Weighing the Evidence

Three Types of Analysis

Technical, Fundamental and Sentiment

“Two Out of Three Ain’t Bad.”

Last week, I had the opportunity to report for jury duty. (I know there are hundreds of jokes that can be inserted here, but I’ll spare you.) I was put in a jury pool for a burglary case and listened as the judge, the prosecutor and the defense attorney took turns asking questions of the potential jurors. In the end I was not selected to sit on the jury, but I learned something that I think can relate to the stock market.

Because this was a criminal trial and not a civil trial, the defense attorney pointed out numerous times that the jurors would be responsible for voting guilty or not guilty beyond a reasonable doubt. He also pointed out that in a civil trial, the attorneys only had to prove that their client was in the right by only 51%.

It was this last part that got me thinking about the current market scenario. When it comes to investing, we can never be sure about which way the market is going to go “beyond a reasonable doubt.” All we can do is weigh the evidence and determine the percentage of factors that suggest the market will move higher and the percentage of factors that suggest the market will move lower. Personally, I want the bullish factors to be greater than 51% if I am going to invest my money, but they don’t have to be 100%.

I look at three different types of analysis to arrive at a long-term or intermediate-term stance on the market: technical analysis, fundamental analysis and sentiment analysis.

Let’s break each one of these analysis styles down in today’s market.

Technical Analysis

The stock market’s current technical picture is neutral at best. The S&P closing below its 52-week moving average during the first week of August raised a caution flag. A few weeks later, the 13-week (one-quarter) moving average crossed bearishly below the 52-week moving average, raising another caution flag.

On the positive side, the S&P closed down around the 1,120 level on August 8, which was the first trading day after the S&P downgraded the United States’ credit rating. The 1,120 level was tested again on August 10, August 19 and August 22 and the index managed to close above this level on all three occasions.

Another positive is that the 13-week moving average has not made a bearish crossover of the 104-week (two-year) moving average. Over the last 15 years or so, you could differentiate between a correction and a bear market by looking at the bearish crossovers of these two trendlines. The only two times it has happened in the last 20 years was in the fourth quarter of 2000 and in the first quarter of 2008. If the S&P fails to rally in the coming weeks, we could see the 13-week dip below the 104-week moving average.

Fundamental Analysis

Turning our attention to the fundamental analysis of the market, we just came through the second quarter earnings season, and the bulk of companies were able to meet or beat expectations. We will be entering the third quarter earnings season in a few weeks and expectations seem to have been ratcheted down quite a bit.

Based on the historical price/earnings ratio of the S&P 500, the market is relatively cheap. Using Robert Shiller’s inflation adjusted P/E ratio for the S&P, we see a reading of 20.44. The low for this indicator over the last 20 years was a reading of 13.32 in March 2009. In the last 20 years, there have been 34 monthly readings below 20 and that includes a 14-month stretch in late 2008 and into 2009. There was also a 15-month stretch in 1991 and 1992. In fact, had you used this P/E ratio as a buying signal over the last 20 years, you would have gone long at the beginning of 1991, in December 1994, in October 2008 and again in July 2010. Green buy arrows on the chart below signify the first monthly P/E reading below 20.

 SPX Chart

As you can see, you would have done pretty well by using an S&P P/E ratio below 20 as a buying signal. In 2008, you would have gotten in a little early, but the S&P had dropped considerably over the previous year.

The concern with the P/E ratio is what if the denominator (earnings) starts falling? This throws the whole equation off and can cause the ratio to rise because of shrinking earnings rather than rising stock prices. As of now, this concern is being addressed with a number of analysts predicting lower earnings expectations for the upcoming earnings reports. If the concern turns out to be valid, the P/E ratio will rise. However, if the earnings come in stronger than expected, the P/E ratio will fall and could signal another buying opportunity.

Sentiment Analysis    

The third analysis approach I look at is the sentiment. I use a number of sentiment indicators to gauge how bullish or bearish investors are towards the overall market. One of my favorite indicators is the Investors Intelligence Report. This indicator measures the investment newsletter industry for bullish and bearish percentages. Over the last 20 years, when the bearish percentage exceeds the bullish percentage, it has been reason to raise a bullish flag, but the best signals have come when the ratio drops to the 0.8 level. The reading from September 14 showed that the ratio was at 0.868. This is the second lowest reading since the 2009 low. It is also worth noting that when the ratio of bulls to bears exceeds three times, it should serve as a warning sign.

II Chart 

Another sentiment indicator I like to look at is the Rydex Nova/Ursa Ratio. The Rydex family of funds has the Nova Fund, which is a bullish fund that targets a return that is 150% of the return of the S&P 500 and the Ursa fund, which is a bearish fund that targets a negative 100% correlation of the S&P 500. The ratio is a contrarian indicator–when it gets too high, a pullback usually occurs shortly thereafter. When the ratio is too low, investor sentiment is too pessimistic and is usually a good sign that a rally is on the horizon. The indicator hit a 10-year low in recent weeks with a reading of 0.16, which is a positive sign for the overall market.

So to get back to the title of this article, when I weigh the current evidence, I see a negative to neutral view from the technical side, a potentially bullish signal from the fundamental side and a bullish signal from the sentiment side. All in all, this leads me to a moderately bullish viewpoint.

Kind of like a civil trial, we don’t have to be convinced beyond a reasonable doubt, we only need to have the majority of the evidence tilted in one direction or the other. In this case, two out of three analysis styles are pointing to a rally. To quote the band Meatloaf’s 1977 hit, “two out of three ain’t bad.”

Good luck and good investing,

Rick Pendergraft
Editor of Cabot Options Trader

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