Market strategy viewpoint – September 30, 2009

Marc A. Zabicki, CFA – Sr. Market Strategist

The art of momentum

KEY CONDITIONS:

The U.S. equity market has come a long way in a short time, with the S&P 500 index advancing 57% since the March lows. To us the gains in stocks have been largely justified and market sentiment moved from a doomsday scenario back to rational expectations. Now, we believe the market may be essentially fairly valued given current conditions. However, at 17.6x trailing earnings numbers and 15.6x forward earnings numbers (according to Thomson Financial estimates) there may be restrictions on how far this market can fundamentally go. In our view, we will have to see additional signs of economic growth for valuations to improve and equities to continue to trend higher.

While we believe we will need economic improvement for this market to justifiably reason its way higher, it could continue its advance based on momentum alone. It has been shown in recent years that this market is more than able to extend beyond fundamental terms that investors may describe as rational. The take-up of technical analysis and the resulting desire to follow trends has likely led to decidedly inefficient markets at times. Based on momentum, markets have shown the desire to swing from irrational exuberance to extreme bouts of fear. With the amount of money in money market funds and "on-the-sidelines" today, this market may have the building blocks for a significant momentum-based rally.

Investors have clearly been favoring the cyclical equity groups during the latest portion of the current rally. Over the last month, Industrials, Materials, Consumer Discretionary and Financials have been providing the equity leadership, with the defensive Utilities, Telecom, Health Care, and Consumer Staples groups lagging. Risk has seemingly been at a premium with some of the more unstable names in the S&P 500 leading the advance over the last 30 days.

The art of momentum

The strength of this market has surprised many and left a few skeptics on the sidelines. Some are cautioning for the simple fact that we have come so far so fast that the market is bound to begin correcting. Some are in the camp that states fundamentals have gotten better and those fundamentals could take the market higher from here. We have considered both sides of the argument, and have indicated in past commentaries that this market has both downside and upside risks for investors. That is, the market could endure a near-term correction, but the current position in the business cycle demands some equity participation as the market is likely biased higher as the economy firms. With this in mind we take a look at current fundamental and technical market issues with a focus on market momentum. We believe that the market is essentially fairly valued at this juncture, given what we know today. And we have been quick to mention that the economy will have to show data that is "sustainably better" rather than "less bad" before we can justify higher equity levels. However, market momentum has, in the past, been capable of taking this market beyond its efficient, fundamental limits. We close with a fundamental look at market valuations by sector, but begin with some momentum indicators that may prove valuable in foretelling potential, near-term turns in the market or the continuation of the current run.

There has certainly been some notable momentum behind this rally. However, the amount of cash on the sidelines (The Investment Company Institute reported $3.2 trillion in money market funds at the end of July), tells us that there is room for this market to be pushed higher. Thus, our review of momentum indicators in this publication shows significant momentum but not an amount that would signal the market is extremely overbought. The recent market trend does indicate that this market may be due for a slight correction, but there are few technical hurdles keeping this market from going higher thereafter. A look at the S&P 500 weekly chart, just below, shows little real resistance up to 1100. Only when we look back near the 1250 level does the market seem to come up against some key resistance levels. Consequently, we believe this market is set up technically to go higher.

The saying goes, "Don't fight the tape" and pure technical traders may tell you: "When markets are trending higher, traders should not try and fight this regardless of what one may believe about the fundamentals or the future. When they are trending lower the same rules apply." Momentum helps define the trend, with little regard for fundamentals. While some traders will use this momentum strategy and the "Don't fight the tape" mantra continuously, it may not be the strategy of choice for the longer term investors looking to buy a fundamentally appreciating asset (ideally a company's stock) at an attractive price. As we mentioned, sometimes market momentum can take financial markets beyond the levels of fundamental reality, to areas where value investors may not seek to tread, at least on the long side. We witnessed this most recently with real estate, and we have also seen it in the past with oil prices, China stocks, technology stocks, and tulip bulbs. The broader market or a specific asset niche will find its momentum, either up or down, and investors need to be able to recognize when momentum is turning and be prepared to alter their strategy. More fundamental or long-term investors may not seek to trust the market's momentum or base their decisions on it, but short-term traders need to recognize its value. Failure to identify a shift in momentum and alter strategy quickly, in an over-valued or under-valued market, can spell steep losses or missed gains for those investors that fail to see the trend shift.

Fortunately, today's market, while displaying some tendencies at following momentum, is not materially overvalued in our view, and thus any downside shift in momentum may prove to be short-lived. Charts 2 - 4 below illustrate three key indicators and each shows a momentum-based reading that currently is indicating the market is not overbought. The charts seem to fortify the technical view of the weekly S&P chart that showed there is room for momentum to take this market higher.

Chart 2, Relative strength (RSI): is based on a calculation where the average gain is divided by the average loss over a specific period (usually 14 or 28 periods, with periods defined as days in a daily chart). Then this relative strength reading is converted into an oscillator that ranges between zero and 100. When the average gain is greater than the average loss, over the period measured, Relative Strength rises, with 50 defined as the centerline and 70 and 30 defined as overbought and oversold levels respectively. The chart below shows the S&P 500 has recently flirted with 70, but current conditions are not overbought. In fact, the market has shown some healthy trend of profit-taking action as the RSI peaks above 70, only to revisit those levels again as stocks sell off and then rise further. In our view, this activity makes a case for the market to continue its trend higher.

