Can The Market Rally Continue?

The following article first appeared at: on 2/14/2013.

Given the recent market highs, are we at the start of a new bull market or wrapping up an old one? We seem to be meeting the five critical conditions for continued gains, but that doesn’t rule out a 10% correction.

 Much has been said about the S&P 500 breaking through its former daily high set in 2007. The question seems to be whether this is the end of a bull market or the start of a new one?

First, let’s put this into perspective. Below is a chart of SPY, the SPDR’s S&P 500 Index tracking ETF, showing monthly returns since 1997. Many pundits like to point out that we have been in a four-year bull market, and therefore, this rally is extended and due to come to an end. This is simply false.

What we have been in for four years is a <i>bear market recovery</i>, as anyone who invested prior to 2008 can tell you. We have simply had a four-year long slog to recovery from the crisis-induced crash.

Figure 1: SPY Monthly Returns (1997 to Present)


 Source: [ Free Stock Charts]

 Second, from a longer-term secular reference, we have really been in a 13-year bear market and recovery cycle dating back to the 2000-2002 tech wreck market crash. Since the market peak in March of 2000, we have <i>not gone above, and stayed above</i> that level for 13 years now. This is the definition of a secular bear market.

The good news is that secular bear markets do end.

Know your P/Es

Below is a chart from Crestmont Research showing the history of secular markets in the U. S. since 1900. As you can see, the market’s history consists of long periods of rising markets (green bars) followed by relatively flat periods (red bars). However, “flat” describes the period from the beginning to the end of the period. Flat periods–or secular bear markets–can be filled with large declines and recoveries.

Figure 2: History of Secular Markets


Source: [ Crestmont Research]

 My point is not that we are at the beginning or end of a bull market. My point is simply that just because we may have re-attained prior market highs, it does not, in and of itself, mean much of anything as to which way this market goes from here. It is simply not that simple. But it makes for good headlines.

Positive trends

So what would give us an indication as to the market’s next move? Citi equity strategist Robert Buckland recently released a study in which he looked at prior 20% rallies that were then followed by double digit gains. This seems to be narrowing in a bit on our current situation, and may add some relevance to our current market high.

He found that to see continued gains, the markets must meet five conditions:

  1. Lower than average starting valuations
  2. Double digit EPS growth
  3. Rising PMIs
  4. Higher U.S. government bond yields and,
  5. Sustained flows into equities

Let’s take a quick look at where we stand relative to Mr. Buckland’s criteria.

  1. Lower than average starting valuations. According to Zacks, Q4 2012 earnings are coming in slightly better than expectations. More importantly guidance has been positive. Standard and Poors estimates Q4 earnings will be $23.83. If you annualize that number you have a P/E ratio of about 15.7 or pretty close to the long term average. While average is certainly not “low,” we have to give some accounting for “QEfinity” with historic low, albeit manipulated, interest rates. A 15.7 P/E is reasonable, but not where historic bull markets start. On the other hand, again considering interest rates, a bull market should be able to break through a 20 P/E quite easily if the other conditions exist.
  2. Double digit EPS growth. Standard and Poors is currently projecting a 17% year over year growth in S&P 500 earnings for 2013. While estimates have been coming down, they have a long way to go before dropping below a double digit estimate.
  3. Rising PMIs. Below is a chart of current and trend results for PMI and its components as reported by Markit, a London-based CDS specialist. PMI is growing “faster” based on a two-month trend. While I wouldn’t bet the ranch on a two-month trend, this does meet the criteria for a continued rally.

Figure 3: Manufacturing at a Glance (January 2013)


Source: [ Markit]

 Higher U.S. government bond yields. This would seem to be both the hardest hurdle and the most counterintuitive. With the Fed buying $85b of paper each month, they would seem to have the ammunition to keep yields low. And most pundits equate rising interest rates as one of the risks to a continued bull market. Below is a chart of the yield curve from Stock Charts.

The black line indicates the current yield curve. The lighter areas show the curve over the last 50 days — darker shaded areas being the most recent. Clearly we have seen a steepening of the yield curve resulting from rising rates.

Figure 4: Dynamic Yield Curve


Source: [ StockCharts]

 Sustained flows into equities. Figure 5 is a chart from Citi showing flows in bonds and stocks. There has been a clear flow of money to stocks since about mid December.

Figure 5: Weekly Bond v. Equity Fund Flows


 Here are some of the numbers from the third week of January:

  • Total equity inflows were $22.2 billion, the second-largest ever.
  • Inflows into long-only equity funds were $8.9 billion, the largest since March 2000 and the fourth-largest ever.
  • Excluding ETF flows, inflows into equity funds were the largest since May 2001, and the first over $5 billion since April 2003, according to Goldman Sachs.
  • Emerging market equity inflows were $7.4 billion, the largest in history.

The rally is on, but…

Current trends definitely support the case for a continued rally, based on Mr. Buckland’s research. The “but’s” would be that the current P/E is not historically low, some “trends” are really too short-lived to comfortably assert that they are in fact trends, and there still are some major macro events lurking on the horizon (will Europe ever be fixed?).

That said, in practice we remain cautiously optimistic. With one short term caveat: the market (SPY) does appear to be at the top of its short term trend line. A 10% correction could take place without violating the current intermediate uptrend as you can see in Figure 6 below.

Figure 6: SPY Trends


Source: [ Free Stock Charts]

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Charles H. Dow Award Winner 2008. The papers honored with this award have represented the richness and depth of technical analysis.


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