there is bad news like Wednesday you put in trades to profit from the ride lower.

[3/20/15] Kevin Cook says the bull isn't done running

[3/16/15] 2015 Just Like 2011?

This year continues to be a difficult one for stock investors as it dipped back into the red once again on Friday. Originally I assumed that 2015 would be just like last year. That being a volatile market with solid returns in the end.

The volatile part is certainly correct. However, I am getting a sneaking suspicion that the attractive year end gains will not be there which would harken back to the results in 2011.

S&P 500 Annual Returns

+26.5% in 2009

+15.1% in 2010

+2.1% in 2011…almost all gains just from dividends

+16.0% in 2012

+32.4% in 2013

+13.7% in 2014

What you will notice is that after the big runs in 2009 and 2010 stocks needed to rest for a while. What you might even call "a pause that refreshes" . This paved the way for ample gains the next three years. So perhaps another refreshing pause is in store.

[3/6/15] The average bull market lasts 63 months. That means June 9, 2014 was when we officially hit the possible expiration date. And on Monday we will celebrate it’s 6 year anniversary (72 months in total).

So that begs the question: Is this bull market running on vapors?

Absolutely NOT!

There are 2 main differences about this bull market that says the party will continue a while longer.

1) Economic expansion is slower this time around. You see, we are used to 3%+ GDP growth coming out of most recessions. This one took a while longer to get heated up with most of the time stuck between 1-2% GDP growth. This means we have not created excesses like most expansions from the past which is the harbinger for future recessions.

2) Still too much money on the sidelines or in underperforming bond funds. The reason being that the current generation of investors were horribly burned twice in recent memory (the bear markets of 2000 - 2002 and then again 2008 - 2009). This means they will be late to the party once again. As they climb on board, stocks will keep trekking higher.

[2/25/15] Investors sat on their hands awaiting the Fed Chairman's statement yesterday at 10am ET. Indeed she strolled in like Jolly Saint Nick giving presents to all investors as stock continued to new record highs while bond rates headed lower.

What did she say?

Let me boil it down for you. First was the boilerplate stuff like: The Fed sees the economy improving as well as employment. This does have them ready to consider raising rates.

Then came the twist that delighted investors. She inferred that the likely trigger to raise rates is when inflation starts getting back up towards their 2% target. With virtually no whiffs of 2% inflation in the air, then it means the rates hikes are a long, long way off.

That was bullish for stocks indeed, and why I got back to 80% long from my previous 60% posture. I am likely on way back up to 100% long if economic data by end of next week shows signs of strength versus recent softness. Of course if the data is weak, then time to get back into a more defensive shell for a while.

[2/15/15 Mitch Zacks]  On the valuations front, a quick view might give the impression that stocks are overpriced – the 12-month forward P/E currently sits around 16.3x (as of February 6), putting it well above the 10-year average of 14.1x.

Dial the 10-year average back another decade, however, and you’ll find that P/Es are quite reasonable at these levels. In 1997, stocks started the year trading at 16.0x, but over the next three-plus years would see that multiple climb to 25.6x, all while the stock market ripped to new highs.

Moral of the valuations story: Betting on P/Es being “too high” would have been a bad move in the mid 90’s, and I think the same applies today. I will concede that stocks are certainly not cheap, but they are also not expensive to a point where growth investors should be overcautious.

The biggest story this earnings season, however, was that of Apple Inc. I recently wrote about how I think Apple is undervalued, but there was a factoid that came out of this year’s earnings reports that surprised many: without Apple, earnings growth would have been 4.9% on the quarter. But, once you factored in Apple’s stellar results the figure jumped to 6.5%!

This goes to show just how influential Apple is in pulling S&P 500 earnings and it serves as a good reminder for investors to habitually look beyond the numbers. In my view, we are getting to a point in this bull market where just as many winners as losers emerge, so being selective in your approach is ever important.  

