Bulls On Parade

I’ll start this blog off with a few announcements. Squared Concept is officially a Registered Investment Advisory firm. Our goal is to work with other RIA’s, family offices and advisors to offer our products as a compliment to their existing strategies. We are working with a marketing firm now to fine tune our message and we will have an update on that soon. As such, we have new compliance requirements that must be upheld including incorporating this blog site into our procedures. Over the next few weeks we will have a new look and feel to this site so please stay tuned.

I am also studying for the Charted Market Technician level I exam at the end of this month. So between our compliance review and the studying this month will probably be a bit lean on the postings. We will be up and running full time shortly though.

1Q16 Portfolio Results.

We finished the first quarter down -0.9%. We underperformed the S&P 500 which finished the quarter up 1.3% but edged out the Nasdaq Comp which was lower by -2.4%. Since inception (July 2015) we are up 19.4% vs. -1.1% for the S&P 500. We are also beating the Nasdaq Comp which is down -4.9% since July.

January and February were strong months for us as we were prepared for the sell-off and subsequent rebound and were on the right side of the tape for most of the first two months of the year. March proved quite challenging as we started to fade the rally way too early. Upon the statements made by Mario Draghi at the ECB the market rally and subsequent sell-off later that day swayed us to close our long bias and start building positions counter to the bullish rally. Later in the month Janet Yellen added fuel to the bullish run by coming out much more dovish than we expected. The market ran further and by this time we were behind the eight ball with nothing more to do than stem our losses for the month.

In the future we will wait for additional confirmation of the trend before scaling in. Case in point, the brief sell-offs that we were watching happened with very little volume and not enough panic. Outside of Central Banking activity there were no major catalysts to warrant a greater sell-off i.e. oil prices hitting new lows, Chinese market turmoil or a European debt crisis. U.S. economic data was also improving a bit. We will also be more measured in our approach to building positions so as not to be too overexposed at the beginning of a perceived trend change. The stock market is forever a humbling experience and we are always learning from it. 

Bulls on Parade

The bulls still seem to be in control. We will continue to stay exposed to the long side of the market until such time that the supply / demand dynamic shifts. Even Friday, with the markets dropping in the morning the bulls came out to rally on the day.

That said we are still concerned by the current levels and are preparing for another pullback in the market. On the SPX daily chart RSI and Stochastics are pointing to overbought levels. Like most oscillators with finite bounds, they tend to break down in a strongly trending market so we have been at these levels for quite some time. We will be watching for sharp downward movements in the oscillators. We are also approaching the top of the trend line since the market started reaching lower highs and lows. This is an important level for us to watch. Failure to break this trend line to the upside could bring a nasty sell-off. MACD momentum has been waning even as the market has continued higher. This doesn’t bode well for the near term picture in our opinion.

SPX equal weight has not been rallying with the index so it seems we are back to the notion of the index being supported by a handful of the largest companies in the index. This could lead to potential problems.

Currently 78.8% of the constituents in the S&P 500 exhibit a bullish point and figure pattern. This is a very elevated level and is greater than one full standard deviation (76.8%) above the mean. While this measure alone doesn’t predict a coming sell-off, it can signify at the very least a stalling period for the index.

On the weekly SPX chart, there are many similarities to the daily. RSI (5) and Stochastics are overbought and it seems we are hitting resistance on the RSI (14). The downtrend remains in place and the MACD line is still trending lower. On the MACD histogram, this recent run has been quite sharp bringing the moving average differential to nearly two standard deviations from the mean. Similar to the daily chart, failure to break this trend could spell trouble ahead.

On the monthly SPX chart things seem to be improving but we are not in the clear just yet. We briefly broke the RSI (14) to the downside as we have done in the previous two bear markets but we were quick to recover the 50 level and hold it. That is a good sign. It would have been good to see the March rally on stronger volume.  The RSI (14) is still trending lower so we need to see a strong market from these levels to break the downtrend. The MACD signal cross is still negative as it was in the previous two bear markets but negative momentum seems to be waning.

We included the Fibonacci levels from the 2009 bottom. A further breakdown in the economic, fundamental and technical picture we believe can knock the S&P 500 back down to the 1600 level. 

We had written our views in the past. We expected a continued sell-off going into the first quarter. We then pivoted and thought we could have a strong reflex rally to end the quarter. That call proved to be correct although my execution of the forecast was terrible. We though the market would ultimately rally back to its 20MMA and continue downward from there. We are at that critical juncture now. We are not clairvoyant in our investment thesis. We are not trying to predict the future (I tried that last month and took losses in the portfolio). We are simply trying to position ourselves for probable outcomes.

When panic emerges, prices sell-off sharply associated with elevated volume levels and a swelling VIX, we will pivot to the short side. If this event doesn’t happen and we rally through the summer we will maintain our core portfolio positions. That’s our plan.

