The headlines in the financial press say it all – “Dow 14,000”. Does this headline have any meaning? What, if anything, are you able to conclude from this fact? As one reads the story attached to the headline, the financial press are clever enough to find both a bull and a bear expounding on their views. The bullish money manager or market commentator says this is only the beginning and more gains will be forth coming. The bearish individual points out last year started the same way, before the big correction. Who does one believe?
As I have stated many times when I read the financial newspapers or online press I can feel my anxiety starting to increase. Doubt begins to creep into my thoughts of where the economy is heading, which has a big influence on the direction of the market. Then I start looking at my model price charts. All doubts and anxieties begin to disappear. This is what I want to happen to you. The math and just the math, free from opinion, will give you confidence. You will be able to see the whole playing field and be able to strategize the market and your portfolio.
So let’s have a look at our S&P 500 model price chart, as of Friday, February 1, 2013.
S&P 500 Index with weekly price bars and EBV Lines (colored lines)
For new readers, we aggregate all the companies in the S&P 500, by market weight into one model price chart, so we can see where the market – as expressed in the S&P 500 Index – is trading relative to its’ EBV lines.
Even though the market, as expressed by the Dow Jones Industrial Average (DJIA), has hit a nice round number – 14,000 – does this mean anything? Asked another way the S&P 500 index crossed over 1,500, like the Dow, the highest since 2007, does this mean anything? The simple answer is, “Not much”!
Don’t get me wrong; I think it’s great the market is moving in the right direction – up! But numbers on an index or index value is about as meaningless as astrology when it comes to markets. Just like our individual company model price charts, it’s about the interplay between the company’s share price and our EBV lines, which are derived from the company’s balance sheet. (Two independent variables interacting with each other.)
As the earnings growth in an individual company will increase the company’s balance sheet over time, the same is true for an index of any composition when viewed over time. So as the balance sheets grow in the companies underlying the index, say in the S&P 500, so do the EBV lines when looking at the model price chart of the S&P 500 index.
So viewing any index number, whether Dow 14,000 or the S&P 500 at 1,500, without looking at the underlying balance sheets or EBV’s, is kind of…. senseless.
OK, back to the model price chart of the S&P 500.
The S&P 500 Index closed at 1513.17 on Friday. EBV+3 for the month of February is calculated at 1567. That leaves an upside of 3.56% or 54 S&P points. EBV+2 on our model price chart is 1135 or a possible 25% downside from Friday’s close. (When at the top of any EBV zone you should always consider the downside or possible risk and judge yourself and your portfolio carefully. Markets are markets and you’ll never know what is possible until they happen.)
So this market has 3.56% upside and a downside of 25% as of Friday. So with trading and investing for the rest of the month I will have the above noted percentages in my head. Yes, I will say to myself every morning this month, “limited upside and lots of downside”, just to remind myself not to get too bullish as everyone, including the financial press and television, seems to be gearing up with excitement about equity markets.
Once we have the math of the current situation, highlighted above. Let’s strategize on some “what if” scenarios.
Scenario 1. My first scenario I highlighted a year ago and occurred throughout 2012. In this scenario the S&P 500 trades close to EBV+3 then corrects 5 to 8% and ramps back to EBV+3, which is higher over time because of the increase in the EBV lines with the growth of the underlying companies balance sheets. One year from this February or February 2014 EBV+3 is calculated to be 1729 or some 14% higher from Friday’s close. This saw-tooth action will repeat itself until the economic climate becomes stronger worldwide thereby increasing equity valuations, and with it a possible positive transit of EBV+3. I believe this scenario is still the most likely.
Scenario 2. A positive transit of EBV+3 would put the equity market in a whole different light. Certainly the preverbal glass of water would be half full instead of half empty. As I have stated before the last positive transit of EBV+3 occurred back in 1992, subsequent to the US S&L crisis and first Iraq war and stayed above this level until 2008.
Over the last year I considered this scenario highly unlikely because of the financials. All of the Too Big To Fail (TBTF) financials where trading below EBV-3 or “In the Blue” as we say at our shop. This was a very negative sign suggesting the balance sheets of these financials were impaired or unhealthy. Over the last few months, both JP Morgan and Goldman Sachs have had a positive transit of EBV-3, or as we say, “Coming out of the Blue”. This sign is very encouraging suggesting these financials, or the assets recorded on their balance sheets, are accruing value in the market’s eyes. Both Bank of America and Citigroup are still trading under EBV-3; along with much of the life insurance industry however their stock prices are fast approaching their respective EBV-3s for possible transits later this year. I still think it’s still too early for the S&P 500 Index to have a positive transit of EBV+3 however the market is the market and it will communicate to us whether it wants to make this positive transit. That said, I remain agnostic on this scenario.
Scenario 3. The S&P 500 Index trades down to EBV+2 is a risk one has to consider, as long as the S&P 500 Index trades at the top of this zone without a possible transit of EBV+3. Marc Faber, for example says the market will fall 20% – 25%, which I have to say is completely plausible according to model price and should be considered. Would I let this fact or scenario over ride my whole portfolio, and be negative on equities? No. Would I margin myself with maximum equity exposure because the market was making new highs, since 2007? No. Would I invest in equities that trade at their bottom EBV zones and with negative transits sell the position? Yes. Would I have cash put aside for possible purchases of my favorite equities at cheaper prices? Yes.
Traffic Light is still yellow!
In my August 6, 2012 blog I presented readers with my traffic light analogy. I stated the color of the traffic light would be yellow for caution. I have not changed the color of this light since its introduction. I have been investing and trading all year constantly looking over my shoulder. Yes, call me paranoid however the math suggests being paranoid is the best course of action. Unfortunately my most likely scenario, this saw-tooth action – Scenario 1, could last for years, as I have previously stated, but the good news is the balance sheets are always growing and EBV+3 will be 11% higher than they currently are next February.
P.S. I’m asked all the time what I think of the market or better still I’m given 20 seconds to explain my market views to a television audience. Sometimes I’m tongue-tied and other times I just laugh unable to color the nuances the market signals are giving through model price work as I have written in this blog. What you say? I would be interested.