Current Bull Market Now More Than 400 Days Without 10% Correction

For several months I have been holding elevated cash levels (above 10%) in most client accounts, due to the fact that the stock market appears overbought and has gone a very long time without a standard 10% correction. In fact, we have now gone more than a year without a 10% drop which is a long time historically. I decided to look at the data to see exactly how overbought this market is relative to other bull markets.

It turns out that the current streak of more than 400 days without a correction represents only the 14th time this has happened since 1928. Of those instances, the current bull market (up more than 80% from the March 2009 intra-day lows) places fourth on the list. The three stronger bull market streaks (1953-1955, 1990-1996, and 2003-2007) ranged from +97% to +131%.

Depending on your time frame, the current streak could be either alarming or unimportant. One could argue that the fourth longest streak in 82 years indicates near term problems on the way, but one could also conclude that the last streak of this length was only a few short years ago, so maybe it is becoming more and more common.

I prefer to look at the longest set of data we have, which is why I continue to hold above-average cash levels. The fewer data points you consider, the less reliable the data will actually be. This can explain a lot of things in various topics, including why there is such a heated debate about global warming right now. If you look at the last 5 years you might conclude that global warming is no longer happening. Conversely if you look at the temperature trends over the last 100 years, it is pretty obvious that global warming is occurring.

Looking at historical stock market data tells me that the current bull market is near the top of the list historically, but of course that does not mean stocks are going to fall anytime soon. Just three years ago the S&P 500 went 4 years without a 10% correction. Today it has only been a little more than 1 year. As a result, I prefer to hold extra cash to use should the correction come, but still have most of my clients’ capital invested in attractively-priced stocks.

Market Is Pricing In 35% Profit Growth in 2010

A theme of mine in recent weeks, as well as for 2010, is that the stock market has risen 70% from the March lows and has begun to price in the current consensus forecast of $75 in S&P 500 earnings, which would be a 35% increase from 2009. As a result, I think the Wall Street strategist consensus of a 10 -15% market gain this year seems overly optimistic. It is far more likely that earnings come in below $75 than above that level.. not a good risk-reward trade off.

Last evening we got the first big earnings report from the fourth quarter (Intel), they blew away the numbers (40 cents vs 30 cent estimate) and the stock is down this morning. JPM reported a decent number this morning (beat on earnings, light on sales) and it is down too. Whenever you see stocks not go up on good news, it is typically a clear sign that the markets have priced in the good news.

Despite a cautious market outlook short term, there are still good investments out there. I will share a couple in coming weeks to halt the post-holiday lull in postings on this site.

Earnings Will Likely Be Good, But How Will The Market React?

I have been prepared for a market correction for a while now, but we have yet to get one. The rally off of the March lows has reached +61% and the momentum continues to be strong. Will it continue even as companies report their third quarter earnings?

Nobody can know for sure, but over the years we have often seen a “buy on the rumor, sell on the news” mentality on Wall Street, especially during earnings season. Stocks ramp up heading into reporting season, only to fall after the news of solid results actually comes out. A similar phenomenon could certainly happen this quarter and as a result I will be carefully watching both what the numbers are, but also how the market reacts to them.

If stocks sell off even after companies post in-line or slightly better than expected earnings, such market action could be the first sign that a long overdue correction in stock prices is on the horizon. In fact, we might already be seeing this. This morning Johnson and Johnson reported earnings seven cents ahead of estimates but the stock is trading down in premarket trading. Will that be the start of a trend, or simply an aberration? We will have to wait and see.

Evaluating Market Level With S&P 500 Having Reached My Fair Value Target

I have written here previously that my personal fair value target for the S&P 500 index was around 1,050. I got there by using an average P/E multiple of 14-15 and projecting a “normalized” earnings run rate for the index of around $70 annually. The index has now risen 60% from its March low and hit a level of 1,074 intra-day on Thursday, about 2% above my target. Naturally, the next question is “what now?”

First we need to reevaluate my initial assumptions to determine if they need to be revised. Current earnings estimates on the S&P 500 for 2009 are about $54, which is a 9% increase from 2008. Estimates going forward are significantly higher than that, at around $73 for 2010. Does my $70 still apply?

In my mind it does. The idea behind trying to determine “normalized” earnings is to eliminate the long tails of the distribution. Valuing stocks based on earnings during a recession ($50-$55) is not very helpful given that the economy grows during the vast majority of all time periods. Conversely, using the previous peak earnings level ($87) factors in a period of easy credit and dramatic leverage which surely boosted profits to unsustainable levels.

So, I would define “normalized” earnings as the level of corporate profits that we could expect in neither a recessionary environment (negative GDP growth), or a highly leveraged economy (say, 4-5% GDP growth). Put another way, what would earnings be if the economy was growing, but not very fast (say, by 2% per year). Something between $50 and $87 most likely, and the number I have been using is $70 for the S&P 500.

Interestingly, the consensus for 2010 is for moderate economic growth, positive but not at the pace we saw earlier this decade. Given that the current earnings estimate for next year is $73, I believe my $70 figure still makes sense, given what we know right now anyway.

Where does that put us in terms of the market? Well, in my mind we are trading pretty much at fair value, but it is helpful to look at both the more bearish case and the more bullish case to get an idea of what the risk-reward scenario looks like. Comparing your potential upside with the corresponding downside should make it easier for investors to gauge how they should be allocating their investment capital.

First, the bears will argue that earnings are being helped merely by cost cutting and that revenue growth will be non-existent because the economy will remain in a rut for a long time. They will contend that earnings in the $70 range for 2010 is overly optimistic and will cite the $54 figure for this year as a more reasonable expectation in the near term. Assign a 14-15 P/E (the median multiple throughout history) on those earnings and you get the S&P 500 index trading between 750 and 800, or 25-30% below current levels.

