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Long-term, financial markets are driven by fundamentals. And in the medium term, they’re driven by the business cycle. That’s why your analysis should always start with both of these.
Right now, the stock market’s fundamentals are undeniably dire …
On a twelve-month trailing basis, the price-to-earnings ratio for the S&P 500 is currently a very high 59. And it’s headed much higher because corporate earnings are still collapsing.
A quick return to the record earnings of 2006 and 2007 is highly improbable for two reasons:
- Sales margins hit record highs during those years and are now down considerably. There is no reason to expect a quick return to these abnormally high margins.
- The financial industry contributed roughly one-third of all corporate earnings to the S&P 500 in 2006 and 2007. It will take many years for banks to return to this strength — if ever.
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| I expect it’ll take banks many years to recover from their monumental losses and regain their strength of 2006 and 2007. |
Other valuation measures confirm that stocks are not cheap. In actuality, they’re expensive! For instance, the S&P 500 dividend yield is 3.1 percent. Historically you should expect dividend yields above six percent to signal a long-term buying opportunity.
What About the Business Cycle?
We’re still mired in a recession. The best that can be said is that the economy isn’t shrinking as fast as it did during the past two quarters. So the reason for all the current ballyhoo and green shoot euphoria is an economy that is shrinking less along with the hope for a quick turnaround.
In this context, it’s probably good to know that most recessions were interrupted by at least one quarter of GPD growth, a rather big green shoot if you will. But these did not signal a turning point, and the recessions reappeared.
So investors should be careful in declaring victory and jumping aboard the bullish ship. Especially since this ship is being overcrowded again after the stock market’s strong rally of the past 10 weeks.
This sharp shift in sentiment is even more amazing when taking the technical situation of the stock market into account …
Technical Analysis Argues
For an End to This Rally
Technical analysis can give you very important hints to help you determine the markets’ future direction. However, I don’t use technical analysis on a standalone basis. I just consider it a very helpful tool to assist my fundamental work.
Here’s how technical analysis tells me that the rally of the past 10 weeks is probably not the beginning of a new bull market but rather a bear market rally that will be followed by renewed weakness:
- The stock market rally since March 9 showed rather weak volume. This is typical for a bear market rally.
- The stocks with the weakest fundamentals — the weakest balance sheets — and the highest short interest have risen the most. This is also typical bear market rally behavior.
- Most indexes in Europe and the U.S. have risen to major resistance areas. Most have touched their falling 200-day moving averages for the first time since May 2008. A falling 200-day moving average is the most reliable moving average to stop a bear market rally.
- Momentum indicators, like the Price Momentum Oscillator (PMO), my favorite, are extremely overbought. Right now they’ve rolled over and issued sell signals.
- Sentiment indicators show a huge shift since March. Bears are again a minority, both in relation to the stock market and the economy. Since sentiment indicators are contrarian indicators, this is an additional red flag for the overall bearish picture.
- Many bullish analysts show analogies with former bear market bottoms to prove their bullish point. They never use the 1930s as an analogy, why? If they did, they’d have to conclude that the market was on its way to new lows … right now.
- Since March 9, the stock market rally has the look of a wedge formation, one of the most reliable chart formations. On May 13, as shown in the chart below, the price broke below the lower trend line of this wedge and did so dynamically. This was a sell signal, marking the end of the bear market rally.
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| Stock market bears are in a minority … a red flag for the overall bearish picture. |
You Should Consider Getting
Out of the Market …
Now!
All of these points strongly argue that the rally off of the March 2009 low was nothing but a bear market rally. And now this rally seems to be ending.
In my opinion, this rally is your opportunity to get out of stocks you own.
Even if — against all likelihood — this rally should turn out to be the first wave of a new bull market, there’s no need to rush in. I would suggest waiting for at least some bullish technical signals, like a rising 200-day moving average, before buying.
Never forget: The biggest mistake investors made during the 1930s was turning bullish too soon!
Best wishes,
Claus
About Money and Markets
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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.
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