Earnings & Sentiment Analysis

The market’s choppy action thus far this month has sidelined us as we await a more prudent entry point. That said, we believe that once this softness passes, we will be on our way towards a continuation of the rally that started earlier this year.

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 as 1Q12 results have come in. As of last Friday, analysts are forecasting $111.06 for the S&P 500 in the coming twelve months. That’s up from mid-$106’s at the start of the year.

This increase in the twelve month forward earnings per share forecast is very encouraging in light of market valuations. Given Friday’s close of $1353, the twelve month forward P/E ratio stands at 12.2x. This stands in stark contrast with the seventeen year historical average of 14.9x, the trailing ten year average of 14.4x and the trailing five year average of 13.1x.

With analysts expecting the S&P 500 to produce $111.06 in earnings for the coming twelve months, this puts the twelve-month forward earnings yield (the reciprocal of the P/E ratio) of 8.13%. This also compares nicely to historical averages and indicates that the stock market remains undervalued, even at these higher levels. Based on our historical averages, we believe fair value for the S&P 500 to be $1575, up 16.5% from Friday’s close of 1353.

Fundamentally speaking, it is our opinion that the S&P 500 is undervalued by 17% based on today’s value of 1353. Using a blend of historical, five and ten year price to earnings multiples, we anticipate the S&P 500 trading near 1575 in the coming twelve months.

While our longer-term outlook is growing increasingly bullish, we can see a somewhat physiological downturn in the market near-term. Our market behavioral model has been calling for a slight correction since early April and it seems the correction in underway, with the S&P 500 down 5.6% and the Nasdaq off 6.2% from the April peak, respectively.

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.

On April 4, our behavioral model told us to take profits and move to a defensive position. We followed exactly what the model instructed and we were able to produce a gain of 0.8% for the month versus a loss of 0.7% for the S&P 500. Then on April 30, the model told us to move back into the market on the long side. This action was short lived as the model quickly reversed on May 7. We have been in cash since then and await further instruction.

We will wait for the appropriate entry point (positive sloping trend line) before we enter the market. For the time being we will stay on the sidelines and let this correction play out.

Joseph S. Kalinowski, CFA