The S&P 500 has dropped over -5% in the last three or four weeks. The reversal from up to down occurred at a point that hosted well known resistance levels. Technically speaking, this is bearish. How about other facts? Are the July lows in danger? Here’s a common sense, simple math approach to the subject.
1+2 =2. 2+2=4.
The simplicity and accuracy of those calculations is undeniable. How about this equation?
Fundamental Weakness + Technical Sell Signals + Overpriced Stocks = Lower Stock Prices. This calculation also seems to be simple and accurate. Let’s look at some equations that don’t make sense.
1+1=3 … or Better Earnings = Higher Stock Prices
Earnings season is over. Most companies beat earnings but issued cautious forecasts. This is particularly true of the tech sector as indicated by the Technology SPDR (NYSE: XLK) and financial sector as indicated by the Financial Select SPDR (NYSE: XLF). By and large, profits are still driven by cost-cutting, not organic growth.
Retail sales, which make up about one third of the economy, continued to fall after the second quarter ended. Additionally, the expectation that taxes will go up might have moved some companies to pull some of next year’s income into this year. This can’t be good for Q3 and Q4 profits.
As the chart below shows, positive earnings reports are not bullish for stocks as indicated by the Vanguard Total Stock Market ETF (NYSE: VTI), especially if future guidance is weak.
2+2=5… or Weaker than Expected Economy = Rising Stock Prices
On July 30, the Bureau of Economic Analysis (BEA) lowered the previous quarter’s Gross Domestic Product (GD) growth from an estimated 2.7% to 2.4%. But it didn’t stop there. The real GDP for all three previous years was revised as well. It was lowered by 0.2% for 2007, it was lowered by 0.6% for 2008, and it was lowered by 0.4% for 2009.
In percentage terms, the real GDP for 2007 was revised down from 2.5% growth to 2.3%. The 2008 decrease was lowered from 1.9% to 2.8% and 2009 growth was revised up from a 0.1% to a 0.2% increase. In essence, the BEA proved that the recession was (or is) much deeper than perceived and the alleged recovery much weaker than previously reported.
This comes as no surprise, as the key sector of the financial debacle – real estate as indicated by the iShares Dow Jones US Real Estate ETF (NYSE: IYR) – remains in a funk.
The U.S. Census Bureau reported that the number of vacant properties, including foreclosures, residences for sale, and vacation homes, reached 18.9 million. Fannie Mae and Freddie Mac continue to lose money.
Has anyone ever wondered how banks can make money on the same kind of loans that pushed Fannie and Freddie to the brink of ruin? Since bad real estate loans triggered the post 2007 economic meltdown, how can the economy recover without real estate leading the way?
3+3=7 … or Positive Analyst Estimates = Higher Stock Prices
A recent Associated Press article observed that “analysts only seem to hit the mark with their estimates in the strongest economic times (2003 – 2006).” Why? “The problem is that analysts get most of their information from the companies they cover. Corporate managers have every incentive to stay positive for as long as they can.”
Is that true; as true as 1+1=2? On April 26, the day the S&P (SNP: ^GSPC) topped at 1,219, the Dow at 11,258, the Nasdaq at 2,535, Bloomberg reported the following: “U.S. stocks cheapest since 1990 on analyst estimates.”
Contrary to analyst estimates, the ETF Profit Strategy Newsletter stated that “the potential exists that Monday’s high marked a significant top.” Since April, the broad market dropped as much as -17%.
In March 2009, with the Dow below 7000 and the S&P below 700, analysts lowered their earnings forecasts from $113 in April 2008 to $40. On March 2nd, the ETF Profit Strategy Newsletter sent out a Trend Change Alert and recommended to buy long and leveraged long ETFs such as the Ultra Financial (NYSE: UYG) and Ultra S&P 500 ProShares (NYSE: SSO).
If you care to know, analysts estimate that earnings for the S&P 500 will exceed their 2006 all-time high, in 2011. Based on that assumption, stocks are cheap. How about that for flawed math?
4+4=9 … or Technical Sell Signals = Higher Stock Prices
The 200-day moving average (MA) is one of the best-known technical indicators, as it provides delineation between technically healthy and sick stocks.
On May 20, the S&P closed below the 200-day MA for the first time since late 2007. Every attempt to rally and stay above it has since failed miserably. On July 2, the 50-day MA for the S&P dropped below its 200-day MA for the first time since late 2007. The same holds true for mid caps, small caps and nearly all individual sector indexes. For good reason, this is called a Death Cross.
Over the past ten years, the death cross has been accurate 75% of the time, with a 19.72% average return on six winning trades and 6.95% average return on two losing trades.
In addition to the Death Cross, there are two head and shoulders patterns, one in the making for over 10 years, and the other has the breadth suggestive of a major meltdown.
5+5=11 … or Overvalued Stocks = Higher Prices
As explained above, based on overly optimistic earnings estimates, analysts believe that stocks are cheap. Rather than basing a future outlook on estimates, it makes sense to use facts as a foundation for any outlook. Why add an extra variable to what’s already an unpredictable market?
Ask Yale Professor Robert Shiller, who’s done extensive research on the subject of valuations, and he’ll tell you stocks are historically overvalued based on the current P/E ratio. Compare today’s P/E ratio with the P/E ratio seen at major market bottoms, and you’ll see that stocks are overvalued by more than 50%.
Another gauge that doesn’t lie is dividend yields. A company’s dividends are a direct reflection of cash flow and financial health.
The current yield is 2.65% for the Dow and 2.05% for the S&P. Even value funds like the iShares Russell 1000 Value (NYSE: IWD) yield only a measly 2.08%. Dividends are close to their all-time low set in 1999 (we know what happened then). This means that companies are cash strapped or overvalued.
Looking at a long-term chart of dividend yields plotted against stock prices shows clearly that markets don’t bottom until dividends skyrocket. Just as ice doesn’t thaw unless the temperature moves above 32 degrees, the economy won’t thaw and show signs of life unless P/E ratios drop to, and dividend yields rise to, levels seen at major market bottoms.
The ETF Profit Strategy Newsletter includes a detailed analysis of four valuation metrics, along with short-term target ranges for stocks and the ultimate market bottom.
Based on simple math and common sense, the July lows are certainly in danger. But it doesn’t stop there.
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