What’s Wrong with this Picture? (Stock Market Edition)

Since the market low in March 2009, the U. S. equity market has “climbed a wall of worry,” up more than 120% from the bottom through year-end 2012.  Yet until quite recently the bulk of new savings dollars flowed to bonds, not stocks.  A huge amount of cash remains on the sidelines, in money market instruments paying next to nothing.

In January, that picture began to change, with significant cash flows into the equity markets.  Is this the start of a new bull market, or only the end of a recovery rally within a long-term secular bear market?

I’m going to offer several data points, some making a bullish cash for equities, some a bearish case.  As I did with the election, I’ll list them in order of my perception of declining reliability, and note whether these are bullish or bearish indicators:

Here are a few of the arguments, just from the last two weeks:

There are few persuasive alternatives to stocks.  The universe of cash and bond investments yield too little to preserve lifetime purchasing power.  Cash has never been a successful long-term investment, but in the wake of QE3, with cash yields near zero for the foreseeable future, those with dollars on the sidelines are beginning to  understand their plight.  If they don’t buy now, when will they?  (Bullish.)

Portfolio managers are playing catchup.  With lots of dollars on the sidelines, earning nothing while the equity markets race toward new highs, money managers face pressure to get invested.  (See my recent post on hedge funds.)  Several smart folks make this point, but unfortunately Jim Cramer of CNBC’s Mad Money agrees.  Normally I would score this one bullish, but given that  Cramer is an utter horse’s behind, having him along for the ride is a bad sign.  (Neutral.)

Bullish sentiment is high.  The AAII Bull Index (American Association of Individual Investors) is in the top 5% of observed, the Greed Index is at a super-high level. Newsletter writers are also very bullish, and there have been ‘The Bull is Back’ headlines in several prominent financial publications. (Bearish.)

Cash is finally flowing into equities.  (Bearish, though if this is a bull market, and not a bear-market rally, we would expect to see much more than one month of positive equity flows before a final market top.)

The Dow Theory just issued a buy signal.  The Dow Transports hit a new high, following a post-crash high for the Industrials.  (Bullish, and less utterly meaningless than most technical indicators.)

The January effect:  As the market goes on the first trading day of the year, so goes the week.  As the market goes in the first week, so goes the month of January.  And as January goes, so goes the year. The S&P 500 was up 2.5% on January 2, up 5.2% for the month, the best start since 1997.  Since 1950, this indicator has only failed seven times, most recently in 2001.  (Bullish.)

The market is expensive.  Earnings are at an unsustainable high as a proportion of GDP, and those who think the market still has room to run are counting on the fantasy of  “forward operating earnings,” which are both meaningless and unpredictable.  When earnings mean-revert, the S&P will give up at least half of its post-2009 rise.  (Bearish.)

The market is cheap.  Priced against projected 2013 earnings, the S&P 500 is trading at only 13 times forward earnings.  Strong earnings growth and a return to the 2007 peak multiple will carry the market 16% higher in 2013.  (Bullish.)

The economy is strengthening.  Real estate prices are recovering, inventories of unsold homes are falling, and both consumers and business are spending more.  (Bullish.)

The economy is running out of steam. Jobless claims are up, as is unemployment, and the economy actually contracted in the fourth quarter.  (Bearish.)

Event risk remains high:  There are multiple potential market-crushing events on the horizon, including a debt ceiling fight in three months, another fiscal cliff showdown when the automatic sequester comes back into play, renewed European instability, the U.S. debt time bomb, a possible Israeli attack on Iran…and the beat goes on. (Bearish.)

Things are quiet in Washington.  Congress avoided default by temporarily raising the debt ceiling, and kicked the can down the road on spending. Could we be entering a new era of bipartisan compromise? (Bullish.  Until the next battle between two sincere, committed and incompatible political philosophies.)

The election cycle.  Historically, the first year of a Presidential term is on average negative for stocks.   (Bearish, but meaningless. While this is true on average, it is wrong about half of the time.)

The Superbowl Indicator:  When the NFC wins, the market goes up.  AFC wins, markets decline.  The Ravens from the AFC East just won the Big Game.  (Bearish.  And we’re kidding here, right?  Time to re-read Fooled by Randomness.)

From time to time, clients will ask, ‘How do you make sense of it all?’  The answer is that, in terms of reading all of the contrary voices every day, we don’t.  Most of this babble is just noise, useless for making prudent investment decisions, and we ignore it.  Instead, we look to long-term valuation measures, and we track six different relative-value ratios day-by-day.If the day-to-day is noise, what is the signal?

In terms of valuation, we start with the CAPE (Cyclically-Adjusted Price-Earning ratio), developed by Robert Shiller of Yale University, which connects the trailing ten-year price/earnings ratio to subsequent ten-year performance.  This measure shows the market slightly above the historical average price, with a projected future return of about 7%. (Neutral to slightly bearish.  More on this in a future post.)

The measures referenced above that seem most interesting to us are the large amount of cash on the sidelines, which suggests the possibility of a buying panic at some point, against the sharply-improved investor sentiment, which suggests a strong possibility of at least a short-term pullback.

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