Update: July 18, 2016: Signal Change Red to Yellow
The short-term market indicator (Market Compass) is being upgraded from Red (Crash Warning) to Yellow (Caution) as stocks have hit new highs. Hitting new highs does not mean we are back to a bull market. Retail and institutional investors continue to be net sellers even at these higher prices. The smart money is being very selective with their dollars.
Corporate earnings and the global economy are still weak, yet corporate buybacks and Central Bank intervention are keeping the markets afloat (for now). U.S. stocks and bonds are quite expensive, but foreign investors and Central Bankers keep on buying. There is a major disconnect between earnings and reality.
Take a look at earnings:
Though earnings have been plummeting since peaking back in 2015, stocks are up 5% over the same period. If stocks were simply to follow where earnings say they should be, stocks would need to drop over 14%. I still anticipate that we are heading for a crash, but it looks more like Sept-November based on my current cycle analysis.
Before a crash, stocks often take months to top out, especially during the summer months. There is rarely enough volume in the summer months for us to reach the peak. Based on current momentum, we still have higher to go. With us hitting new highs in the markets last week, I’m now projecting the S&P 500 could go another 5-6% higher for a top around 2,300-2,400.
We are due for a pullback as the markets have charged higher without a correction, but I do not expect us to reach new lows before a crash.
Market Indicator Update: Coast is clear?
Take a look at our indicators…
High Yield Bonds:
As you can see, our current indicators (Transportation, Emerging Markets, High Yield Bonds, and U.S. Oil), all but oil are above their 50-day and 200-day moving averages, giving us a signal that a crash threat is no longer imminent. This can change in an instant, but for now the coast appears to be clear.
With the Bank of Japan (BOJ) and European Central Bank (ECB) set to begin new rounds of stimulus, we could see another couple of months of euphoria before investors get a dose of reality. Japan has been doing stimulus for decades and it has NOT produced any economic growth. These Central Bank injections are like a steroid they inflate then deflate.
With the change in the Compass, this is not an “all clear” signal to buy stocks. In fact, I suggest if you are adding stocks, you should do so with caution. Quality is the name of the game!
5-Point Stock Inspection
I continue to prefer stocks that make it through my five-point stock inspection…
This looks at:
1. Earnings Trends: Earnings provide us with one of the best ways to track where a company’s future stock price is heading: I look at four areas to gauge the trend:
- Earnings Growth
- Positive Earnings Momentum
- Positive Earnings Revisions
- Positive Earnings Surprises
2. Price Momentum: When looking at a company, I will measure a stock’s momentum and growth potential. It is calculated based on factors such as the stock’s earnings growth and sales growth direction and magnitude, its price movements relative to S&P and a number of other factors. A stock with a high growth rating, for example, would indicate that the stock’s growth momentum is strong and positive over the long-term.
3. Financial Strength: In looking at the financial strength of a company, I typically focus on four main areas:
- Earnings Growth
- Increasing Sales
- Expanding Operating Margins
- Free Cash Flow
- Return on Equity (ROE)
4. Valuation: When looking at a company’s valuation, I measure its long-term price appreciation potential. It is calculated based on the company’s intrinsic and relative valuation results. A very high value rating, for example, indicates that both intrinsic and relative valuations point to attractiveness of the stock. I typically utilize two ratios to see if a company’s shares are attractively priced:
- P/E Ratio (price to earnings ratio)
- PEG Ratio (price to earnings / growth ratio)
5. Risk: In analyzing a company’s risk level, I utilize three categories: conservative, moderate, and aggressive risk stocks. I measure the long-term risk of a company by looking at a company’s standard deviation and beta over a five year-time horizon. A higher standard deviation and beta implies more variable and uncertain returns. A stock with a lower risk rating (conservative) would generally prove to be safer and more predictable than stocks with higher risk ratings (moderate or aggressive).
I recently published my Top 25 Stocks for Q3. This is a great place to start on finding quality stocks to own while we wait for the markets to top. I prefer those that pay dividends and those that are “best in class” within their respective industries. Additionally, I prefer sectors that are continued to see high demand.
Though a crash does not appear to be imminent, caution is still warranted. Over the next week or so I will selectively be removing some of the hedging positions and inverse ETFs from the portfolios (for now) and may add these back if conditions change.
There are still plenty of opportunities in the stock, currency, and commodities markets that I will be trading over the next several weeks while we wait for the markets to reach their final peak. During the crashes of 2000 and 2008, the bulls fought hard before the crash. the markets reached new highs and went higher and higher before crashing.
I believe we are witnessing the same phenomena now. These current bubbles are FAR larger than those two previous bubbles so when things go down, I expect it to be quite quickly. Credit is getting tighter, stock market euphoria is growing, and now it’s just a matter of time before the other shoes drops. In the meantime, I will be looking to help us increase returns without significantly increasing risk.