Market Analysis December 22 2013

Have We Topped Out?

Those who played the Fed drama from the long side this past week (or, even better, shorted the VIX) once again were rewarded. Even the most stubborn traders are beginning to get the hint. The brief knee-jerk downward move after the Fed announcement was incredibly perfunctory, showing that the Bears are getting worn out and rattled from all their abuse. The market remains dangerous, but the Fed is hammering home month after month that it has no intention of raising rates and no intention of doing anything again (as opposed to the horror of May 2013) to spook the market any more than it has to.

Having learned those lessons, what do they imply about the future? We need to decide if the market is over-extended, fairly valued, or under-valued. After that, it is up to random events, corporate earnings and overall economic realities to deliver our profits and losses.

Where's All the Money?

We are going to tackle this question, of market valuation, from a couple of different angles. First, the chart below, "Taper Fears Halt Fund Flows," is quite illuminating.The top panel, "Cumulative bond+equity+balanced flows," shows that when the uncertainty of taper talk started going into overdrive last summer, cumulative money flowing into bonds and equities went flat. That money is sitting under mattresses, in gold, or overseas. Or, perhaps, it is sitting somewhere else of significance to us. Which leads us to the bottom panel.

The bottom panel, "Money Market Mutual Fund Assets," shows a rise in money market mutual fund assets during the same period, since last summer. It started going up when Bernanke decided to scare the pants off everyone and sent REITs into a tailspin due to fears he was on the verge of madness suddenly allowing rates to rise. What a coincidence! Actually, it's no coincidence at all. Rather than stick money into bonds or equities while the specter of a market break and collapsing bond prices due to taper was hanging over everyone's heads, savvy investors were parking their money in that "someplace else," namely, the parking lot of money market funds.

Note also in that bottom panel what happens at the start of each year - 2010, 2011, 2012, and 2013. The money market funds go down. Where do they tend to go? Why, into bonds and equities! This is the "January Effect."

One might, in simplistic technical analysis terms, see the recent sideways action with a slight upward bias of money market fund holdings as being a bear flag for such holdings (Bullish for stocks, that is). If it is, the money market outflows easily could resume into 2014, at least to the lows of earlier this year. If that happens, then the market will start to run out of ammunition. But it has to happen first.

Taken together, these two panels suggest to me that there is a lot of money sitting on the sideline because the Average Joe has not trusted the gains we have seen since May, when Bernanke made such foolish comments that spooked the market badly. Joe's been waiting for the other shoe to drop ever since, which would cause an avalanche of selling, enabling him to get in the market at choice lower prices. The problem with that thinking is now plain, as Bernanke and company actually did learn something from last May and this time dressed up their mini-taper and made it seem almost like a non-taper. The market spurted higher, and once again Average Joe is left with his pile of money in his money market funds, watching the market run away from him yet again. Will he finally give in and start moving some of that money into stocks and bonds? What do you think?

Market volume has been atrociously low during this period. Average Joe is too scared to risk his money, so primarily the pros are benefiting from this market rise.The pros are counting on the "dumb money" to start flowing into the market again.

In summary, the top panel suggests that the flow of money that was interrupted over the past six months could easily resume it's upward trajectory. The bottom panel shows where such money is available and ready for action.

Is the Market Pricey?

Our other approach to valuation is a historical one. The market fluctuates in value over time between extremes of prices as a ratio to corporate earnings. The correlations are astonishingly similar over a span of 150 years - when the same limits are reached, the same things happen, over and over and over.

The above chart, courtesy of dshort.com, "Real S&P Composite: 1871-Present with P/E10 Ratio" is informative. It shows that the market tends to bottom in roughly the same area, 4-8 PE/10, while it tends to top in a similar zone, 22-44 P/E10. P/E10 is different than straightforward P/E only in the use of a 10-year average of real earnings.

Currently, the S&P P/E10 is shown as 24.7. This is within the zone of previous market tops, though in the lower part of that zone. This chart suggests that the market is fully valued, in fact could be getting toward over-valued. However, it also shows that the market is not in bubble territory such as in 1929 or 2000. The uptrending regression line also suggests that the market is relatively less over-valued now than it has been at previous such over-valuations in the past, i.e., the market has tended to become more comfortable with slight over-valuations over time, making them less over-valued. Whew.

The bottom line is that earnings are vital to carrying the market higher. The January earnings season this time around is incredibly important, perhaps much more so than usual. A good earnings season will help to justify current valuations and pave the way to higher ones.

