After the deep sell off in August, the S&P 500 traded on a very volatile range between 1220 and 1120.
The market broke down from its 1120 support and things were looking pretty grim. However yesterday during the last hour of trading the market had a sharp reversal on European news and recovered this level.
I personally think that the market will start a powerful move either to the downside or upside. This move will be violent and will cause wrong footed investors and traders lots of pain. There are good arguments for the Bull and Bear camp that could be catalysts for a strong move.
One thing is certain, the market will not remain trading in a quiet range for the rest of the year. A big move will occur and one has to be prepared to invest and trade it accordingly.
In this article I will recap the most powerful arguments and factors that support a bullish and bearish view and then conclude this writing with my own personal opinion.
Bullish Factors
There are a variety of bullish technical indicators and sentiment readings that have reached extremes comparable to important market bottoms. Most of this bullish factors are of a contrarian nature.
Breadth Momentum:
During the crash that occurred in early August, the number of stocks that participated to the downside was massive and reached "bear market" readings. The market bounced various times and then sold off back the 1120 support in the S&P 500 but the breadth of stocks that fell back to the lows decreased. Even though when the S&P 500 sold off and broke the 1120 support on Monday, the number of stocks dropping was above the August lows.
This is a positive divergence that tends to form in market bottoms. Using the McClellan oscillator we can observe this bullish pattern. It seems that markets made their breadth and momentum low on August and now they are forming a price bottoming process.
Sentiment:
With the sell off in the markets a lot of sentiment indicators are showing pessimism and few bulls. Advisors are recommending a very low exposure to stocks and investors are taking money out of mutual funds and buying treasuries.
The Investor's Intelligence Survey shows that 45.2% of the newsletter advisors are bearish and only 34.4% are bullish. This generates a bull/bear relationship of 0.76 a very low reading that is comparable to when the market bottomed in March '09.
Advisor sentiment tends to be a reliable contrarian indicator when it reaches extremes such as the current readings.
Another interesting sentiment study is the Rydex Traders cash level compared to their exposure to the markets. Rydex funds are leveraged and offer exposure to different sectors of the market.
This great chart and stats from www.sentimentrader.com shows that the current 1.5 cash to leveraged fund exposure tends to signal important bottoms in the market.
When these readings are reached the market tends to gain on average 26.3% in 6 months and 39.2% in 12 months.
Fourth Quarter Most Bullish for Stocks:
Markets tend to show their strongest performance in the fourth quarter being positive 76% of the time with and average gain of 3.5%.
Performance tends to improve after a bad quarter in which the market looses more than 10%. When this occurs, the quarter following the steep loss tends to be positive 80% of the time and with an average gain of 5.5% for the S&P 500. This chart and stats are fromwww.birinyi.com
S&P 500 P/E Ratio & Bond to Yield Ratio:
With Monday's plunge under 1120, the S&P 500 dropped to a 11.69 P/E ratio, one of its lowest levels in 22 years. As Eddy Elfenbein (@eddyelfenbein) stated in his blog, for the current price of the S&P 500 to make sense he states the following:
" if we assume that the market is going for 14 times next year’s earnings, that would mean that earnings would have to drop 20% next year. Earnings are currently expected to rise over 13% next year."
Based on the earnings forecasts and normal valuation of the S&P 500 which tends to be around 15, stocks are cheap today.
Also the S&P 500 is currently yielding 2.2% vs. the 10 year treasury which is yielding 1.89%. Only the in 1960's and as the market bottomed between the end of 2008 and early 2009 was the S&P 500 yielding more than a 10 year treasury.
This shows that stocks are relatively cheap to treasuries which have strongly gained in price in a fear trade as stocks sold off hard.
Bearish Factors:
After highlighting some of the many technical, fundamental and sentiment factors that suggest that a bottom is near in the stock market lets look at the bearish factors that cloud over the bulls.
The main problem affecting the markets is macroeconomic. Simply stated, there is too much debt in developed economies such as the USA, Europe and Japan.
Debt has grown at a faster rate than GDP for decades and it is a mathematical certainty that doing this for a prolonged time must lead to a collapse as debt has one day finally be paid off or defaulted.
This creates a sharp reduction in consumption and investment and thus demand in the economy is drastically reduced. Banks and business go broke and credit tightens. Prices fall sharply and the economy enters a sharp contraction.
Unemployment rises dramatically and the economy remains in deep recession for years as the excessive debt is reduced to sustainable levels.
We saw a preview of this in the 2008 crisis as the subprime market crashed and defaults started pour over the economy bringing the financial system to the brink of destruction as liquidity disappeared.
To avoid and alleviate, in the short term, the deep demand contraction in the economy that ocurred as the private sector defaulted debt, equity prices collapsed erasing 401K's, home prices tanked and consumer confidence fell to the floor, the US government (among other developed countries) started to stimulate the economy by increasing its spending while adding public debt.
The fiscal deficit grew to approximately 1.5 trillion, about 10% of GDP causing economic growth as the private sector continued to shrank. Once public spending started to contract during this year, GDP growth immediately shrank and now the economy is in the brink or once again in a recession as the debt continues to contract to sustainable levels and private consumption is weak.
In Europe the problem is worse. The "fiscal credit card" that has been used by PIIGS countries to stimulate the economy and give their citizens a variety of benefits such as early retirement, vast unemployment handouts and free education, is starting to get declined. They are being forced to cut spending and benefits and thus reduce GDP which will produces an economic slowdown or recession.
Defaults in public debt are to be expected which could create massive bank failures that further erode credit and confidence in the economy.
The US is enjoying record low interest rates and could once stimulate the economy with more fiscal spending as Obama is proposing with a new "jobs plan" of approximately 500 billion or 3% of GDP. With this, he could short term avoid that the economy enters a recession once again. However, right now there is no political will to increase spending as some republicans and the tea party opposes it.
It is probable that this plan won't get passed in congress and thus the economy will continue its downtrend.
With a very high risk of fiscal defaults in Europe (in which there is still no coordinated "bailout plan" for the PIIGS and bank failures are probable), the US economy returning to recession as fiscal and monetary stimulus is reduced and with the risk that China entering a sharp slow down, growth prospects for the world look grim.
Earnings forecasts will start to get drastically cut, margins will become smaller and multiples will start to contract. If banks in Europe or US go bust, liquidity will drastically tighten causing mass liquidation of stocks, commodities and precious metals will occur. As "recession" headlines start to mount, investors get scared and sell their stocks in panic, fueling the downtrend.
The negative macro picture is real and unless there is a coordinated political and monetary intervention to "kick the can" down the road once again, things will get worst and stocks will continue to get hit.
Conclusion:
As you can see there are powerful arguments to call for a rally or deep sell off in stocks during the fourth quarter of 2011.
I personally think that even though the macro picture is extremely grim, stocks are due for a bounce from their deep oversold condition and thus will probably rally before falling further.
In March of 2008, when the S&P 500 dropped 20% as the financial crisis mounted, the market rallied for about 10 weeks for continuing to slide.
We need to see some aggressive action in the US with more fiscal stimulus plans and more "quantitative easing" to create a rally that will last months or even years.
Europe´s politicians will have to find a coordinated solution to "bailout" debt burduned PIIGS. Countries like Germany will have to make sacrifices to make this happen.
If this isn't done, this rally will be short lived and stocks will sell off further.
Bottom line, with coordinated political action or not, there are macro imbalances that sooner or later will need to be addressed as debt growth has surpassed GDP growth for decades. This problem has been "kicked down the road" but the tools available to do this are running out and one day reality will have to be dealt with.
Great trades and returns can be achieved by picking the right assets, but I don't think it is a good tim
