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US market complacency

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Published on: Thursday, July 24, 2014

by Michael Knox

The two things that the US market might be worrying about are: first, the end of Quantitative Easing and secondly, the likely increases in the Fed Funds rate in 2015. In recent days, the commentary that I have been reading on the US market seems remarkably complacent.

People really don’t seem to be concerned about the end of QE. Many suggest that even a tightening of the Fed Funds rate may be dangerous for bonds but not a problem for equities. To me, this suggests a state of some complacency. Maybe it is the right time to update our model of the S&P500 and see if we can find evidence of that complacency in market valuations.

In Chart 1 above, we see quarterly operating earnings per share of the S&P500. So far 21.3 per cent of companies listed in the S&P500 have reported their earnings for Q2 2014. The result is that operating earnings per share for Q2 are estimated to be $US29.64. This is actually higher than the preseason estimate of $US29.51.

Quarterly operating earnings per share are expected to rise further $US30.71 in Q3 2014. When we look at our chart, we can see that earnings numbers in the range $US29 to $US30 are pretty good compared to the level of $US25 where they were stuck for quite a long time in 2012.

The problem is whether or not the equities market has got ahead of a pretty good earnings picture. To build a model of the S&P500 we actually need 12 month rolling earnings. These are estimated to be $US111.96 in Q2 2014, rising to $US115.75 in Q3 2014. The Q3 number is the highest on record.

Source: Morgans

In Chart 2 we see our updated model of the S&P500 based on those 12 month rolling operating earnings. We also use the current 10 year bond yield of 2.48 per cent. This gives us a current fair value for the S&P500 of 1827 points. Our fair value rises to 1,880 points by the end of December 2014.

The problem is that the actual level of the S&P500 passed those levels quite a while ago. On 22 July, it traded at 1973 points. This was 146 points higher than our model estimate on that day. So what we can say is that the market is a bit overvalued and there is a bit too much optimism already built into the levels that the market is trading at. Is the level of overvaluation really that dangerous?

In Chart 3 we see our overbought/oversold indicator for the S&P500. This tells us the amount that the S&P500 is overvalued or undervalued by in terms of standard errors. On 22 July, the S&P500 was 0.422 standard errors too expensive. This is nowhere near as overvalued as it would have to be to signal a bear market. To do this it would have to be at least one standard error higher. In simple terms, the market would have to be around three times as overvalued as it is right now.

Still, the market does tell us some things. In statistical terms an overvaluation of 0.422 standard errors means that the S&P500 has only a 33.6 per cent chance of going up. This is a polite way of saying that it has 66.4 per cent chance of going down. Right now, the market is around eight per cent overvalued and it has a two out of three chance of going down.

We think there’s a reasonable chance of a healthy bull market correction sometime in the next few months. Keep an eye out. This might just provide a trading opportunity.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


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