Investors in U.S. equities seem to have embraced a new market paradigm in which upside spikes come more swiftly than the downside selloffs. Remember when it used to be the other way around? When fear was stronger than greed? The market is consolidating its gains off the early-October V-bottom reversal, and no one seems to be in any hurry to unload shares this time around, with the holidays rapidly approaching and all. After all, there are bright blue skies directly overhead giving hope and respite from the early freeze blanketing the country.
In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.
Market overview:
Currency wars continue as central banks seek to stimulate their economies through devaluation in a race to the bottom, while corruption and ineptitude in places like Russia and Brazil destroy their currencies. It appears that the EU is finally starting to see some benefits, as its latest reported GDP growth showed up slightly to the positive side. Here in the U.S., GDP growth is expected to be at a 3.3% rate over the second half of 2014 and 4.4% for 2015.
As commodity prices continue to sink with a strengthening dollar and no inflation in sight, the former largest public company in the world Exxon Mobil (XOM) has seen its market cap tread water at around $403 billion), while Apple (AAPL) continues to pull further ahead ($670 billion) and Microsoft (MSFT) moves into the second spot ($409 billion). As discussed below, our fundamentals-based SectorCast rankings score Energy and Basic Materials at the bottom, primarily because of Wall Street’s continued downward revisions in forward earnings estimates. Nevertheless, both sectors have seen such price declines that their forward valuations are still quite attractive compared with the overall market.
So, how is the overall market valuation right now? On the one hand, the S&P 500 P/E using trailing inflation-adjusted earnings is about 25 right now. However, this is the same historically elevated level it has been since 1990, so there is no imminent danger about it. Moreover, forward P/E on the S&P 500 is about 16, and the spread between the S&P 500 earnings yield (6.3%) and the 10-year Treasury yield (2.3%) is 4% versus the historical norm of about 3%. Also, robust stock buybacks are likely to continue for a while at the prevailing ultra-low borrowing rates, which lowers the denominator in EPS and offsets new stock offerings and IPOs that typically serve to increase the denominator and dilute the overall profit pool. So, the market’s forward valuation is still reasonable.
As investors have embraced their new paradigm of elevated valuations, fear of missing out rather than fear of losing capital, and only brief bouts of market weakness that serve as fleeting buying opportunities, old hands at this game have been slow to adjust. This is why so many hedge funds lost a good bit of money in October, even though the market actually finished the month in the green. It seems that most of them dumped their favorite ideas, like longs in S&P and Nikkei futures, and shorts in the euro and yen, when they encountered that sudden and long-overdue spike in volatility, but then all those prior positions suddenly reversed and went back above their prior highs.
