Another Bullish Stock Market Indicator
August 31, 2011
David R. Kotok
As readers know, we are arguing that the August 9th intraday level of 1100 on the S&P 500 Index was, at least, an interim selling climax, and may have been a final climax. In an earlier piece (see www.cumber.com) we cited a First Trust Portfolios LP, August 11, research study. It showed that down days of greater than 6% were followed, after an appropriate period of time, by much higher stock markets. Today we will add another indicator to the list of support for the climax thesis. This one is compiled by Jason Goepfert and is rooted in an economic survey released by the Philly Fed.
First, a reminder: we do not know whether the August 9th intraday low was an interim climax or a final climax. We will not know that answer for another six months or so. What we do know is that it was subsequently tested twice in the futures market, and the 1100 level held. Since those tests, the S&P 500 Index has rallied to 1212, which is about 10% above that intraday bottom. The trend seems to be positive.
Overhanging the stock market are countless forecasts of recession. Many super-bears have high probabilities of recession. You will find them frequently quoted in print. You will hear them on radio, and witness them on television.
We are not among the super bears. We do not forecast a super-recession in 2012. Our view is that the economy was at its weakest in the second and third quarters of this year. Part of that weakness was attributable to supply-chain interruptions that originated in Japan. These interruptions will have run their course by the end of the third quarter, and the reversal effect will be in place during the fourth quarter.
Weakness is also attributed to the political wrangling we see in Washington and the uncertainty it creates. In addition, we now face the weakness effects of an earthquake and Hurricane Irene. This, too, is rapidly becoming old news.
We look past the negatives and are more optimistic. For the fourth quarter of this year, we are taking up our growth estimates. We believe there will be a kick to GDP growth coming from the repairs and recovery after the earthquake and the hurricane. Meanwhile, Federal Reserve Chairman Ben Bernanke has also made monetary policy very clear: very low interest rates will be sustained for quite a while. All this is bullish for the stock market.
Let us turn our attention back to those markets.
Jason Goepfert, President of SentimenTrader.com, has another, somewhat obscure but important indicator. We thank Jason for permission to share it with our readers. Inquiries about Jason’s work may be directed to him at www.sentimentrader.com.
Jason examined the Philadelphia Fed Index, an index that, in part, triggered the recent serious stock market selloff. This weakness of the Philly Fed Index was used by many to support their forecasts of coming recession. Jason said, “Well, maybe when things are ‘so bad,’ they actually get ‘good.’” He examined the Philly Fed readings since 1968. Ninety-five percent of the time when they were below -30, that is to say, a negative indicator worse than thirty, the S&P 500 Index showed a positive return one year later. That was true on nineteen of twenty occasions. The median return was approximately 23%. The only exception was during the collapse of the tech stock bubble in January 2001.
There were twenty events, with nineteen of them being bottoming indicators. At the time of each of those events, the Philly Fed index was cited by some forecasters as an intense and negative economic indicator. However, many negative economic indicators are coincident with bottoms, and the Philly Fed survey may be one of them. They point towards activity when things are at their worst.
At Cumberland, we think the time to acquire positions in stocks is when they are discounting the most negative outlook. In our view, there is a good chance the August 9th low was the final selling climax. However, we reiterate that we are not completely certain of this.
Separately and strategically, stocks are inexpensive in our view. Why do we say this? If you value the earnings of the S&P 500 in 2011, you can estimate that $95 will reflect the operating earnings when this year is completed.
Even if there is very slow growth for the next seven years, by the time we arrive at the end of this decade, it is likely that the GDP of the United States will be approximately 20 trillion dollars. From that GDP will come profits for American companies. We can make some very conservative assumptions about them. At the end of the decade and with 20 trillion GDP, the profits will be higher than they are today when the GDP is 15 trillion. Remember, those profits are the source of the S&P 500 earnings.
If you take the earnings of American companies as represented by the Standard & Poor’s 500 Index and you test them against the riskless returns on either cash, where the return is near zero, or the 10-year Treasury, where the return is 2%, you can compute what is called an equity risk premium. This is the difference between the riskless return and the return you get from the earnings of companies. It is irrelevant whether those companies retain the earnings and reinvest them, or use the earnings to buy their stock back or pay those earnings out in dividends. What each company chooses to do is a stock-specific issue, while the aggregate of the S&P 500 and its earnings helps you compute the equity risk premium.
Is US history, it is a very rare occurrence when the equity risk premium is somewhere around six or seven full percentage points, that is, six hundred or seven hundred basis points. When this has happened, it has represented one of the great buying opportunities in the stock market, in a strategic sense. This measure does not help you decide to trade on Tuesday or Wednesday; it is not a day-trading tool. It is a strategic valuation tool.
To sum this up: we see the equity risk premium as an attractive valuation metric. We see Jason Goepfert’s analysis of the Philly Fed as an economic data-based indicator that the stock market is poised for a strong recovery. We see the same thing with the First Trust sentiment-based measure about 6%-down trading days. We also see the characteristics of a panicked selling climax on August 9th. To us, the evidence says the odds favor being invested in stocks.
Cumberland Advisors’ equity accounts remain fully invested in our diversified exchange-traded funds strategy. In our balanced accounts we have raised the equity weight and lowered the bond weight. With ETFs, we use a core satellite approach. We use several broad-based ETFs as well as industry and sector ETFs. We are bullish in our long-term outlook. We believe there is a high likelihood that the Standard & Poor’s 500 Index will be above 2000 by the end of the decade, and it may be much higher.
Happy Labor Day.
David R. Kotok, Chairman and Chief Investment Officer