S&P 500 Index 1868
By Steve Blumenthal
March 12, 2014
We’ve been doing some additional work around the risk on and risk off buy and sell indicators that Big Mo generates. I share some of that data below (under the Big Mo chart). Take a look.
Included in this week’s update (the usual weekly charts):
- Sentiment Charts – Crowd Sentiment is Extremely Optimistic: Hedge
- Sentiment Indicator Based on Forecasts Gathered From 130 Stock Market Newsletters
- Cyclical Equity Market Trend Charts – Both Trend Charts Remain Bullish
- Big Mo – Sell Signal to Buy Signal Data (average decline -11.20%)
- S&P 500 Index Median PE Overvalued and Undervalued Price Targets (as of February 28, 2014)
- Provided are several links to learn more about the use of options to hedge
Investment Sentiment charts 3-11-2014:
Sentiment Chart 1 – NDR Crowd Sentiment Poll – Extreme Optimism:
We have quickly moved back to Extreme Optimism (Bearish) in this chart. Investor sentiment most recently peaked at 73.9. This is the second highest reading ever recorded – data 1995 to present. I continue to favor hedging long-term equity exposure until extreme pessimism is reached.
If you are a new reader, the gray area highlights the historical market performance when Investor Sentiment, as measured by Ned Davis Research, moves into the Extreme Optimism (Bearish) Zone (above the dotted black line or a reading of 66).
Sentiment Chart 2 – NDR Daily Trading Sentiment Composite – Neutral
Sentiment Chart 3 – Sentiment Indicator Based on Forecasts Gathered From 130 Stock Market Newsletters
The following Investors Intelligence Survey of Advisory Services shows the most optimism since 1987 (NOT A TYPO).
The chart is centered on the concept that the stock market tends to be a manifestation of group psychology in motion, as highs coincide with extreme group enthusiasm and lows coincide with excessive crowd fear. This sentiment indicator uses forecasts gathered from 130 stock market newsletters. Such information can be useful at opinion extremes, because at those extremes the stock market majority is usually wrong. Almost by definition, a top in the market is the point of maximum optimism and a bottom is the point of maximum pessimism.
This is concerning from an extreme sentiment standpoint; however, I will really get concerned when either of the following cyclical trend charts turns bearish. For now, the major cyclical trend for equities remains higher and I continue to lean in that direction.
Following are two of my favorite cyclical market trend charts:
Cyclical Equity Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1 – 13/34-week EMA – The cyclical bull market’s uptrend remains in place. Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical trend indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2 – The Big Mo Multi-Cap Tape Composite continues to signal a bullish uptrend for the market. The last “B” buy signal was in 2011. Note the 84.6% Profitable Long Trades and the Gain/Annum when “Bullish” investing in the S&P 500 Index and the “Switch” to cash on Bearish readings. While no process is perfect, this is a chart to keep your eye on.
Big Mo – Sell Signal to Buy Signal Data (average decline -11.20%)
We have been doing some work to see if we can zero in on a more systematic risk management structure. I have long followed and favored Big Mo which combines a number of quantitative indicators to determine the primary health of the market. We looked at all of the sell dates going back to 1980 and the entire subsequent buy dates. Hedges established at 10 out of 12 sell signals would have been successful. The above data looks promising. We’ll continue to keep a close eye on Big Mo.
S&P 500 Index Median PE Overvalued and Undervalued Price Targets
In the next chart, we look at the median price to earnings ratio (PE) to get a sense of current valuation. Are U.S. equities, in general, inexpensively priced or expensively priced? If we buy an inexpensively priced asset, there is greater future return potential. Stating the obvious, if we pay too much, our return potential is more limited. Not a problem if you have a 20-30 year time horizon and the ability to stay the course when turbulence hits (2002, 2008, etc.). It is a problem when a major correction occurs just prior to your retirement.
There are many ways to measure valuation. I favor median PE for it is a mathematical process based on ACTUAL earnings. History has shown that Wall Street analysts tend to over-estimate future earnings. The challenge for those who favor forward earnings estimates to calculate PE is that there is a long pattern of those estimates subsequently being revised lower. Thus, this is too much of a moving mark for me.
Median PE gives us a very good picture of current market valuation and helps frame short-term to intermediate-term upside and downside price targets vs. historical levels. This understanding can prove valuable in the management of your money. For example, one might wish to hedge downside risk when prices become richly priced. The reverse is true when valuations are attractive.
Here is how to read the chart. The current Median PE is 20.5 (data through 2-28-14). The 50 year median PE is 16.7. If you take the most recent reported earnings (median calculation) and times it by the 50 year average PE of 16.7, you get a suggested fair value of 1517.53. A 1 standard deviation move above 16.7 suggests the market is overbought at 1987.32. This is approximately 18.4% below the current levels. Here is the chart as posted last week.
The probabilities to me suggest an upside target of 1987 for the S&P 500 Index with a fair value at 1517. Given the current support of the Fed (as in don’t fight the Fed), the downside or undervalued target of 1047.75 is far less probable.
The problem that I see today is that sentiment is very bullish and the crowd is generally wrong at points of optimistic extreme. Thus, my belief that some proactive form of risk management (hedging) makes sense as it relates to your important long-term equity portfolio positions.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
Conclusion
The conclusion remains the same (see prior Trade Signal posts here). The cyclical bull market trend for stocks remains in place; however, risk is elevated. A Median PE of 21 based on actual earnings puts the market approximately 20% above its 50 year fair value. Click here for PE and Profit Margin charts.
Sentiment may serve as a guide in determining when to put some form of risk protection in place. Think of it as inexpensive insurance. I will become much more concerned when the cyclical trend turns bearish.
A note on the cyclical trend in interest rates – rates have been moving lower and are nearing a point that may turn the cyclical trend for bonds from bear to bull. While there can be no guarantees in our business, I note that we have begun to see a shift towards bond ETFs in our tactical strategies. We continue to hold mostly long equity exposure in our CMG Opportunistic All Asset Strategies as well as our CMG Tactical Rotation Strategy. The CMG Managed High Yield Bond Program remains in a buy signal as well.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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