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A Common Sense View for Investing in Stocks

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June 18, 2013
Chad Karnes, Chief Market Strategist

Henry David Thoreau is credited as saying, “Things do not change; we change”.  This is especially important when trying to take an objective look at the financial markets.  Recognizing that the markets and financial analysis don’t necessarily change, but our justifications and rationales can and do, is a big step in the right direction of objective analysis. 

The last few weeks I have examined the markets using our four pronged approach to help facilitate an unbiased perspective.  Fundamentals, technicals, and sentiment are all important, but sometimes a little common sense goes a long way.

A Little Common Sense

Thomas Paine, in his famous book Common Sense wrote, “A long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom.  But the tumult soon subsides.  Time makes more converts than reason.”  Today, we have a simpler term for this type of thinking, recency bias.

The market (Nasdaq:QQQ) has now rallied for four years.  Following Paine’s script, if we were to ignore any history, then investing now might make sense as the market’s four year rally has indeed created a superficial appearance that buying into this rally works.  The “Fear of Missing Out” as we discussed in our most recent Newsletter speaks to just that. 

But we as well Thomas Paine know that just because something is in place for awhile doesn’t necessarily make it right or certain it will continue into the future, and that is all you should care about if you are putting new money to work today. 

Wall Street in its usual role is the formidable outcry in justifying a rising market begets a rising market (NYSEARCA:VTI), but the tumult may soon subside, just as it did in 2000 and again in 2007.

Based on a longer history of a simple chart of the stock market, does this look like the appropriate time to put new long term money to work? 


Time Creates more Converts than Reason

The average length of a cyclical bull market within a secular bear market lasts 3.1 years.  We are 4.2 years into this rally, well past that 100 year average before a sizable pullback.

The chart below, included in our April ETF Profit Strategy Newsletter, shows that statistically this market (NYSEARCA:SSO) has rallied longer than most of its previous post recession rallies and is the third longest ever.  After each of the rallies listed below followed a deep correction (NYSEARCA:UVXY) that presented a much better longer term buying opportunity as P/E's moved back below historical averages, and investors got more for their money.

Common Sense Valuation

Prices (NYSEARCA:SPY) have risen over 140% the last four years and valuations are now showing it. 

Valuations suggest that companies are relatively expensive as the 10 year Shiller P/E resides at 24x.  This compares to a 130 year average of 16.5x and a median of 15.9x.  As we suggested in our latest Newsletter release 5/23, “By this measure stocks are hardly a screaming deal.  U.S. stock prices at this precise moment should be purely viewed as a momentum play with expired plates”.

Using simpler P/E ratios, the latest quarter’s reported earnings of $88 came in at 18.6x, from a low of 13.0x just 18 months ago when earnings were just $1 lower at $87.  This shows that investors are paying much more today for essentially the same amount of earnings (chasing prices instead of earnings). 

A final look at the inflation adjusted S&P earnings shows that they actually peaked at $95 in June of 2007.  This means that investors are still paying more today for real earnings of $88 than they did in 2007.  The real P/E today of 18.2x compares to 2007’s market peak P/E of 16.5x.

Today’s market prices are higher than they were at the 2007 market peak (NYSEARCA:SSO) given earnings levels and are also higher than the historical average and median by pretty much all measurements.

Combining our Four Pronged Approach

Taking a step back and recognizing that most markets (NYSEARCA:IWM) have rallied over four years and are up significantly, making companies much more expensive today than they were even 18 months ago, is a good start in developing an unbiased long-term opinion using some common sense. 

The fundamentals, as outlined in my recent article “Earnings Games”, suggest that the market indeed has gotten ahead of itself as earnings growth slows to a halt. 

However, the technicals, which I also recently discussed on ETFguide.com, have yet to confirm a breakdown in the uptrend, and 1600 is the first price level to watch for that trend change. 

As outlined in our Technical Forecast, “thus far 1600 has held, but if it fails, then it is likely the larger trend has turned down”.  Until 1600 fails, the trend remains up, but all the other warning signs are there and suggest that when the trend does finally break, the expected pullback, just as history teaches us, could be sizable, but normal.

Just because the markets have rallied and are up doesn’t mean we should give into our fear of missing out and make a long term decision that is not currently ideal.  Remember, “A long habit of not thinking a thing wrong, gives it a superficial appearance of being right”.  Or, as we like to put it, "the market may have legs, but it has no brains".

The ETF Profit Strategy Newsletter uses independent and unbiased common sense in analyzing the fundamentals, technicals, and sentiment to stay ahead of the markets.  

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CommentsAdd Comment

ChadK, ETFguide said on July 15, 2013
  Chartist, I agree. I also wrote about XLF and XLE leading the markets higher last summer in our August 2012 Newsletter published 7/20/12.

Again it seems these two leaders must become laggards before any substantial downturn will be upon us.
 
 
Chartist said on June 30, 2013
  Chad,

I'm watching XLF, XLY, and XLV for signs of weakness in the broader stock market. All three of those S&P sectors are still outperforming the S&P 500 but when they begin to crack, the rest of the market will follow. Very good analysis in this post.
 
 
Ron the Editor said on June 21, 2013
  Hey Ben,
We appreciate the kind words about ETFguide - we're blushing 8-)
 
 
BenTheDominator said on June 20, 2013
  Kudos ETFGuide for calling the upcoming drop that we actually lived to witness this week.
Maybe it's time to consider subscribing to your service :) and get a glimpse at your Weekly analysis in detail.
BenTheDominator did not do much dominating after all.

Although I truly believed that a resumption of the uptrend was in the cards for this week (and a correction starting only a few weeks from now), too many technical signs had me reduce my holdings to only 15% of my portfolio about 10 days ago. So the damage is very minimal. Waiting now for the next entry opportunities.

 
 
CelamerK said on June 18, 2013
  Agreed Ben and one more thing: Cyclical bull market within a secular bear nails it. I don't for a second believe this is a "new bull" as the Kool-Aid drinkers try to argue.
 
 
BenTheDominator said on June 18, 2013
  Nice overview of the financial landscape. Thanks.
It's also appreciated that you are cautious and not calling a market top right here.

The Fed will probably stick to its QE4 due to the unemployment rate, weak growth, and low interest rates, and knowing all too well what damage 'tapering' insinuations can bring about.

That in turn will translate to marking this week a breakout week for the stock markets with the SP500 regaining its recent high and proceeding upward from there, to the dismay of all doom-Sayers.
In 1995 for example, the SP500 was up 14% by end of June, and went on to add 20% by January 1996.

There is never anything 'wrong with the weather'. Only with the models that forecasters use. It's very natural to get upset when our best analysis of reality doesn't measure up to what IS, but what IS is all that matters.

Just stay with the trend until it changes, and keep the profits coming (to use to short the market when time comes)
 
 
grant8 said on June 18, 2013
  Good points Chad. This "bull" is way long in the tooth. You don't need to be a history buff to see this, just observant.
 
 
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