Trading Notes - 2/6/12

When speaking of our tactical strategy, we allude to our shorter-term plan of action (one to three months) within our longer-term plan of action (one to three years). When crafting our tactical strategy, our thesis revolves around our proprietary behavioral model.

Our behavioral model attempts to capture human trading emotions mathematically. It combines years of data from various indicators and aggregates it into an easy to understand model that assists in the investment decision making process. Our indicator encapsulates the put/call ratio, the volatility index, pricing and volume analysis, new high/lows and point and figure analysis to report the daily scores used in making decisions.

Our indicator will score within one of five basic market cycles. These cycles include “Extreme Euphoria”, “Greed”, Rational Market”, “Fear”, and “Extreme Panic”. Depending on where we are in the market cycle determines how aggressive our portfolio structure.

Typically, the best time to aggressively buy US equities is when we are rising out of Extreme Panic. The best time to be conservative is when we are falling from Extreme Euphoria.

Delving further in the interpretation, our models comprise of two lines. The first is the “Trigger Line”. This line tracks the general movements of the market and provides us with a “heads up” that a time to act is approaching. The second line is the “Trend Line” and provides us with the actual actionable entry or exit into the market.

The trigger line bottomed in the extreme panic zone and started higher on October 4th this year. The trend line turned higher soon after and we decided to increase our long exposure aggressively on October 12th.

While the strategy worked well for us in the month of October, we overstayed our "risk on" position when in early November the trigger line started lower. By November 14th the trend line was headed lower and an investor should have decreased his long bias in favor of a more defensive stance.

On December 6th, the trend line started higher once again.

We continue to have a long bias in place but are becoming increasing cautious in the near-term. Based on our behavioral model, both the trigger and trend lines have entered the “Greed” zone. While not a major cause for alarm, we are ever watchful for a sense of complacency in the market that may offer a pull-back from the markets lofty northward journey.

Bottom Line: We believe the US equity markets will continue to move higher through early February and we continue to deploy a bullish portfolio framework. Once the trend line in the behavioral model slopes negatively, we will take profits and assume a more defensive stance.

Our Strategic Outlook

We have seen a very dramatic improvement in the corporate earnings picture since the start of the year and it has really accelerated in earnest with the official launch of the 4Q11 earnings season. As of last Friday, analysts are forecasting $106.90 for the S&P 500 in the coming twelve months. That’s up from mid-$106’s as we head into the month.

This increase in the twelve month forward earnings per share forecast is very encouraging in light of market valuations. Given Friday’s close of $1344.90, the twelve month forward P/E ratio stands at 12.6x. This stands in stark contrast with the seventeen year historical average of 15.0x, the trailing ten year average of 14.6x and the trailing five year average of 13.2x.

Using these historical valuation measures, one would place a twelve month price target for the S&P 500 within a range of $1411 to $1604, some 5% to 19% higher, respectively. Using and average valuation, we are placing a fair value target on the S&P 500 of $1526 or 13.5% higher than Friday’s close.

Fundamentally, the US stock market is undervalued and quickly approaching a buy point that will start a long-term rally. We are confidently making this call based on the fundamental research we have calculated and analyzed.

Our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices. The key elements within our fundamental model focus on:

1 - The twelve-month forward earnings yield for the S&P 500 (which is the inverse of the twelve-month forward P/E ratio).

2 - Expected earnings growth over the coming twelve months.

3 - Yield differential against the ten-year treasury yield to attempt to capture security rotation.

We have been tracking this model for over fifteen years and it has produced significant market directional opportunities. Unlike our behavioral model that seeks out more shorter-term directional movements in order to capitalize on excess returns through tactical portfolio rebalancing, our fundamental model provides information on larger secular shifts in the US equity markets and directs our strategic positioning.

We are close to getting significant buy signals from the fundamental model.

Our Fundamental Model

When interpreting the fundamental model, one needs to wait for the trigger line (thin blue line) to fall below zero and buy when the trend line (thick orange line) starts to head higher.