Chart 3, Momentum: There is a technical indicator called Momentum, or by another name, Rate of Change (ROC). It is an oscillator that measures the percent change in price from one period to the next. ROC displays the rate of change as a percentage, while the Momentum indicator displays it as a ratio. The calculation behind the indicator for each is the same. Momentum can be used as a short-term buy and sell signal, as some traders use it to buy when the indicator turns up or crosses above zero, or sell when the indicator turns down or crosses below zero. The S&P 500 index chart shows relatively strong momentum but comparatively the indicator is not at the extremes of the recent past. This indicates momentum is favorable, but the market is not overbought.

Chart 4, Volume: In addition to watching the pace of momentum, investors will also want to see corresponding high volume to help "confirm" the advances or declines. Currently, this is where the bullish momentum case breaks down a bit as volume has been light as the market has advanced. More bullish indications would be given if volume had been strong as the market has reached its latest new highs.

Traders will tell you that stocks or markets will trend higher, trend lower, or move sideways. Only one of these instances is good for the long investor. The momentum indicators mentioned help define strength (a trend higher) in the market and point to the likelihood of that strength being maintained. Meaning, we do not believe the market has become overheated. The fact that these indicators are not being "confirmed" by high volume leaves us a bit cautious. However, this may be related to the fact that there is still a lot of money on the sidelines. With little trading resistance up to 1250 and positive momentum indications, we believe this market looks technically biased higher.

Cyclical sectors reign

Much of the market momentum and rebound since March has taken place in the more cyclical equity sectors and those groups that got hit the hardest during the downturn Cyclical groups have lead the market higher as investors built in the expectations of an economic rebound. Cyclical sector outperformance is consistent with what is typically seen during a trough and then rebound in the business cycle.

Meanwhile, our equity sector allocation recommendations have been well-placed to take advantage of the rally. We have remained overweight the Financials and Industrials spaces, and we have balanced that with what we believe is necessary defensive exposure during this recovery, an overweight rating in the Health Care sector. While the market's trajectory has seemingly been nothing but positive, we still consider defensive exposure as necessary to help buffer some economic inconsistencies that may arise. Meanwhile, equalweight recommendations in Technology, Materials, and Energy have also been relatively well-placed to take advantage of the equity advance. Where we differ with the market's performance over the last six months is in Consumer Discretionary (retailer, restaurant, and hotel stocks for example). In June we moved from an equalweight to an underweight position in Consumer Discretionary with the idea that investors had built in some potentially unreasonable expectations about a rebound in consumer spending. We believe a consumer spending rebound will be relatively lackluster, while sector price moves, to us, seem to indicate more bullish expectations. Further, we downgraded our outlook on Consumer Staples, in June, from overweight to equalweight, based on relative valuation. And in June we downgraded utilities as well to underweight from equalweight, while we remain equalweight the Telecom group to take advantage of some of their stable dividends.

From a fundamental perspective, this market does not strike us as overly-expensive despite an approximate 57% run since the March lows. The S&P 500 Index trailing price-to earning multiple is 17.6x, which is at a level consistent with past points of business cycle recovery and does reflect the lack of inflation pressure and easy monetary policy. Further, we believe the S&P 500 Index's trailing multiple may be a bit overstated, given the substantial losses that occurred in Financials in late 2008 and early 2009. In regards to forward earnings multiples, the S&P 500 is set up at 15.6x earnings, which again is a reasonable number in our view.

Looking at each equity sector (previous page) shows further evidence that valuations are not out of line at present levels. Across the board in price-to-earnings, price-to-book, price-to-sales, and price-to-cash flow readings, valuations are in some cases far lower than the mean numbers taken over the last 13 years. Given the likely slow growth coming out of this recession, lower valuations are justified and we would be concerned if metrics rushed back to average levels. Fundamentally, we find some comfort that this market is not overvalued, when each equity sector data set is observed. Consequently, if economic conditions do improve beyond the inventory improvements currently being witnessed, we believe valuations do have additional room to grow, thereby pushing equity prices higher over time. Where the risk resides from a fundamental perspective, is that if the corporate earnings growth implied by the forward earnings multiple fails to materialize. Failed expectations, particularly as it involves consumer spending impacts on corporate earnings, would likely crimp multiples and hurt equity prices.

Equity yields much more attractive than cash and treasury bonds

Broadly, we still are constructive on equities at the current time. We believe our S&P 500 Index year-end target of 1060 that we recently revised is biased for further upward revision based on the technical and fundamental underpinnings in the market. However, we are stopping short of that revision at this time, given the likelihood of some potential trading weakness during third quarter earnings season. We will reassess our index target after gathering more data in October.

On a relative basis, the standing S&P 500 earnings yield of 5.6% (forward yield 7.1%) far outpaces the 10-year Treasury yield of 3.3% and the 90-day T-bill rate of 0.09%. This relative attractiveness likely has been a key driver in the market as the Federal Reserve, through monetary policy, has designed a favorable environment for equities. We expect this environment will continue as several key Fed officials, including Ben Bernanke, have given indication that the Fed will remain accommodative with policy. As long as this is the case, we believe investors will continue to choose equities first, followed by bonds. Right now we believe it is not fiscally prudent to keep large amounts of your portfolio in cash due to extremely low yields.

While we are decidedly wary of too much Treasury exposure here, we are continuing to find value in corporate and municipal bonds. In aggregate, long-term corporate bonds are yielding 5.5%, while municipals are yielding 4.6%. Both groups remain attractive in our view, despite some recent contraction in yield spreads versus Treasuries. The table below indicates our position on the relative attractiveness of each asset class subset.