Let's look at another chart to see how over-valued the market might be, or whether the chart above is simply scaring us.

This chart, courtesy of Business Insider, "Markets Chart of the Day," shows the S&P 500 Forward 12-Month P/E Ratio over the past 15 years. The three horizontal dashed/squiggly lines are: 1) the 5-year average at 13.0; 2) the 10-year average at 14.0; and 3) the 15-year average at 16.2.

First off, the 15-year average is skewed a bit higher than the others because of the Dot.com mania. However, that period of time is as much a part of stock market history as the catastrophic collapse of spring 2009, so don't discount it too much.

What this chart shows us is that the market currently is fairly valued. In fact, if we throw out the 15-year average for the reasons above, it is slightly over-valued. However, the market has been much more over-valued in the past, as you can see on the chart itself. If it is currently over-valued, it is not over-valued by much. That suggests that current valuation is of little significance in predicting future market direction. In fact, it is quite reasonable to conclude that for a market to get very overvalued first has to be a little over-valued, so a little over-valuation is a necessary precursor to much higher valuations later. Or, the market could get spooked by earnings, realize it is slightly over-valued, and tumble until it is under-valued.

Notice the double-bottom on the lower chart, when the market actually did get under-valued. That happens during times of sheer panic. We see no signs of such panic brewing because of fundamentals at the moment that are comparable with the housing etc. crisis of 2008 (the "Great Recession"). The economy may be sputtering a bit, but it is absolutely undeniable that it is in recovery mode. That is when it tends to head towards becoming over-valued, as it did following the recession (not so "Great") of 1990-1991 and the Recession of 1982.
Taken together, the valuation charts suggest that the market is properly valued, but it is nowhere near a bubble state. It very easily could get a lot more over-valued, i.e., go higher from here. Valuation really is not a determinative factor in this middle range of valuation.

Bottom line: there is no reason to think the market is going to abruptly stop increasing its valuation here - though anything is possible. Betting your money on the market suddenly coming to its senses and realizing that it is getting ahead of itself, and collapsing because it has a moment of Jungian clarity, is a great way to lose that money, though anything is possible.

The Nikkei

The Nikkei 225 is a market that you ignore at your peril. It is where a lot of US funds are parked, and it is easy to invest in, directly through Japanese stocks that trade in the US like SNE, or through ETFs and the like which track it and other Japanese indexes. The unhedged EWJ is perhaps the largest and most well-known such fund, but there are many others.

If you aren't invested in the Nikkei, but are curious, consider hedged funds such as DXJ and DBJP. The reason to consider a hedged fund is that the Nikkei 225 and the Yen have a very strong tendency to move in opposite directions. If you are unhedged, a large fraction of your gains from a move higher of the index will be wiped out by a depreciating Yen (though, should the Nikkei fall, that implies an appreciating Yen, which would cushion the blow to your portfolio). Do your own due diligence, don't make investment decisions without it.

Many analysts are projecting the Yen to weaken substantially over the coming years. That implies a strengthening Nikkei 225.

I don't have a lot to say about where the Nikkei 225 currently is that the chart below doesn't say, so let's have a look.

As you probably don't need me to say, but I will anyway, the Nikkei currently is at a hugely important juncture. It has been in a megaphone pattern since its collapse in the early 1990s and is hanging at the very top of that pattern.

Megaphone patterns are usually considered topping patterns. However, in this instance, that's not very likely, considering this megaphone followed the epic collapse of the bubble of the 1980s. This megaphone is much more likely to be a reversal pattern, so that when it is breached, it will show a distinct change of trend. The change of trend here would be higher.

Without going into a lot of fundamentals, the Abe programme in Japan appears designed to bust the Nikkei 225 higher by stimulating consumption and exports by depreciating the Yen. Unlike in the US, the Japanese monetary stimulus is just beginning. It literally has years to go, and traders know all about what the US QE did to US stocks. If the Abe stimulus affects the Nikkei 225 anything like the US Fed QE experiment affected the US markets, the Japanese markets could shoot higher for some time to come. Of course anything is possible, the downtrend line could hold, and the Nikkei 225 could fall to new lows. We need a break above 16000 for confirmation.

So, minus all the gobbledy-gook, the bottom line is: if the trend line shown is breached, that would be very Bullish for the Nikkei 225. A break above 16000 is going to trigger an awful lot of buy stops by robots around the world, and a break back below 13000 would trigger an awful lot of selling. Be on the watch right now for any break above 16000, which the odds (fundamentals) seem to favor happening.