Next, we have the bulls on the other end of the spectrum. They believe that slow to moderate growth in 2010 is likely and S&P 500 earnings in the $70 to $75 range are reasonable expectations. They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside.

From this exercise we can determine the risk-reward using all of these arguments. Bulls say 10-15% upside, bears say 25-30% downside, and I come in somewhere in between at a flat market. Therefore, I am cautious here with the S&P 500 trading at 1,066 as I write this. To me, aggressively committing new money to equities at these levels comes with a fair amount of risk given that the best case scenario appears to only be another 10 or 15 percent. As a result, I am holding above average cash positions and being fairly defensive with fresh capital. There just aren’t that many bargains left right now, so I am hoping the next correction changes that.

Speculative Trading Lends Credence To “Rally Losing Steam” Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market’s dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC’s Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Powerful Market Rally May Be Running Out of Steam

After a very surprising employment report this morning (payrolls declined ~350k versus expectations of ~525k), the market reacted well at first but sellers have emerged. The fact that the market is flat today tells me the rally is losing steam (normally that type of jobs report would mean 200 or 300 points on the Dow). We may be at a point now where slow economic improvement has been priced into stocks, and as a result, incoming data that supports that thesis may not give a huge jolt to equity prices going forward.

This is a perfect example of how the stock market discounts the future ahead of time. We have had an enormous move since early March (S&P 500 up 42% from 666 to 944) on expectations that the economy would begin to slowly improve. Now that it appears to be happening, the market is looking ahead at what might be next. The answer to that question is a lot less clear.

My personal fair value target for the S&P 500 remains 1,050 but I have been raising cash into this rally below that level because there are still risks to the economic recovery and I want to save some cash for the next market drop. Recovery has to be a foregone conclusion, in my view, for the 1,050 level to solely dictate my actions.

Not only that, but more and more strategists are looking for 1,000 on the S&P 500, whereas they weren’t even mentioning it as a possibility a month or two ago. As a contrarian, that makes me think it is getting less likely we will reach that level in the short term.

After Huge Rally, Market Digests Earnings Season and Bank Capital Raises

With most first quarter earnings reports having already been released, along with bank stress test results, the action in the market has died down considerably. After a 40% rally, the S&P 500 has been consolidating between 875 (a key technical support level) and 930 (the recent high). Such backing and filling is a strong sign. One would expect a pause after such a huge move, and despite the fact that the banks are rushing to issue billion of dollars in new shares, the market is absorbing that new supply fairly well (the stocks are down from their highs but they seem to be building a base and fear has subsided).

As for earnings season, first quarter results largely exceeded reduced expectations. Bulls and bears will continue to debate whether beating those low estimates was a positive or not, but merely stopping the earnings decline would serve to put a floor on stock prices. If the rate of decline in both the economy and corporate profits can decelerate, we could very well see sideways market action for a while. With the S&P 500 up from 666 to nearly 900, that would be welcomed by most investors.

The recent rally has been predicated on the idea that Q4 2008 and Q1 2009 will turn out to be the worst quarters for the economy. If GDP can rise sequentially throughout the year, and turn positive on a year-over-year basis by the fourth quarter, corporate profits will likely have hit a bottom. This scenario is priced into equities, so we really need it to play out that way for the S&P to hold the 900 area in coming months.

There are still plenty of people who are negative on the economy and either don’t think a rebound will occur later in 2009, or if it does, it will be short-lived and we will see even worse times in 2010. If that proves true, we could very well see a retest of the March lows, as the bears are expecting.

Where do I come down? I think there is a decent chance we do not see 666 on the S&P 500 again. By “decent” I mean, say, between 50% and 67%. The rest of 2009 could very well be rocky though, so we could certainly get a correction or two, especially after a 40% rally in the market. As a result, I am holding some cash (10-20% right now in many cases) in order to take advantage of any other leg down if we get it. That cash number will likely increase if the market rally continues and we approach my own fair value estimate (1000-1050 on the S&P).

In general, I think a solid path would be for the market to trade sideways for a while. Digesting the big move we have made, rather than simply seeing another large sell-off (which was the typical course over the last year or so) would send a signal that the worst may be behind us and we can slowly recover. I agree with many who believe an economic recovery will be neither particularly fast, nor violently strong, but simply muddling along with little or no GDP growth would go a long way to supporting stock prices at their current level and take the calls for 600 on the S&P off of the table.

Look For Swine Flu Related Opportunities

To me this swine flu outbreak looks a lot like avian bird flu; fairly contained and overhyped. Of course anything is possible, but as Wall Street frets about swine flu (Dow futures are down 150 this morning), investors should be on the lookout for investment opportunities. Worries over bird flu led to numerous bargains, especially in the poultry industry. We’ll have to see what stocks, if any, are adversely affected by swine flu worries. Chances are they will excellent investment opportunities just as were available when SARS and bird flu were the worries of the day.

Q1 2009 Earnings Exceeding Estimates So Far

Are you surprised that the market is acting as well as it has lately, especially with earnings season having begun? Still waiting for that overbought correction after six weeks of gains in stocks? Me too. Why the relative strength? Well, according to Bespoke Investment Group first quarter earnings are coming in well above estimates so far (20% reporting):

“A fifth of the companies in the S&P 500 have reported earnings for the first quarter, and so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of earnings season. When comparing actual earnings versus estimates, Consumer Discretionary, Financials, and Energy are leading the way. On the downside, the Industrial sector is the only one where actual earnings have come in weaker than expected. Earnings season still has a long way to go, but the fact that growth has come in better than expected thus far has been one factor driving the market higher.”