Wednesday, June 2, 2010

An Ugly Picture is Worth a Thousand Words

The process from bullish to bearish has begun. Like the oil from the gusher in the gulf, the unwelcome first wave of bearish reversals has washed upon the previously pristine bullish shores.

As the first chart* clearly shows, the EAFE (EFA) has satisfied the Mega Trend reversal conditions with price below its moving averages, moving averages crossing (50 day below the 200 day), and both moving averages pointing downward. As the first chart also shows, when a Mega Trend is set it tends to stay in place for many months, usually years. Virtually all other European indices have followed the EAFE's suit. Asian indices are not far beyond, with China poised to join the bad news party (see second chart). Only the US indices stand tall against the global bearish trend. That bravado, however, like much heard from the remnants of the super bull camp, seems poised to fade.

It is possible that the bearish trend signals will be limited to Europe. It is also possible that bullish resistance from the US and Asian indices will hold up and lift their European brethren back into bullish mode. Unfortunately, history does not support such an outcome.

Investment Strategy Implications

It's easy to debate the bullish or bearish view from a fundamental perspective. Expected strong earnings plus average to above average P/E ratios imply a much higher level for stocks. Low interest rates and low inflation also provide bullish fodder.

The opposing camp has its bearish economic ammunition most notably the mountain of debt as far as the eye can see (with its solvency and not just liquidity implications) and a kick the can down the road solution to nearly every difficult economic and public policy problem.

What is less subject to debate is the history illustrated in the above charts. If other indices join the bearish parade, you can kiss the bull market goodbye.

Until then, Yogi Berra said it best, "It ain't over 'til it's over". Most indices have NOT flipped to bearish readings. However, the charts above do not paint a pretty picture of things to come.

*click images to enlarge

2 comments:

Aaron said...

Forgive the stupid question: why should "...above average P/E ratios imply a much higher level for stocks"?

I assume you meant high P/E now implies higher future stock prices in the future.

Isn't high P/E ratios an indicator that reversion to the mean P/E is more likely in the future, probably through lower Price?

Vinny Catalano, CFA said...

Aaron,

Far from a "stupid" question.

Your points are accurate. The one I am making is as follows:

15 (which is the average P/E for the S&P 500 over the past several decades) times $80 (approximate mid point of current 12 months forward look for operating earnings for the S&P 500) = 1200.

If one were to discount that 12 month ahead number by the average return for large stocks over the past several decades (which is 12%), you end with a current S&P 500 fair value of 1071.

Accordingly, an above average P/E would put the current market at much higher levels. For example, 17 times $80 = 1360, which = 1214 discounted current fair value.

Hope this helps.

Vinny