Near-Term Opportunity

This week we’d like to take a fundamental overview of the market and make the bullish case that stocks have additional room to rally from current levels.

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

Our Fundamental Equity Model

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 short-term 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.

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.

What the Model is Telling Us

As can be seen in figure 3, we are below the zero line and the trend line has turned higher. This puts us on alert that we are approaching market bottoms and will increase our long exposure as the market offers the opportunity.

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

We received similar signals in March 1989, December 1990, October 1995, October 2003, July 2006 and May 2009.

Each time the S&P 500 went on to rally +20% over the next twelve to eighteen months with the average return around 28%.

Inexpensive Based on Corporate Earnings Projections

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 came in. As of last week, analysts are forecasting $110.00 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 $1405, the twelve month forward P/E ratio stands at 12.7x. 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 $110.00 in earnings for the coming twelve months, this puts the twelve-month forward earnings yield (the reciprocal of the P/E ratio) of 7.8%. 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 $1550, up 10% from Friday’s close.

Sector Rotation

Putting aside the favorable valuation, we anticipate a further push higher due to sector rotation. Over the past year, investment money has flowed from “risk on” assets such as stocks into safe haven securities such as U.S. Treasuries.

We are seeing subtle signs that risk tolerance is increasing and as a result, U.S. Treasury yields will start to move higher as will stock prices. Consider the following events from last week.

1 – For the first time since May 2011, the Consumer Price Index is showing year-over-year inflation at a lower level that the 10 year U.S. Treasury. Thus for the first time in fourteen months, 10 Year Treasuries are offering a real rate of return albeit minimal. Given the pending supply disruptions in food (the drought) and increasing fuel costs, it’s just a matter of time before these core inflation measures work their way into the broader economy.

2 – The spread differential between the 10-year and Treasury Inflation Protected Securities (TIPS) has reached the highest point since April and is 6% above the ten year average differential.

3 – Institutional investors have been unwinding their “long” positions in Treasuries and have started to accumulate “short” positions. According to the Chicago Board of Trade, short positions outnumbered long positions by 14,595 contracts. http://www.businessinsider.com/treasuries-are-on-their-longest-losing-streak-since-february-2012-8

4 – “A rare occurrence in the U.S. government bond market last week could be signaling a big upward move in yields is on the way.

Last week, three consecutive Treasury auctions, involving 3-year, 10-year, and 30-year bonds, "tailed"–in other words, the bonds all ended up trading at higher yields than markets were pricing before the auction–indicating weakening investor demand for Treasury bonds after a big rally over the past few months.

Morgan Stanley head of U.S. interest rate strategy Matthew Hornbach wrote in a note to clients that "a week to remember is in the history books," given that three Treasury auctions tailing in a row like they did last week–which Hornbach calls a "hat trick tail"–doesn't happen very often.

When the hat trick tail does happen, however, it can be a precursor to a significant correction in the bond market.”

http://www.businessinsider.com/the-last-time-we-had-a-week-like-this-us-government-bond-yields-surged-2012-8

Barring another European or geo-political event, there is a significant opportunity on the horizon for a coming sector rotation out of safe haven instruments and into riskier assets. We will continue to monitor the pulse of the market and take investment action accordingly.

Joseph S. Kalinowski, CFA