Now let's look at the "fundamental analysis" of the markets. Fundamental analysis encompasses many things, including the earnings growth potential of a given market or stock, its debt levels, and price relative to sales and earnings.
The "talking heads" are all talking about single digit growth in earnings this year - and they may be overstating the possibility of a good year for earnings. This is important because right now the S&P 500 is selling at a P/E of about 15.6! The P/E of a stock is usually thought of as "valued fairly" when it is equal to the next year's expected earnings increase in percentage. This means that the S&P 500 is extremely overvalued - by about fifty percent - if indeed earnings are only going to grow in the single digits this year!
This is not a positive factor at all. If in fact earnings growth is decelerating, as is predicted, by approximately 12.5%, then the market suddenly looks VERY overvalued! For all of 2006 the s&P500 grew earnings at 13.04%. Zacks expected earnings growth in '07 to be 10.52%, while more recent predictions have been "high single digits." It could be said that the S&P was "slightly overvalued" at the end of 2006. If these deceleration numbers are accurate, then it REALLY looks overvalued now!
A peek at the technicals of the market is at least as disturbing. Technical analysis is the viewing of past performance in an effort to glean a hint of where the market is headed in the future. It is not an exact science and in fact is often DEAD WRONG, but it does provide some hints and the strength of the signals given can usually be calibrated in some fashion.
Here is a chart of the last year's S&P 500 action:
Last summer we moved down to the 1225 level in the S&P, rebounded for a bit, tested that low again and then began to move higher - a move that persisted until the end of February. This is a common pattern - what is called a "double bottom". The decline going into the bottom last summer, however, was fairly orderly - it was not so much a plunge as a slide over the course of a month or so.
In February we fell off a cliff. We then tested that low and breached it, then retraced about 3/4 of the loss and failed in the advance at that point. This is fairly negative signal and in fact is sometimes thought of as a "double top", although the more "traditional" pattern retraces all the way back to the top and meets resistance there. What tends to back this, however, as a potential "double top" is the small dip in the middle of February that preceded the plunge - the advance failed there at that point of resistance.
A look at the two year chart shows a similar plunge in October of 2005, but that one was followed by a retracement which did not stall out and a subsequent solid advance.
Going back even further, to the tech bubble days, we see a more ominous trend. The bubble saw S&P numbers near 1550 at the peak. Those values have not been seen since, and the retracement from those highs was almost fifty percent! Perhaps most importantly, as we approached the 1500 level the advanced stalled and then failed, and has failed a retest.
Look at the present day chart, it appears that the trend remains solidly down. If you draw a line from the top of the recent highs through the failed retest, you see a downtrend line that remains unbroken - with lower highs being taken since that failure.
In addition volume on up days has been notably weaker than on down days. Markets (or individual stocks) rising on weaker volume is not a good sign. It means that prices are rising more because of fewer sellers than lots of buyers. Volume shows conviction behind the move and is an important confirmatory signal that the move you're seeing is "real".
And, as we sit now, it appears that MACD (momentum) is turning negative.
What does all of this mean? In my opinion, it means we are headed for lower markets. On a technical analysis perspective I would expect a retest of the lows of February in the 1370 range. If that is violated, and especially if it is violated on heavy volume due to a geopolitical or business blowup of some sort (say, in the mortgage lending space) we could very easily find ourselves back in the 1220 range within a very short period of time.
This would be a roughly 15% haircut on the broader markets.
Of far more serious concern is the possibility that we fail at the 1220 range. That would put the next real support at the 1175 level and, below that, around 1130. The latter would represent a 20% correction.
There is VERY STRONG support around 1070-1090 - failure there takes us under 1000 in very short order, potentially all the way back to the lows of the crash near the 790s!
Finally, and possibly most importantly, the yield curve in US Treasuries is present inverted, although mostly at the very-short maturities. This has an extremely high correlation with recessions. While this signal has dissipated a bit in the last couple of weeks it is still worrisome - until a more-normal appearance resumes this is a signal that you must pay attention to due to its very high predictive value.
Will it start Monday? This is not possible to know. It is entirely possible that we will first see yet another attempt at an advance, or even two or more. But unless we can break out above the mid February highs in the S&P 500, from a technical analysis perspective the trend is downward!
When you add to all of this the economic background issues I just don't see higher markets in the near future, nor do I see support for the "quick recovery" we had going into last fall that led us to the highs we recently enjoyed.
Now will the worst happen? Not necessarily. But what I believe, and what I've planned for in my portfolio at the present time, is that we're going to see:
So what do you do if you're in the equities market right now and fearful of trouble? Here's my take:
Remember that in a down market capital preservation is critically important. When the 2000 crash came the indices fell 50%, but many people lost far more than half of their portfolios.
DO NOT ATTEMPT TO BOTTOM FISH! Several associates of mine thought "the worst was over" when tech stocks were cut in half, bought in heavily, only to see them collapse to 10% of their former price - or go underwater entirely! If you miss the first 5-10% of the upswing when this is over but only take 10% of the loss that everyone else suffers you will be so far ahead you won't care about not "calling the bottom." There is almost no chance of being right about when "it's over" - if we do see a recession I would not be heavily back into equities on the long side until there is at least one full quarter of solid earnings growth behind us. Until then, I'm remaining defensive.
This sort of down move tends to be violent, unanticipated until its well underway (at which point you've already taken BIG losses) and impossible to get good insurance against at any sort of reasonable price once it begins. Therefore, if you are going to hedge your holdings against this sort of damaging market downturn you need to do it BEFORE the plunge occurs - its too late once it starts as the premiums will go through the roof just as they would if you could buy insurance a day before a hurricane was to hit your home!
There are some who believe we are headed for a full-on depression. I am not so cynical. I do, however, believe that we are looking at a deep and quite-possibly prolonged recession, followed by several years of very slow economic growth. I also believe that there is no chance that the housing market is going to see any material turnaround until 2010.
Mistakes by policy and lawmakers could make the situation far worse, but are unlikely to make it better - the seeds of this problem were sown in the years after the 2000 tech explosion when money basically became "free" (I enjoyed it just like everyone else - I bought a new truck in 2001 with zero interest for three years and no money down), and now the chickens have come home to roost.
Where We Are, Where We're Heading (2013) - The annual 2013 Ticker
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