[2/2/15] Kevin Cook here to kick off the week for Steve...

There is a perfect storm of macro worries eating away at the confidence of market bulls right now, and none of them have anything to do with Greece. Here are the only drivers you need to focus on...

•  Earnings forecasts plummet driven by the Oil Bear and the strong US dollar

•  Federal Reserve seems determined to raise interest rates by June

Optimistic earnings estimates for the S&P 500 for 2015 have fallen from around $133 to nearly $125, with most of the damage occurring for Q1 as Energy profits will be cut by more than half. Meanwhile, the strengthening US dollar, which will only get stronger as the euro drops, is hurting exports now and the sales and profit impact will only get worse .

Then if you hear one of the most steadfast doves on the FOMC, James Bullard, say "Zero rates are not right for this strong economy," on Bloomberg TV Friday morning, you can see the perfect storm unfolding: rate hike "liftoff" will only make the dollar stronger and exacerbate the damage .

Bottom line: Large investors will still pay a 16X P/E multiple for growth in this bull market, but if the profit picture drops much below $125, you can see why the S&P 500 would drop below 2000. The way the market is acting, it seems like a trip to 1900 is more likely this month than new highs. In short, great buying opportunities are right around the corner in preparation for new highs by April.

[1/26/15] 1 + 2 = ???

Let's push back from the day to day volatility to the big investment picture. There are only 2 things you need to know right now.

1)  US economy is still expanding.

2)  QE around the globe is keeping government bond rates super low in the states too.

1 + 2 = bull market still firmly in place.

More specifically, if stocks traded based upon their historical relationship with bonds, then the S&P 500 would hit 2400 this year. Since many investors are still cautious that these low rates are still too good to be true is why I say 2300 is in the cards this year.

Stay on the sidelines at your own risk.

[1/16/15] Stocks fell below 2000 twice already in January. Both times bouncing higher before the close. We were not so lucky on Thursday closing at 1992.

Right now I see 4 possible scenarios listed in order of likelihood:

1) Bounce Friday and be done with this downward move.

2) Head down to 200 day moving average at 1967, then bounce.

3) Head below 200 day like we did in October to scare everyone silly, then bounce.

4) Bear market starts now. Watch out below!

#1 and #2 are about equally likely in my book. Given that we are only talking about a 1.5% move to the 200 day moving average says that it's not worth executing trades in such a tight space. Instead we should calmly wait for the bounce the same way we have seen it unfurl countless times since this bull market began.

#3 could happen as it did back in October. Yet remember that was the first break below the 200 day in over two years. So probably not going to repeat so soon.

And for me #4 can be tossed out because the fundamentals just don't add up to a bear market starting now.

You should conduct a similar rational review of what you expect to happen. Better to plot your moves based upon calm calculation instead of overreacting in the heat of the moment.

[1/11/15 Mitch Zacks]  I expect the S&P 500 to generate roughly 8% total return including dividends in 2015 based on an examination of fundamental drivers.

With expected 2015 GDP growth of +2.9%, steady earnings growth, and below average inflation expectations (+1.6%) I see equities maintaining relative attractiveness to bonds. This should provide a modest tailwind for stock prices.

If stocks remain cheap relative to bonds, and if interest rates stay near where they ended in 2014, and if corporate earnings growth materializes as we expect, then 2015 should be a good year for the S&P 500.

A further possible upside scenario is for the S&P 500 to experience P/E expansion due to interest rates remaining lower for longer than investors are anticipating. If the P/E multiple can continue to expand, and if earnings growth reaches the high single digits in 2015...

The 8% Estimate of Total Return for the S&P 500 May Prove to Be Conservative.

Bull markets do not tend to end at P/E multiples that are slightly above average. Instead, they are imperiled when P/E multiples are extended and euphoria is rampant with investors "swinging from the chandeliers." We are not at that point yet, although the rate of P/E multiple expansion is likely to decelerate.

