The Window of Opportunity

When analyzing market direction, we utilize our proprietary behavioral model to determine the appropriate investment strategy from a tactical standpoint. In Late March and early April, the orange trend line in our model was testing the “greed” area of our market cycles, thus we decided to start taking profits from our gains from earlier in the year and start building defensive and short positions.

We remained short through most of April as the model dictated, actually producing gains in April where the major indices showed declines. Then in early May, on the heels of an enormously strong earnings report from Apple Computer, the market model turned higher and we covered our defensive-short positions and took a long bias in equities.

That call turned out to be wrong. Several days later, the market model turned lower once again and we were forced to sell our open long positions for losses. At that time the model indicated that we needed to take another defensive-short position. For fear of over trading, we chose to stay in cash. While the notion of being in cash through this downturn is somewhat comforting, we did leave potential profits on the table.

We are always a student of the market and are continually humbled by it. That said, once this correction runs its course, we will be in an excellent position to take advantage of the new rally and we anticipate superior returns for our investors this year.

Where will the market bottom?

We do not have a crystal ball. Our model cannot forecast the future, but provide insight real time suggesting when the appropriate time for action is upon us. Clearly we are in a correction, but most assuredly it will come to an end.

We cannot know what the catalyst will be that drives investors back into equities, but we have several hypotheses that may serve as capitulation. These include but are not limited to; the Federal Reserve initiating QE3, resolution of our pending fiscal cliff, a Greek exit from the euro and strong corporate earnings.

Federal Reserve

Given the remarkably weak employment numbers on Friday; it appears the US economy is headed for another slowdown. Possibly more important, economically sensitive commodities such as oil and copper are in a free fall. Light sweet crude is approaching $83 a barrel, down from $110 a few months ago and copper is trading at its lowest level in five months.

With such strong signals that the US economy is stalling, the odds of the Fed implementing another round of stimulating buying increases dramatically. Some analysts believe further Fed action may be effectuated as early as their next meeting in three weeks.

Many believe another round of QE, the purchasing of several hundred billion dollars of Treasury securities and mortgage-backed securities may be in store, as opposed to another round of “operation twist” that ends this month. Operation Twist, as it’s called signifies the Fed’s intention of selling shorter term securities and purchasing longer term securities for the purpose of keeping longer-term interest rates lower.

Analysts believe the Fed will not renew this strategy as they are running out of short term securities to sell without drastically altering their balance sheet. Having too much exposure on the long end of the yield curve will exponentially damage their balance sheet once rate inevitably start to rise.

Regardless, an announcement by the Fed introducing another round of stimulus purchasing may be enough to “catch a bid” and start the market higher.

Fiscal Cliff

It seems we are approaching, what many are referring to as the “fiscal cliff” by the end of this year. The fiscal cliff consists of several events, each of which is expected to be counter intuitive in promoting economic growth. By the end of this year, the Bush tax cuts are slated to expire, as is the payroll tax cuts. The automatic budget cuts from last year’s super-committee debacle kick in as does the ObamaCare tax hikes. Pile on top another debt ceiling showdown and one can see why both President Obama and the Congress score poorly in their handling of the economy.

Economists estimate, the onslaught of anti-growth initiatives can shave as much as 4% to 5% off of 2013 GDP. That is pretty significant. We do not anticipate a quick resolution to this problem as it is politically unpopular in both camps. Republican challenger Mitt Romney will base his entire campaign on the Presidents mismanagement of the economy and President Obama knows the only platform he is able to run on are the “no-show” Congress.

Most likely, this situation will linger until after the election season but will be resolved in an eleventh hour lame duck session. That said, should Congress and the White House work together to resolve this issue, then we may see some positive reinforcement move back into the stock market.

The Euro

Treasuries and German bunds fell to all-time lows on Friday. The yield on the ten year Treasury fell to yield 1.47%, marking the first time EVER that yields fell below 1.5%. The 10 year German Bund was yielding 1.12%, also all-time lows. Even more astonishing, the two year German note sank to a low of negative 0.012%. That is correct. There is a minus sign in front of that yield, which means that investors are PAYING for the opportunity to invest in near-term German instruments.

There are many that claim this is in preparation of an exit by Greece from the euro common currency and that German assets would appreciate in the event of a euro-zone breakup. Continued calls for a European fiscal union, a common “euro-bond” and recapitalization of Europe’s troubled banks have been stymied by policy leaders in Germany. Additional calls by southern European nations rejecting austerity measures is a major contributor to market uncertainty.

This is going to sound bizarre.

Our thought is that the probable exit from the euro by Greece will have a positive effect on the US equity markets. While the outcome is not favorable in many ways, it puts an end to lingering uncertainty and allows for the next phase of reconstruction to begin.

In any case, positive and constructive solutions stemming from Europe will absolutely be a catalyst that drives the market higher.

Corporate Earnings

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 $111.02 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 $1278, the twelve month forward P/E ratio stands at 11.5x. This stands in stark contrast with the seventeen year historical average of 14.9x, the trailing ten year average of 14.3x and the trailing five year average of 12.9x.

With analysts expecting the S&P 500 to produce $111.02 in earnings for the coming twelve months, this puts the twelve-month forward earnings yield (the reciprocal of the P/E ratio) of 8.7%. This also compares nicely to historical averages and indicates that the stock market remains undervalued. Based on our historical averages, we believe fair value for the S&P 500 to be $1563, up 22% from Friday’s close.

While May was challenging and disappointing from an execution standpoint, we are extremely excited about the opportunity that the market will provide once this correction plays out.

Remember, the market offers us only one or two windows per year to make all the significant profits for the year. This will be one of them.

Joseph S. Kalinowski, CFA