Thursday, February 28, 2008

Valuation Gap Closing. Near Term Upside Still Intact.

The equity rally coupled with the rise in rates (10 year US Treasury) over the past several weeks has brought US stocks close to a temporary stalling point. This can be seen on two levels – one technical, the other fundamental.

From a technical analysis perspective, the chart to your left* shows that one short-term metric (slow stochastic) is registering a near term overbought (80 reading or higher) while two other short-term indicators (momentum and MACD) are positive (upward slope to each). To some the fact that the S&P 500 touched its 50 day moving average and then backed down will be interpreted as the market encountering resistance at its moving average. This point is both wrong and largely useless as stocks and indices crisscross their 50 day moving average with great regularity - a point I have noted several time before and as can be seen by looking at the above chart)

(FYI - for more technical analysis perspective, I encourage you to listen to my interview with Louise Yamada posted yesterday.)

From a fundamental valuation perspective, stocks have closed their valuation gap (see Expected Return Valuation Model)** to some degree thanks to the rise in stocks and rates. However, the expected return at a reasonable $82 operating earnings number for 2008 is still averaging around 20% upside potential.

Investment Strategy Implications

The valuation gap has closed to some degree. However, stocks remain sufficiently undervalued to warrant a near-term bullish bias. As for the technicals, while the mega trend is negative (see prior blog postings on the Moving Averages Principle), the near-term indicators remain mostly positive and will likely improve once the near-term overbought is resolved.

*click on image to enlarge
**subscription required


NewstraderFX said...

There is an indication that was given by the stochastic on Wednesday and Thursday (and confirmed on Friday)that suggests the market is headed for another 10-15% downward movement.

Price closed on Feb 1 with the stoch showing overbought. Price dipped from there, but rose again to another peak on Feb 27-that price was again at stoch oversold, but at a lower price then the previous oversold on Feb 1. What the stoch is saying at that point is that even though price has decreased (relative to Feb 1) it's still too expensive and therefore likely to fall further. The signal was maintained with Thursday's drop and confirmed by Friday's movement.

There are two recent incidences of this occurring-price made the same "Double Stoch Overbought" with the
first being at Oct 10 with Oct 31 (9% drop after Oct 31) and the second at Dec 10 with Dec 26 (12.5% drop after Dec 26)

You can put this together with one of the oldest maxims that I know of regarding the economy-housing leads the economy into and out of recessions. It's plain that with inventories rising as price is falling, demand is very slack and that a bottom is not within site for this sector.

Therefore, a recession is very likely to last longer then H2 2008 and extend at least into H1 2009, something that is not in my opinion priced into the market-but will be.

Another possibility is to see a temporary up tick in Q3 08 (possibly extending into Q4) from the Fiscal Stim Package. But unless I see a seasonally adjusted 3 month decrease in housing inventories (along with a bottoming of prices), I won't believe in a bottoming in housing and therefore the economy.

NewstraderFX said...

"Price dipped from there, but rose again to another peak on Feb 27-that price was again at stoch oversold".

Change "oversold" to "overbought."

Vinny Catalano, CFA said...

Thank you, newstraderfx. I appreciate the comments and point of view.

NewstraderFX said...

If I may be so presumptuous, I posted an more extensive explanation of this on my blog: