First of all, I would like to congratulate our friends across the pond for their vote. I was moping around early in the week wondering why the polls showed them likely to remain in the EU. Longer term, I think the outcome will be a very positive one for the average British citizen. That is if it actually happens - I notice that the elites haven't given up and they are trying various ways to reverse the vote. In terms of stock market impact here in the US, the only obvious conclusion is that volatility will pick up until things calm down. I would caution, though, that I would much rather invest when valuation was more favorable. I have been fully hedged for a few weeks because valuation is so poor. While it improved again last week, it is still negative. It would take another 2% or so of decline before my indicator would allow a modest net long position. Earnings expectations remain positive and we'll have to wait and see if earnings are impacted in a significant way by events in Europe. Sentiment is improving but is still neutral. There is a good chance coming volatility will improve sentiment enough to justify a more bullish outlook from that indicator. For now, I remain 100% hedged.
In spite of the decline in equity prices last week, it was still not enough to move my valuation indicator from a negative position. Earnings estimates remain in an uptrend so a hedged position seems to be the best way to handle the risk of high stock prices. Sentiment measures are very mixed, with some indicators bullish and others bearish but the net result is just a neutral reading. All other things being equal, it would take an additional decline in stock prices of 2-3% before my model would move to a modest net long stock position.
Not much change in the market last week so valuation remains at very high and unattractive levels. Given the poor economic backdrop, this seems like a good time to be out of stocks or hedged if ideas are available that look attractive. Earnings expectations are for about a 9% increase over the next twelve months. That seems too high because reported earnings have actually been declining for the last couple of quarters. Sentiment factors are neutral with a slight negative bias. My model continues to show a zero net equity exposure. That will only change for the positive if stock prices decline or there is a large increase in anticipated earnings.
The S & P 500 was unchanged last week. However, that fact obscures some interesting divergences. First, the average stock, as measured by the Value Line Geometric Average, is still down around 9% from its high about one year ago. Secondly, the average stock has been doing better than the S & P 500 in the very recent past. This has caused valuation for the median stock to increase to the point where it is now negative. It could certainly go even higher but I question why that would happen given the current economic outlook. It is true that earnings estimates for the next year are still trending modestly higher so that will be a prop for the market as long as it persists. Sentiment remains just neutral. With valuation so poor, my model has moved out of the market entirely. I will go to a hedged position for the time being.
Richard Moore, CFA
With my wife in Hawaii