YELLOW FLAGS ON EQUITIES

US equities have been rising almost non-stop since September 1, 2010, right after Ben Bernanke’s Jackson Hole speech. The S&P 500 Index is up 25% since then, a real blessing for the Fed’s QE2 program which is betting on a positive wealth effect from rising equity markets. Small caps have done even better with a 34% gain since August 25.

The S&P 500 Index has been toppish since mid-January. At 1285, it stands 6.5% above its 100-day m.a. and 10.3% above its 200 day m.a..

From a valuation standpoint, the Rule of 20 continues to point to 1500 on current trailing earnings of $79-80, for a 15-20% upside potential to fair value. This remains a good target for this year. However, the risk of a technical correction towards the 200 day m.a. is not insignificant, skewing the risk/reward ratio and raising a yellow flag for the shorter term.

Economic forecasts have generally moved towards more optimism recently, much like sentiment indicators on equity markets. Even notable bears have mellowed their stance.

Yet, problems remain and news will not always be positive. The Citigroup Economic One-Year Chart for UNITED STATES (CESIUSD:IND)Surprise Index has been rising sharply since September and is now at levels that have historically proven toppy. Recent weekly data on retail sales have been sluggish and employment, a key criteria for sustained positive economic trends, remains stubbornly weak.

The Philly Fed Business Conditions Index, designed to track real business conditions at high frequency, continues to suggest a muddling-through economy, warning of impending more negative economic data.

Plot of ADS Business Conditions Index in the Most Recent Two Years

Chinese equities have corrected 11% since early November. Commodity prices seem to have peaked and gold is testing many support lines.

Even leading stocks such as Apple and Google are showing signs of fatigue. We are in the middle of the Q4 earnings season and surprises have been positive on both revenues and profits. Yet, the S&P 500 Index keeps bumping on the 1300 level and trading on lower and lower volume.

spy

So, be prepared for some volatility in a rising market.

 

Leave a Reply

Your email address will not be published. Required fields are marked *