With the earnings yield of the S&P 500 (essentially the inverted P/E multiple) significantly higher than the ten-year treasury yield, the conclusion is that stocks will remain attractive relative to bonds, and that the expectation of the market going up in 2015 is reasonable.

Investors should be aware that historically in any given year the market has roughly a 67% chance of rising and a 33% chance of falling. This coming year is no different than any other. The more things change the more they stay the same - the odds of the market rising in 2015 are in investors' favor.

If you examine historical returns of the S&P 500 post-World War II, the expected rate of return for the S&P 500 is roughly 600 basis points above the risk-free rate. Unless an investor foresees a potential negative event that will catch the market off guard, my experience is that one may expect the base rate and adjust that based on perceived optimism or pessimism.

Right now, several years into a bull market that began in March of 2009, the market feels slightly more pessimistic than it should, As a result, I think there is a chance that the base rate will surprise to the upside.

[1/7/15] Tuesday's action was very typical for a session right after a massive sell off like Monday. That is where investors get rattled by the violent decline of stocks. So they say to themselves "I will sell on the next bounce in price" . And just like clockwork investors took advantage of the Tuesday morning bounce to get back in a selling mood.

Here's the good news. These are signs of a bottoming process as sellers run out of steam allowing buyers to take the upper hand.

Yes, we might quickly flush down to the 200 day moving average at 1960 to scare everyone silly. The key is to understand that economic data still points to +3% growth and now bond rates are lower. Thus stocks are that much more attractive on valuation basis.

Read: Buy the Dip!

In fact, I threw a 3X long ETF into my portfolio Tuesday to get to 115% long the market.

[1/6/15] 2014 started off with a thud as well and yet the S&P provided investors with a +13.7% gain. Truly ask yourself if anything seems different now than the recent past when we were making new highs.

The answer is that the fundamental picture is still equally bullish. So this pullback is nothing more than a round of profit taking that makes way for the next leg higher.

How bad could it get?

As we learned during the October correction, it can get a lot uglier than you think before a lasting bounce surfaces. But really, that was the first 10% correction in over two years. This is likely a more benign event.

We should get ample support at the psychologically important level of 2000. And if need be, the 200 day moving average at 1960 should do the trick. Given where we closed Monday night, it says investors should be firmly long stocks now to benefit from the looming bounce.

5 common mistakes

In this series I will discuss the five most common mistakes investors make, and what you can do to avoid them. With a stronger understanding of behavioral finance and these errors, you will be in a better equipped to avoid them!

Overreaction/availability bias. What is it? In financial terms, overreaction is the tendency to react in the right direction—but excessively so. It’s the Rumors Run Wild investing equivalent of someone getting upset at something small and losing his temper completely. An example would be an investor who pulls out of the stock market completely at the first sign of bad news. Overreaction is usually related to availability bias, which means overestimating the probability of more recent, memorable events that you observed personally. An example is an investor putting too much weight on recent negative information instead of the big picture. When both biases are combined, many investors make the situation even worse by going all in because the market is doing well (and usually at its peak), and going all out when the market is doing poorly (the best time to buy!). To counteract these tendencies, understand that you may have information that is correct, but not complete. Instead of relying on only what you know, add in the missing pieces to put things in a larger context. This can help mitigate the tendency to react too strongly in either direction.

Focusing on short-term performance. We all know that focusing on the long-term is the key to success, but we can’t help but overreact to short-term performance. That’s because we tend to overweight the importance of whatever’s going on right now. Simply put, we’re wired to be short-term thinkers, and overcoming that tendency is a difficult—but not impossible—task. The pain we feel of losing something today is greater than gaining something in the future. It doesn’t help that the media bombards us with short-term developments in the markets. When this happens, we want to step back and understand investors with a long-term frame of mind are rewarded. You want to focus on your goals, not performance. A goals-based financial plan is the financial foundation for everything else. If your goals or time horizon hasn’t changed, then there is no reason to change your asset allocation. This one of the main reasons to use a financial planner, who can reassure you and keep you on track.

