Whether you look at it as a fundamental investor, a value investor or a technical investor, the market is getting ready to take a turn for the better.
Let’s start with fundamentals. All the evidence shows that the economy is gradually improving — there’s not a hint of a double-dip out there. Corporate profits outside of technology and telecom are back to within 3% of all-time highs, and now even technology-sector earnings are coming roaring back. There are huge pro-growth tax cuts in the legislative hopper.
As soon as the markets get some sense of certainty about when, how — and if — we’re going to take military action against Iraq, investors are going to open their eyes and see how good things really are. If there wasn’t a great deal of strength girding this economy, then I assure you that technology stocks and high-yield bonds wouldn’t be doing what they’ve done so far this year — they’re the best-performing asset classes.
Onward to value. I’ve written here many times about my “yield gap” model of equity valuation, which thinks of forecast earnings as an implicit yield for holding stocks, and compares that to the income yield from long-term Treasury bonds. Today the earnings yield of stocks dominates the income yield from bonds by one of the widest gaps at any time over the last 19 years (that’s how far back my data go). That means stocks are very, very cheap — in fact, the “yield gap” model says the Standard & Poor’s 500 would have to rise by about 38% to be fairly valued.
Sound crazy? Well, the only time the “yield gap” has been much wider was last October. Coming off that market bottom, the S&P 500 rallied about 25% in seven weeks — and the NASDAQ 100 rallied 45%. Value really matters, and don’t let anyone tell you that it doesn’t anymore!
Now, on to the technical. Say what you will about technical analysis — some people love it, some people hate it — but this time an especially compelling piece of technical work is perfectly confirming the market view that’s coming from my fundamental and value work.
The technical indicator that has caught my attention is one produced by my colleague Fredric Goodman. I’ve known Fred for 25 years — and there’s nobody I’ve ever met who knows more about technical analysis or who keeps track of more indicators every day. Now Fred is telling me that his most important indicator — he calls it the Summary Index — is winding up for a major buy signal.
The Summary Index, as the name suggests, is an “indicator of indicators.” It’s made up of 29 of Fred’s other major indicators — including such exotic beasties as the S&P volume oscillator, the nine-day positive day average, up-volume as a percent of up-volume plus down volume, the thrust oscillator and dozens of other indicators too bizarre and obscure to list here. Every day Fred scores the 29 indicators “buy,” “sell” or “neutral,” adds up the scores and smoothes the result. Voila: the Summary Index.
The Summary Index gives a buy signal when a preponderance of indicators has been screaming “sell,” and then suddenly starts to reverse. The exact numbers are arbitrary, but in terms of the way Fred calculates the Summary Index, he waits for it to fall below a value of 4.5 and then rise back above it again. The Summary Index fell below 4.5 last Wednesday, and bottomed at 3.45 this Tuesday — it’s now heading back up. The buy signal could come within a matter of days, perhaps as soon as next Monday.
The last Summary Index buy signal was after the market closed on Oct. 7 of last year. If you were following that signal and bought the next day, you’d have caught the exact low point for the NASDAQ 100 absolutely precisely. You’d have been just two days early to catch the low point for the S&P 500. OK, visualize Fred holding up his cocked index finger to his pursed lips and giving it a victorious poof!
To be sure, the Summary Index hasn’t been perfect. Since late 1998, which is as far back as Fred’s Summary Index data go, it’s given nine buy signals (seven were winners) and nine sell signals (again, seven were winners). If you’re curious about the full track record, you can see it by clicking here.
It sounds great, but the Summary Index suffers from the same risk that all technical indicators do: just because it has worked in the past is no guarantee that it will work in the future. This is a tough game — and Fred is intensely aware of what can go wrong. “I don’t want to be a Pied Piper,” he told me on Friday.
Fred’s no Pied Piper, and if you’ve been reading this column over the last couple of years, you know I’m no perma-bull pundit. But over the past six months I’ve been getting more and more bullish, and now I’m seeing the pieces of the bullish puzzle really start to come together. And just as it always happens — it’s just when investors are getting the most scared and the most fed up.
In fact, one of Fred’s indicators is the survey of the members of the American Association of Individual Investors to see how many are bullish and how many are bearish. Right now, excluding the small number who are neutral, 73% are bearish and 27% are bullish. Fred says that’s a new record for bearishness since he started tracking these numbers in 1987. And you know what happens when everyone is bearish? That’s right. The market goes up.
When fundamentals, value, sentiment and technicals all intersect, it’s time to pull up your socks and get ready to take some bold action.
First published at SmartMoney.com
