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Big Divergences Are Negative

7/13/2014

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Whenever the vast majority of stocks perform much more poorly than the major averages, it is a cause for concern.  Last week was an example and, actually, the whole year to date period shows similar negative divergences.  With the Russell 2000 now negative for 2014, I wonder how long the averages can hold up.  My model is as negative as it can get in a period of rising earnings estimates.  I am taking a fully hedged position again.

Earnings:
I am beginning to add in 2015 earnings expectations now that we are in the final half of the year.  This weighted estimate for 2014-2015 is still in an uptrend. 
As long as this continues, my first earnings indicator is positive.
Looking at earnings 52 weeks ahead, estimates are also in  a clear uptrend.
With both indicators positive, earnings exposure remains at 100%, same as last week.
Looking at the gap between last twelve month earnings and future 52 week projections, the gap has
reached negative levels and that gap is increasing.
The large and widening gap dictates a reduction in the earnings factor by 25%.
Total earnings factor exposure and maximum total exposure remains at 75%, same as last week.

Sentiment: 
The equity put/call ratio continued at very low levels last week as put buyers are still missing.
Exposure remains at -10%, same as last week.
Small option buyers are also very bullish but still haven't crossed into extreme territory.
Exposure remains at 5%, same as last week.
NAAIM managers stayed all in last week.
Exposure remains at -10%, same as last week.
When two of my sentiment indicators are maximum bearish and the other one is neutral or
negative, I assign a sentiment factor reading of -10%.
This is the same as last week.

Valuation:
My long term valuation indicator remains negative as expected stock returns over the next 10 years
are still below the yield on the ten year treasury and are actually now below 2%. 
This factor continues to call for 0 equity exposure.
Percentage of stock prices represented by net current assets remained the same last week.
Exposure remains at 0%, same as last week.
Comparison of stock earnings yield to ten year treasury yield increased last week.
Exposure increases to 50%, up from 30% last week.
Total valuation exposure is 17%, up from 10% last week.

To get a combined exposure for these three factors, I multiply them together and then take the cube root. 
However, since the sentiment factor is -10%, I assign an overall exposure for the three factors           at -10%.  This is the same as last week.

Technicals:
My comparison of yields on treasury bonds compared to lower quality corporates held in a modestly positive position last week.
I add 10% to account for this factor. 
New highs - new lows on the Nasdaq remained positive last week. 
I add 20% to account for this factor.
My trend indicator for new highs - new lows on the Nasdaq turned negative last week.
 I subtract 25% to account for this factor.
Total technical adjustments this week are +5%, down from +30% last week.

After adjustments, total exposure for the week is -5% or, after rounding, 0%.
This level of exposure does not exceed the current earnings cap and is down from 25% last week.

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