May 2013 – Monthly S&P 500 Market Strategy Update

Talk about a market rally!  (US equity market that is!)  Since mid November 2012 the market, as measured by the S&P 500, has rallied almost 18% to May 1, 2013.

As I have been noting in my “Monthly Strategy Update” blogs, I have been foolishly calling for a correction as my most likely scenario.  Well, so much for this most likely of my guesses. (see blog)

Let’s first review our model price chart of the S&P 500 Index.  First our short-term model price chart (weekly price bars).

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

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

For perspective I have included our long-term model price chart (monthly price bars).

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

S&P 500 Index with monthly price bars, 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 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.

S&P 500 Positive Transit of EBV+3

As you can see in the above model price chart the S&P 500 had a positive transit of EBV+3.  This is AMAZING and we should stop and ponder its implications.  Our EBV levels are about valuation.  Collectively in a capitalized weighted index known as the S&P 500 equity prices are increasing in terms of valuation – equity asset prices are increasing.  Whether this is occurring because of corporate profits, good government policy or market participants searching for yield does it really matter?  Some market professionals think there are negative reasons for this unexplained (according to them) market rise but I would like to point out these persons exist in every market cycle and receive considerable ink from the financial press.

As I have stated in previous blogs this is the first time the S&P 500 Index has had a positive transit of EBV+3 since mid 1992.  Our long term chart unfortunately doesn’t go back this far, and you have to take my word for it, but you can see from our model price chart how the market increased from 1995 to 2000 subsequent to the positive transit of EBV+3 in mid 1992.  Am I saying this will occur again?  What I am saying is you have to think of this possibility – the possibility of a long-term secular bull market in US equities.  Is there anyone else saying this?  No one I know!

Risk and Reward

Markets and individual stocks are about risk and reward.  Obviously good investors want to minimize risk, wherever possible, and maximize reward.  This is what our EBV lines are all about.  Making purchases close to support or our EBV line minimizes possible downside risk in that if there were a down transit of this same EBV line this would be an excellent sell point for your position or investment.  In other words market prices don’t have to fall very far to let you know the position should be sold thereby not placing a significant portion of your capital at risk.

What am I saying?

The risk and reward of the US equity market has changed.  With the S&P 500 Index trading above EBV+3 the risk is minimal and the reward is EBV+4 or 1980 in the above S&P 500 model price chart.  That’s an upside of a further 25%.

Even if the market trades along EBV+3, this implies a return of 10.5% plus dividends.  (How did I get 10.5%? EBV+3 one year from May 1, 2013 is 1749.  We get this number by inputting all the balance sheets of the underlying companies in the S&P 500 Index, add estimated annual earnings on a bottom up basis less projected dividends for the year and calculate EBV+3 one year hence.)

Traffic Light turns Green!

Back in a blog post last August (here) I started to use a traffic light analogy in terms highlighting and/or quantifying the risk level for investors/traders.  In my initial assessment I thought the traffic light should be yellow to signify caution.  Why?  The S&P 500 Index traded under EBV+3 signifying limited upside (to EBV+3) and a big downside to EBV+2.  Now, with the positive transit of EBV+3, the downside risk is EBV+3 and the upside is EBV+4, some 25% higher.  I do have to emphasize these general market calls which I blog about are secular (long term) in nature and will last until the market moves significantly higher changing the risk and reward characteristics which I have highlighted above.

What if the S&P 500 has a down transit of EBV+3?

The S&P 500 potentially could negatively transit below EBV+3 for a period of weeks maybe a few months, in what I call a “break out pull back”.  A “break out pull back” formation is common in model price work and very bullish when there is a “re break out” or a positive transit of EBV+3 for a second time.  Traders can be quick to make profits from such an event, but long-term investors should ignore such market gyrations and hold quality equities for the long-term.

Conclusion

For the month of April, 2013 the S&P 500 Index had a positive transit of EBV+3.  This is an historic occasion in our model price work and noteworthy.  The traffic light is “green” in that the risk and reward for long-term US equity investments is heavily skewed towards the reward side of the ledger.  In other words, the proverbial wind is at your back when choosing quality US large cap companies.  This could be the beginning of a secular run in US large capitalized equities that could last years.  And of course this positive transit doesn’t preclude some future hiccups in terms of monetary policy, and a million other macro considerations that have yet been imagined or forecasted but the market is speaking to you and it’s saying as of today and the foreseeable future all is well!

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