Following the herd. The average investor usually follows other investors. If there is a sudden rush into a hot sector such as tech, then a herd investor will follow suit even if the lemmings sector is clearly overpriced. This is what happened in the dot-com bubble of the early 2000s. Herd behavior can have disastrous effects when an investor buys when the market is high and then in a panic sells when the market starts going down. Why do people follow the herd? Because psychologically, it gives you a sense of security that everyone else is doing it. That is why testimonials, word of mouth referrals, and social proof are very powerful. In order to counteract this behavior, find out the root cause. Is it because you don’t want to appear foolish and left out? Is it because of peer pressure? The key is to know the true value of the stock, not what people say about it. Most people will never buy a house or car without first finding out what it is worth. However many buy and sells stocks as though the price and value don’t matter. According to research, men (47%) are more likely than women (9%) to follow the herd.

Confirmation bias. Those with a strongly held belief will only look for information that will validate their belief and ignore contradictory information. This habit is known as confirmation bias. People may feel as though they are making an informed and correct decision, but their choice may be skewed by their own biases. For example, you may like a certain investment and pay attention to information that supports your decision (strong recent performance) but gloss over other information (high price-to-earnings ratio) that doesn’t support your decision. What makes this more difficult to deal with is that many of us don’t know that we do this and are more close-minded than we think. One of the things you can do is pretend you are in a debate and argue the opposite side. Research the position contradicting the belief you currently hold so you can be objective as possible. It is important to have the complete picture when making a decision.

Anchoring. People have a tendency to rely on the first piece of information (the anchor) when making decisions, even if the information is not relevant. This is why car salesmen start with a high price, so the buyer judges the value they get based on how far below this price they go, not necessarily what the car is worth. An investor may hang on to a losing stock by waiting for it to break-even at the price they bought it at. The investor is anchoring the value of the investment to the original value, not the actual value of the stock, and thus taking on more risk. To avoid anchoring and using an individual number as a reference point, evaluate investments as if it were a new purchase. Reframe the situation and ask yourself “If I didn’t already own this stock, would I buy it today at is current price? If the answer is no, then you know you are anchoring and need to avoid fixating on the particular reference anchor.

While we may never be able to eliminate our emotionally-driven tendencies, we can reduce the impact by better understanding how we make decisions. Be proactive to avoid these mistakes so you can override negative behavioral tendencies!

-- David Chang, Thinking Smart, Midweek, December 23, 2015

Sunday, December 13, 2015

The Golden Cross

Now, I want to talk about this interesting technical formation that we call a Golden Cross. It’s a crossover of the S&P 500, where the 50-day moving average moves up through the 200-day moving average coming up from the bottom.

Now, this is a long and widely used technical pattern that technical traders have looked at for many, many years. And it’s not the beginning of a bull market. What it does is it confirms the bull market, or it confirms that the uptrend, if you will, is well entrenched.

This I calculated way back in the middle of November that would probably occur in the middle of December. Well, now, we’re getting a lot closer to the middle of December, and it looks like it’s still going to happen, right around that time. Interestingly enough, it’s going to happen right around the same time as the Fed meeting. So we’ve got potentially two large catalysts that could push the market higher for the remaining two weeks of the year. So keep your eye out on that.

Now, the last time there was a Golden Cross, which lasted about three and a half years, the market moved up about 49%. Now, that doesn’t mean it’s going to happen this time because we all know past performance is no guarantee of future results, but when technical traders step in, it does tend to push the market a little higher, and we’re probably going to see that in the middle of December.

-- Randy Frederick, 12/8/15

Sunday, December 06, 2015

stop orders stopped?

The New York Stock Exchange [NYSE] announced in mid-November the decision to eliminate stop orders and “good-till-canceled” orders from the investor playbook. When used correctly, stop-loss orders can be a resourceful tool to curb losses, and they can also be used to prevent a stock from falling back to its cost basis – which theoretically ensures you make a profit.