As can be seen we are below the zero line and the trigger line has turned higher. This puts us on alert that we are approaching market bottoms and will increase our long exposure more aggressively when the trend line heads higher.

When following these rules of engagement, our fundamental model has picked points in the market when the US equity indices have gone on to return 28% on average in the following year.

We are extremely energized by the opportunity the market will offer us once we have confirmation in the fundamental model. Our anticipation that it will happen sometime in the first half of the year, possibly after one more pull-back for the S&P500.

Taking a closer look at the historical market calls that our fundamental model has provided, one can see the lucrative opportunities presented. There have been six other buy signals since 1985 not including the one we are receiving today.

1 - Displays our fundamental model in the mid fourth quarter of 1988. Our trigger line alerted us to a potential opportunity in November 1988 and we received the actual buy signal in March 1989. The S&P 500 went on to rally 25% from those levels over the next year.

2 - Shows our fundamental model in the fourth quarter of 1990. The trigger line gave us the signal to be on watch in October 1990. The buy signal came relatively quickly in December of the same year. The S&P 500 moved higher by 29% in the following year.

3 - Came in December 1994. As the exhibit shows, the buy signal ultimately arrived almost a year later in October 1995. The S&P 500 moved aggressively higher over the next year and a half producing returns in excess of 35%.

4 - September 2002 is when we obtained the next fundamental trigger indication. As seen in the exhibit, the buy signal arrived in October 2003, over a year later. By January 2005, the S&P 500 had rallied close to 20%.

5 - Shows our fundamental model in the final quarter of 2005. The trigger line gave us the heads up in October and the trend line gave us the buy signal by July 2006. Within a year’s time the S&P 500 ran 20%.

6 - Trigger comes in December 2008.. The trend line though kept us out of the market until May 2009. Upon the buy signal the S&P 500 went on to return an astonishing 37%.

7 - We expect to see the S&P 500 to return in excess of 20% in the next twelve months.

Bottom Line: Our shorter-term tactical outlook remains bullish and cautious. Given the favorable trends in corporate earnings, our longer-term strategic outlook remains neutral and increasingly optimistic. We are waiting for the “official buy signal” from our fundamental models before changing our stance. That may be coming sooner rather than later.

NASDAQ relative outperformance

We continually look for clues as to market direction and guidance on how to proceed. One gratifying trend recently has been the relative outperformance of the NASDAQ relative to the S&P 500. It would appear the general investment pattern over the past month has been one of enthusiasm as market participants focus on improving US economic trends, diminished news of Armageddon from Europe (this will prove to be temporary) and strong corporate earnings. The NASDAQ has been the index that has led on the way up.

The following chart compares the performance of the two indices. When the slope of the two lines are heading lower, that means the NASDAQ is underperforming the SPX and we will remain in a market down trend. Late last year, we highlighted the necessity to see an improvement in this ratio in order to confirm the new uptrend. The Nasdaq usually leads us out of a correction and clearly, the slope of both the trigger and trend line are heading higher indicating near-term strength.

Sector Rotation

Last month we were encouraged by the price performance of the individual sectors that embody the S&P 500. We have been tracking cyclical versus defensive sectors. With the resurgence of cyclical sectors as relative outperformers, we are compelled to remain steadfast in our long exposure to those names that would lead any perceived rally on the horizon and appreciate in price as the economy grew. We consider this trend to be preliminary evidence that a double dip recession for the US economy is not in the cards and earnings and valuations should prove robust this year.

The next chart shows our cyclical / defensive index. This simply compares the price performance to those sectors considered cyclical to those considered defensive. A few weeks ago the trigger line in this model started higher and pierced the trend line to the upside. It is now within one standard deviation from the mean. We consider this a very positive development for the market and the economy.

Bottom Line: We are seeing a strong and steady rotation back into those sectors that will lead the market higher.

Joseph S. Kalinowski, CFA