I find it somewhat puzzling that the market would respond so positively to the reduction in Japanese rates to below zero. It is certainly not an indication that things are improving there or anywhere else for that matter. Ultimately, I think market action simply reflects an oversold condition and short covering. My model did not change in any significant way last week. Earnings indicator #1 is still negative and earnings indicator #2 is still neutral but it is now very close to going negative as well. Sentiment moved just slightly less bullish as the market rebounded. Valuation remains neutral. Market internals generally remain in a negative trend. I think it will be important to watch how the broad market does compared to the major averages in order to get a clue as to when this bounce will end. Momentum may carry the market a little higher but I expect new lows.
After some requests to add opportunities on the short side, I have tweaked my model to take advantage of those times when going short makes some sense. If earnings continue to deteriorate as I think they will, there should be some profitable short-side trades ahead. I am looking at two earnings indicators now: One looks at the percentage of stocks in my modified S & P universe that have posted positive comparisons in the latest quarter. That indicator is now bearish. The second indicator compares estimated earnings for the same universe one year ahead with estimated earnings one quarter ago. That indicator is now neutral. Overall, while not the most bearish possible, shorting is now active and going to the long side will require at least improvement in one of those earnings indicators. My sentiment indicators have improved dramatically as the market has suffered and are now bullish. Valuation has also improved but only to the neutral level.. It would require at least an additional 20% decline in stock prices to make my valuation indicator fully positive. My model after revision has been short and remains 30% net short. If one is less adventuresome, my model continues to call for zero stock exposure.
While it is certainly possible that a bounce could occur at any time, it is surprising that my sentiment indicators have not strengthened to extreme levels given the damage that has been done - especially to the average stock as the Value Line Geometric Average continues to perform horribly compared to the major averages like the S & P 500. Earnings are still classified as bearish and will probably remain so for some time unless economic activity picks up. Valuation has improved but only to a level that my model considers neutral. After some requests to adjust my model to take advantage of shorting, I will work on that and hopefully have something next week. For now, though, I intend to remain either in cash or 100% hedged.
After the worst opening week of the year in history investors are beginning to appreciate some of the negatives I have been addressing here. I did a thorough analysis of earnings last week and came up with the fact that I would rather use actual quarterly earnings recently reported rather than estimates that I think just basically follow what has happened rather than what will happen. I have posted a chart under Chart Of The Week. At the current time, and actually for a few months, earnings have been increasing at a declining rate and more companies are reporting lower earnings. My analysis is that earnings are now a negative indicator and my model's exposure to stocks will remain at zero until that situation improves. My other indicators, both sentiment and valuation, have improved because of the collapse last week but are still just neutral. We are way overdue for a bounce but my model suggests a zero exposure now.
Richard Moore, CFA
With my wife in Hawaii