The key word here is ‘theoretically.’ What the NYSE ultimately found was that stop orders were only being minimally used (3% of all orders) and they were also being used incorrectly more often than not. This has created unintended losses for investors and, in some circumstances, triggered more broad-based selling. The NYSE had seen enough, so as of February 26, 2016, stop orders are off the table.

Why the Rule Change?

By definition, retail sales figures cover total sales from the previous month. As such, they don’t tell us what’s going to happen – they tell us what’s already happened. In that sense, retail sales are more of a coincident indicator than a leading one. It gives us insight about the current state of the economy but not where it’s headed.

The ‘straw-that-broke-the-camel’s-back’ came on August 24th, right in the midst of the global equity correction. Stocks were exhibiting high degrees of volatility for several days (not unusual), but on August 24th hundreds of securities posted unusual moves to the downside. Though not fully proven, studies since by the NYSE and other firms have shown that stop-loss orders most likely played a role in exacerbating those losses.

Additionally, many investors lost a lot more than they bargained for when they set their stop-loss price points. Here is an example of how stop-losses work and can go awry – if you own security ‘ABC’ at $30, set a stop-loss for $20 but ABC opens trading the next day at $10, you are going to end up selling for around $10 a share. It’s quite possible that you totally miss your $20 stop-loss price point because, once the stop price is reached or lower, your stop-order is converted into a market order – executed at whatever the available price is. In some cases, like August 24th, that can mean selling your stock for a significantly lower price than you intended.

The NYSE received several inquiries from retail investing firms concerning stop-loss orders and their impact on pricing and, after analyzing the matter, decided that they are so infrequently used – and so often misunderstood – that they are better off not existing at all.

-- Mitch Zacks

*** [but...]

The NYSE ending GTC orders – which typically expire in 90 days anyway – isn't a big deal because brokerages have their own in-house GTC orders investors can still employ.

And brokerages will still offer stop-loss orders. The only difference will be they'll get triggered in-house and then sent as a limit or market order to be executed.

Since investors can still place stop orders and GTC orders with brokerages, the NYSE saying it will no longer accept them doesn't appear to be earth-shattering.

Thursday, December 03, 2015

market valuations and expected returns

Key Points

Inflation and interest rate-based valuation measurements suggest the market remains inexpensive.
But more traditional P/E ratios and other unique models suggest the market is expensive.
Ultimately, what matters more for the market is the direction, not the level, of valuations.

I’ve written many times about equity market valuation being both in the eye of the beholder and a function of the chosen indicator. Even the most common valuation metric—the price/earnings (P/E) ratio—has many derivations.  The table in this report is a summary of most of the common (and somewhat less common) valuation metrics, and a subjective assessment of whether they are sending an inexpensive or expensive message about the stock market presently.

The punchline is that valuation is presently a very mixed bag—with a few indicators saying the market is quite cheap, while others saying it’s quite expensive. This muddied picture continues to be one reason for our continued “neutral” rating on U.S. stocks (meaning investors should remain at their long-term equity allocations).

The five valuation measurements falling into the inexpensive or fairly valued category are:

Rule of 20:  Stocks are considered fairly valued when the sum of the S&P 500 forward P/E ratio and the year-over-year change in the consumer price index (CPI) is equal to 20 (or inexpensive when it’s below 20).

Fed Model:  This model compares the S&P 500’s earnings yield (which is the inverse of the P/E—or E/P) to the yield on long-term U.S. government bonds. Negative readings suggest favoring stocks over bonds.

Equity Risk Premiums:  These subtract either the forward 10-year U.S. Treasury bond yield or the forward Baa corporate bond yield from the forward S&P 500’s earnings yield (E/P). Positive readings suggest stocks are undervalued relative to bonds.

