April 2013 – Monthly S&P 500 Market Strategy Update

Here is our Model Price chart for the S&P500 for the market close on March 28, 2013:

S&P 500 Index with weekly price bars, and EBV Lines (colored lines).

S&P 500 Index with weekly price bars, and EBV Lines (colored lines).

Remember we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.

Isn’t this model price chart amazing!  Look what the market, as defined by the S&P 500 is doing.  The market looks like it has “melted” into our EBV+3 (red) line – see Economic Book Value (EBV) under Key Concepts.  Not only “melted” but also one has to ask, “Where is the variability (volatility) of the market?”  Remember these are weekly price bars!  The market has spent the last four weeks barely moving in terms of volatility.  You have to squint to see what the market has actually done relative to our EBV line.

What to make of this phenomenon?

EBV+3 has become the ceiling for this market at least temporarily.   The S&P 500 from the low of mid November (1343) to March 28, 2013 (1569) has climbed 16.8%, not including dividends.  As predicted in my earlier blogs the S&P 500 Index has reached EBV+3 or 1569.

So what happens now?

From my perspective three sceneries are possible:

Scenario 1: A good old fashion correction.  Remember what a correction is?  We haven’t had one for quite some time.  Queue the Europeans!  A correction in the S&P 500 would create value for traders and investors leaving room for the market to rally back up to EBV+3 maybe in the fall of 2013.  As I have written previously this would give the market a “saw-tooth” pattern, which has been in evidence for a good deal of time in the last four years.  (You can see our long-term Model Price chart contained in other blog, here.)

Scenario 2: The second way the market could create value is to have corrections within individual sectors.  Almost rolling corrections, if you will, where investors and traders seek out value and make returns as money rotates within these individual sectors and industries.  These rolling corrections can occur while the S&P 500 Index itself stays relatively calm and hugs our EBV+3 (red) line in the future.

Scenario 3: A positive transit of EBV+3 (red) line.

Which scenario?

The easiest scenario to discuss is Number 3.  As I have said in previous blogs I don’t feel it’s time for a positive transit of EBV+3.  Why? Time spent with model price charts and a guess, is my answer.  Major market indices usually like to hang around their EBV lines before a major transit.  The most popular model price chart formation – where price bars intersect with our EBV lines – I have seen is the “break-out pull-back”.  In other words, the market will have a positive transit only to break down through the EBV line only to have a secondary positive transit back up through this respective or aforementioned EBV line, in this case EBV+3.  All this market action takes time, especially with weekly price bars, so market participants have to be patient until the market does its thing.  I believe a late summer or fall positive transit – either primary or secondary positive transit – will give the market time from here to consolidate, wait on economic data, and get a sense of earnings over the next few quarters.

I will grant you Scenarios 1 and 2 are a variation on a theme.  To my mind, the market, from here, has to create value for investors, traders and maybe shake out some nervous longs. All individual sectors or sub groups in the S&P 500 are up significantly since the beginning of the 2013.  Certainly the consumer staples, financials and healthcare sectors are due for a rest or consolidation.  Will the dividend payers continue their upside action? What sectors will take over this leadership role when sector leaders consolidate?  Is it time for large cap technology companies to make a run?

Discussion of EBV+3

Some EBV lines are more important then others.  We have color coded EBV lines that have more significance and you will notice our EBV+3 line is red highlighting its’ worthiness.  I believe once the S&P 500 has achieved a valuation in excess of EBV+3 this will signal the US economy is strong enough to support and sustain an equity valuation level that allows individual companies to trim their super solvent balance sheets thereby creating additional equity valuations.  This positive feedback loop will help create additional valuation thereby further increasing valuations over a secular period of time.  Yes, a bull market! (I have discussed in detail this positive feedback loop in my blog “S&P 500 – Why the US stock market is going up (Part 2)”.)

I do expect the S&P 500 to have a positive transit of EBV+3 sometime in the future.  As I have pointed out the last positive transit of EBV+3 involving the S&P 500 was back in 1992.  This positive transit was a precursor of a major bull market from 1992 to 2000, an 8-year run.  I do expect a similar bull market in our future both in terms of longevity and gains of this prior “Bull Run”.  Yes, hard to believe but the math is the math.

If the S&P 500 Index were to crawl along our EBV+3 (Scenario 2) this would be good news for investors because of the compounding which occurs in the companies within the S&P 500, as we add earnings estimates, on a bottom up basis, while subtracting established dividends, calculating on a pro forma basis where our EBV+3 line will be next March of 2014.  We calculate our EBV+3 (red) line to be 1734 or some 10.5% higher than the close on March 28, 2013.  Not a bad potential return even after this market run from mid November to present, considering potential fixed income returns in the future.

Conclusion

Back in September 2008 the S&P 500 broke below EBV+3.  As at the end of March of 2013 we have traded back to EBV+3, some 4 and a half years later.  Increased valuation in equity markets is of a result of positive and correct fiscal and monetary policy no matter what the newspapers and bearish pundits say.  Indeed the US economy seems to have some positive momentum and equity valuations are increasingly recognizing this fact.  A positive transit of EBV+3 would be significant and a precursor of much higher equity valuations in the future.  We are on the doorstep of equity markets giving a positive signal that the financial wounds of the past are clearly healing opening the door for normal markets in the years to come.

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