Rabbitt Analytics Newsletter Q-Market Strategy (Volume 7.08)
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Paul Rabbitt RabbittAnalytics .com |
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A Liquidity Driven Bull Market
We characterize the current market environment as an "in process" bull market. This is a liquidity-driven bull market, rather than valuation- or earnings/economic growth-driven. There is a reported $3.4 trillion in sideline cash. A portion of that cash combined with a slow and gradual conversion of pessimists back into optimists will serve as a good backdrop supporting rising stock prices ahead. In the short-term, stocks have rallied through one of the weakest seasons of the stock market calendar year. The economic and earnings recovery concept seems well discounted in current prices, leaving stocks subject to short-term headline events.
Technical Strength Is Good-Resistance Being Encountered
Price action has been strong with the regular "saw tooth" corrections. Liquidation pressure is minimal on the corrections. Investors have repeatedly purchased price-dips. The recent rally has recovered most of the past 30 days' losses, resulting in a compressed trading range. Compression leads to dynamic change. Increasing volatility over the next thirty days would not surprise us.
Skepticism Fading as Appetite for Risk Increases
Contrarian sentiment is not a simple short-term timing tool. Our lengthy experience with contrarian sentiment market analysis suggests a nuance. Investing contrarian to widely held sentiment is most advantageous as the consensus "mania" grows old and begins to fade, rather at the peak of the mania.
For example, the peak in recent fear was first achieved in early 2008. That high level of fear continued through April 2009 and would have been a poor buy signal in the first ten months that it prevailed. In April the consensus fear began fading. As it faded, capital, that had been sidelined, began returning to the equity markets.
As expected, our proprietary sentiment model, published continuously since 1989, currently forecasts an S&P 500 return of ten percent over the next year. That's a decline from nearly fifty percent return forecast it delivered as recently as April. Nevertheless, the ten percent forecast still suggests there is sufficient fear and pessimism in the market to drive stocks higher over the next year, based solely on sentiment contrarian analysis.
Monetary / Liquidity Factors-a Strong Positive for Stocks
The Federal Reserve has projected an unconcerned attitude towards the risk of rising inflation. High unemployment, lack of manufacturer pricing power, and flat housing prices will contain inflation for the next year or more. Rates are likely to remain low for some time.
Third-quarter GDP increased three percent thanks to federal fiscal and monetary stimulus. This is a good, but not a buoyant, recovery compared to previous recessions where the average recovery has been somewhere around six and a half percent.
Fourth quarter growth will be hampered with no "cash for clunkers" thereby slowing auto sales. Moreover, lagging employment, tepid wage growth, and slow home sales will add to the malaise.
The recession is over and we do not expect a double dip. The US will lag the world's economic growth, expected around four percent. The recovery in the US is expected to be a jobless economic recovery, with GDP growing at approximately 2-2-½ % annually for the next few years. The negative wealth effect from housing prices and stock prices, reduced employment, and reduced credit availability will continue to hamper personal consumption.
Earnings and Valuations are Positive Factors
Compared to the severe decline of corporate earnings over the past eighteen months, forward EPS comparisons will look very favorable. With ninety percent of S&P 500 companies reporting, the average third quarter earnings surprise is seven percent. Three hundred forty companies beat consensus estimates while only sixty-two fell short - well above the average. S&P 500 net income has risen eleven percent versus the second quarter, although still down eleven percent versus last year. The driver behind the stronger-than-expected earnings is cost cutting, rather than increased demand. As the recovery progresses, demand will follow and the shift to demand-driven sales growth will occur.
The 2010 bottom-up earnings estimate is $76.70. The top-down earnings estimate is $70.05. Using a median $72, the current S&P 500 PE ratio on forward earnings is under 15x. We believe analysts are overly conservative in their estimates as they have been repeatedly burned over the past two years.
Paul Rabbitt is an independent research analyst and portfolio manager. He is CEO of Rabbitt Capital, and chief portfolio manager of hedged and private capital. He is President RabbittAnalytics.com, delivering independent stock research to private and institutional clients since 1998 featuring the "Q" Stock Ranking system, a twelve-factor stock risk/return model ranking 2500 stocks daily, since 1989, with one of Wall Street’s best published track records.
Paul previously held dual roles as both Senior Portfolio Strategist and Chief Quantitative Analyst at CIBC Oppenheimer where he was an employee and partner for twenty years.
Institutional Investor Magazine has ranked Paul among the top eight quantitative strategists. He is a frequent commentator in the national and international media.