Dividend Yield:  Compares the current dividend yield on the S&P 500 with both historic averages and the 10-year U.S. Treasury yield. At near-equivalent yields, the market is seen as fairly valued.

The seven valuation measurements falling into the expensive category are:

Forward P/E:  Probably the most common measurement, it divides the current S&P 500 price by 12-month forward expected operating earnings. It’s presently slightly above its ~20-year median of 15.9.

Trailing P/E:  Also a common measurement, it divides the current S&P 500 price by 12-month trailing operating earnings. It’s presently comfortably above its ~25-year median of 17.8.

5-Year Normalized P/E:  This model uses four years of historic earnings, two quarters of forward earnings, and takes the midpoint between reported and operating earnings (it’s a take on Shiller’s CAPE, but with a shorter time span, and with an adjusted earnings calculation). It’s presently comfortably above its ~70-year median of 18.1.

Shiller’s Cyclically-Adjusted P/E (CAPE):  This model uses an inflation-adjusted price for the S&P 500 and divides by reported earnings over the prior 10 years. It’s presently comfortably above its ~135-year median of 16.

Price/book:  Divides the current S&P 500 price by the book value of its components. It’s presently slightly above its ~38-year norm of 2.4.

Tobin’s Q:  Developed by Nobel Laureate James Tobin, it’s a fairly simple concept, but laborious to calculate (calculations are done by the U.S. government and the ratio’s readings are provided by the Fed). It’s often called the Q Ratio and is the total price of the U.S. stock market divided by the replacement cost of all its companies. A high Q (greater than .85) implies overvaluation.

Market Cap/GNP:  Considered Warren Buffett’s “favorite valuation indicator,” the model is the ratio of total U.S. market capitalization to gross national product (GNP). It’s presently well above its ~65-year mean of 69%.

Market Cap/GNP

Caveats

Three of the valuation metrics above—one of which falls into the inexpensive category and two of which fall into the expensive category—deserve mention for important caveats to consider:  Fed Model, Shiller’s CAPE and Market Cap/GNP.

Fed Model:  Cornerstone Macro highlighted the problem with the Fed Model in a recent report on valuation. “For much of history, before the early 2000s, bond yields and earnings yields were within close range; making such a comparison an important branch in the asset-allocation decision tree. Since 2002, the gap has widened to historic highs, and has exposed the shortfalls of the model.”
“In mid-2002, the yield on the 10-year government bond fell below the yield on the S&P 500. It has never crossed back since then. Thus, the Fed Model has told asset allocators for 12 straight years now to prefer stocks over bonds. That’s quite a long time to buy and hold stocks … especially while bonds have rallied so much over that time. This is one where you sometimes should fight the Fed [model].”

Shiller’s CAPE:  In a version of this valuation analysis I published last May, I dissected the CAPE and the caveats which are crucial to consider. I’ve linked to that report here: Devil Inside: Dissecting the Most Popular Valuation Metrics

Market Cap/GNP:  As for Warren Buffett’s favorite valuation indicator, some caveats are also worth mentioning. As noted by Cornerstone, “this metric has huge weaknesses, such as not recognizing structural changes in a country’s financial system, productivity, tax policy, demographics, etc. … the list is long on why this metric isn’t useful for comparison over time.”

In sum

You could probably find two market analysts on opposite ends of the spectrum from bullish to bearish; and they’d probably cite valuation as one of their reasons. It’s confusing for investors, who would probably love a simple and foolproof approach to valuing the stock market. There are myriad factors which affect valuation levels and their direction; including economic growth, inflation, Fed policy and even geopolitics.

Finally, and importantly, what’s perhaps more important than the level of valuations, is the direction they’re heading, regardless of the metric being used. In general, valuations have been expanding across most metrics and in the near-term, the conditions remain ripe for that trend to continue; at least until earnings can “catch back up” to valuations.

-- Liz Ann Sonders, Schwab Investing Insights, November 30, 2015