Corporate Earnings

We are entering earnings season. I read the most recent earnings report from factSet and they highlighted some interesting earnings adjustments. As we all know, sell-side analysts always start the year overly optimistic and reduce forecasts as the year progresses. That said the rate of change in these downward revisions have been excessive. They write, “During the first quarter, analysts lowered earnings estimates for companies in the S&P 500 for the quarter. The Q1 bottom-up  EPS  estimate  (which  is  an  aggregation  of the  estimates  for  all  the  companies  in  the  index)  dropped  by 9.6%  (to  $26.32  from  $29.13)  during  this  period.

During  the  past  year  (4  quarters),  the  average decline  in  the  bottom-up  EPS  estimate  during  a  quarter has  been 4.4%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.0%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 5.3%. Thus, the decline in the bottom-up EPS estimate recorded during the first quarter was larger than the 1-year, 5-year, and 10-year averages.

In  fact,  this  was  the  largest  percentage  decline  in the  bottom-up  EPS  estimate  during  a  quarter  since Q1  2009 (-26.9%). “

Much of these downward revisions are coming from the messages sent through the 1Q16 pre-announcement period. Once again FactSet goes on to note, “At this point in time, 121 companies in the index have issued EPS guidance for Q1 2016. Of these 121 companies, 94 have issued negative EPS guidance and 27 have issued positive EPS guidance. If 94 is the final number for the quarter, it will mark the second highest number of S&P 500 companies issuing negative EPS guidance for a quarter since FactSet began tracking the data in 2006. The percentage of companies issuing negative EPS guidance is 78% (94 out of 121), which is above the 5-year average of 73%.”

We tend to look at the twelve month forward EPS estimate for the S&P 500. According to Bloomberg estimates, the twelve month forward EPS estimate for the S&P 500 is $123.09. Taking into account S&P 500 cash flow per share of $188.97 and book value per share of $736.38 we still find the S&P 500 overvalued by some 15%. Just reverting to the mean based on today’s figures justifies $1760 to $1770 for the S&P 500. If it drops below the mean (as is usually the case) our mark of 1600 isn’t all that far-fetched. Attempting to trade based solely on fundamental analysis is difficult and in most cases the market will stay at elevated valuation levels for quite some time. It is a useful exercise though when looking at earnings trends.

In a recent post of ours we noted the importance of the rate of change in the twelve month forward earnings forecasts. In the post we wrote, “This is an important point because the direction of earnings forecasts have a fairly tight correlation with the direction of equities so the one month slope of the earnings forecast line is useful to watch. Bear in mind forecasted earnings are a reactionary lagging indicator so by the time you actually pick up a negative reading in the slope of earnings, the market has already given up a lion’s share of its gains and you’ll be a day late and a dollar short.

Tracking the rate of change in this figure has some use though. The slope of the line has a natural tendency to be positive (as does the stock market) so by tracking the rate of change, we could get a warning even if the slope of the trend is positive but decelerating. This may lead to a bit of noise and false readings but we look at it as a “head’s up” for potential problems. The chart below shows a z-score for the one month slope of twelve month forward forecasts going back twenty years.”

As can be seen in the chart below, the rate of change in the twelve month earnings forecast for the S&P 500 hasn’t been all that great.

“When the z-score falls below zero, it indicates decelerating or negative slope and should be used as a warning signal. If the figure recovers quickly then we breathe a sigh of relief and move on with our investment and trading thesis. But once that line continues lower to around -1 standard deviation, bad things happen in the market. The ultimate story here is that we definitely need earnings and revenues to improve dramatically in 2016 to justify a continued bull market.” 

We have also been tracking profit margins. “It appears we are seeing a continuation of earnings being produced on fewer revenues. We have spoken about the mean reverting nature of profit margins.

The figure below shows what happened to the S&P 500 the last two times profit margins started to roll over.”

Perhaps with greatly reduced earnings expectations and a weaker U.S. dollar we could be in store for an earnings season with large beats but ultimately the revenue and earnings picture needs to improve in order for the market to continue to climb.

Bottom Line: We understand we are at a critical juncture on the stock market at these levels. Improving economic and corporate earnings can propel the market to new highs. That said we understand the risks associated with this latest rally. The global economy continues to be tepid at best, as is seen from the lack of confidence exhibited by the worlds Central Bankers, the corporate earnings and revenue data don’t appear all that strong and the technical picture is at key turning point levels. We are maintaining our core long positions at this time but will put hedges in place and take a short directional bias at the first sign of trouble. As a sign of trouble we will look for a catalyst driven sharp sell-off on big volume.

Until next time, happy trading.

Joseph S. Kalinowski, CFA

Email: joe@squaredconcept.com

Twitter: @jskalinowski

Facebook: https://www.facebook.com/JoeKalinowskiCFA/

Blog: http://squaredconcept.blogspot.com/

 

 

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