My best guess is that the market will continue to consolidate or move somewhat higher in the short run because small investors and speculators are still very bearish and, therefore, my sentiment indicators are very bullish. Earnings, however, remain on the edge of collapsing but have not done so yet. Last week's results were up marginally for estimates one year out. Earnings as reported have been declining for many weeks. My model considers earnings as the most important component so it continues to call for a small short position. I don't like to get into politics but this week could be important for the economy and stock market going forward. If we end up with a race between Trump and Clinton for the Presidency, I don't think investors win either way. Neither candidate is a free trader and we know what can happen when trade wars get going. It could get ugly.
As I mentioned last week, it was just a matter or time until the oversold condition of the market was corrected. I probably should have paid more attention to the extreme position of one of my sentiment indicators but the overall picture remains the same. My earnings indicators show one bearish and the other just barely hanging on to neutral. Valuation remains neutral and sentiment is still positive but not extremely so after last week's rally. My Elliott Wave buddies tell me that we are in minor wave two now - to be followed by a disaster known as wave three down. If earnings don't improve, I'm afraid they could be right. My model is still very cautious and calls for zero exposure or a modest short position.
At some point a rally like last Friday's will be extended just on the basis that we have declined too far - too fast. That could happen at any time but it would just be a temporary rally unless something more fundamental can change. One of my earnings indicators remains solidly bearish and the other is still neutral but on the verge of going bearish also. It is going to be very hard for a sustainable rally to occur if earnings expectations are declining. This is especially true when valuation is only neutral as it is now. Sentiment is the one bullish factor but it is not bullish enough to change stock exposure on its own. My model remains negative and suggests avoidance of equities until conditions improve. For the more adventurous, a 30% net short position continues for another week.
When things go wrong in this market it can be very painful. This is especially true if one happens to own a popular high-flyer like Linked In. It was down 40+% in one day last week after some disappointing comments about future earnings. I would expect more disasters going forward as my model continues to hold a negative or zero exposure to equities depending on how aggressive investors want to be. There were no changes in my earnings indicators last week - they are still negative and neutral. Valuation improved marginally but is still neutral. Sentiment actually turned a bit less bullish last week as small investors and speculators became just a bit less concerned. They probably are waiting to see if we will hit new lows before panic mode kicks in. My model shows a negative 30% stock position again this week.
Richard Moore, CFA
With my wife in Hawaii