Friday, November 15, 2013

Weekly Market Summary

3 of the 4 US indices made new highs this week, as did 8 of the 9 SPX sectors. Both trend and breadth are strong.

SPX closed higher for a 6th week in a row. It has closed higher on the 7th week just twice in the past 10 years (including January of this year). This kind of strength has, in the past, led to higher highs in SPX further out. The trading odds are here (via @WildcatTrader).

Coming up next for SPX is a breach of the 1800 level. In the past, centennial milestones (1400, 1500, etc) have led to anywhere from a 4% to a more than 10% reaction. We detailed this yesterday here.

Given seasonality, any weakness would likely be short lived. Funds that have underperformed feel the pressure to chase the indices into year-end, deploying any cash they may have. In January, investors open their year-end statements and sell underperforming funds, so the incentive for funds is strong. And, when investors see how well their investments performed in 2013, they in turn also deploy any idle cash into equities. For these reasons, November through January is regarded as the strongest period of the year.

In 2013, what has mattered has been trend and volatility, both of which remain equity positive.

What has not mattered has been pretty much everything else. At times, there have been divergences in breadth, strength in bonds, and weakness in commodities and cyclicals. Lumbering macro and company fundamentals and shifts in seasonality have mattered not at all.

So, with that said, let's review fundamentals.

The financial reporting for 3Q is essentially over. At the start of 3Q, EPS growth was expected to be 7.2%; the actual will be less than half that, about 3.5%. Sales growth will be 2.9% (in-line).

For the full year, EPS is now expected to grow 4.8% and sales to grow 2.0%; at the start of the year, those numbers were twice as high, at 9.5% and 3.7%, respectively.

So, when the consensus expects 10.8% EPS growth in 2014, you are well-advised to lower that by half. The pattern of downward revisions this year is typical for most years.

Since the start of the year, we have maintained 4% growth for both 2013 and 2014. For 2013, it looks like we will be very close.

Two noteworthy features of these numbers. First, buybacks have boosted EPS growth by around 2 percentage points according to Goldman. That's roughly half of the yearly growth. In other words, organic growth is about 2%.

Second, M&A has boosted total sales growth. According to Goldman, 20 companies had y-o-y sales growth in 3Q of 13% due to M&A activity; the other 370 companies had average sales growth of 2%. Again, organic growth is 2%.

This should not be surprising. Trend in employment growth has been 1.5% (chart). Core inflation is 1.2%, the recent read being the softest since October 2009 (chart). The consumer spending portion of 3Q GDP showed 1.5% growth, the lowest in two years (chart). Rail volume growth is 1.6% YTD. All of this is very consistent with organic growth in corporate sales and earnings of 2%.

From a fundamental standpoint, that means we are heading into 2014 with a market that is more than fully valued, whether you use a forward or trailing PE, a 10-year PE, price to sales, market cap to GDP, or Tobin's Q. Goldman uses five methods for valuing SPX and sees full value at 1650 (chart).

All things being equal, sales growth should pace returns from here. In reality, investor exuberance implies that anything can happen.

To take just one example, on a trailing 12-month basis, SPX is valued at 16.2x; this was the peak during the 2003-07 bull market. Notice, by the way, that trailing PEs were only higher when the economy was in a recession; EPS leads price, so on a trailing basis the market becomes 'expensive.'

The same is true when viewed over the past 140 years. Aside from recessions, the only higher valuations were during the 1987 bubble and the 1990's tech bubble. Current valuation (green line) is certainly near prior highs and well above average. For 2% organic growth, that is rich.

It is less attractive for small caps. According to Michael Santoli, RUT trades at "roughly a 40% premium to the S&P 500 – essentially as pricey as they’ve been in the modern era” (article).

Moreover, periods with higher valuation have also seen EPS grow at more than 10%. Today, in comparison is less than 4%. This relationship is not surprising.

Our strategy, has been to temporarily look outside of the US indices for better risk-reward investments. You can follow these on Twitter. In particular, USO (post and chart), EEM (post and chart and entry), TLT (chart and entry) and NLY (chart).  

Given the strength of the current trend and positive seasonality, we expect to be back in long the US indices soon.