I have been working daily on designing and backtesting various option strategies, which will continue to be my focus for the foreseeable future. As a result, the time available for writing new posts has been and will continue to be quite limited.
That said, I feel obligated to comment on the status of the equity market, as I did at the end of 2015.
Earnings are Declining
The single most important fundamental factor influencing equity prices is earnings. And year-over-year earnings have declined for four consecutive quarters - even if we ignore the energy sector. Despite this fact, the S&P is up almost 7% in the past two months.
Earnings are down and prices are up. How can we explain this? The market could be factoring in a higher future growth rate in earnings. I certainly hope that would not be the case after four consecutive quarters of declining earnings. The market could be assigning a lower risk premium, one low enough to overcome the decline in earnings. I will concede that recession risk has declined in the past two months, but the risk is still material.
Fundamentals are Weak
According to the latest Trader Edge Recession model, five out of 21 explanatory variables are still indicating a recession. Granted, this is down from eight the previous month, but it is still almost 25%. Recession risk is still significant and the U.S. economy is weakening. GDP growth was 1.4% in Q4 2015, but the advance GDP estimate for Q1 2016 was only 0.5%. 1.4% was hardly impressive, but 0.5% is very weak. Similarly, growth in industrial production is indicative of a recession.
Market is Overvalued
The market can continue to climb in the face of weak fundamentals and even declining earnings. In fact, the old maxim always holds: the market can stay irrational longer than we can stay solvent. That said, the equity market is also overvalued. When combined with weaker fundamentals and declining earnings, this raises the stakes for the bulls dramatically.
We don't need a recession for the market to correct by 20%. Reverting to a normal valuation level would be sufficient. If we do enter a recession from such an overvalued level, the magnitude of the decline would be breathtaking.
Earnings are declining, fundamentals are weak, and the market is overvalued. Can prices continue to rise? Absolutely. Is the market attractive on a risk-adjusted basis? Absolutely not.
Most momentum and relative-strength based technical models are bullish after two very strong months of equity returns, but do not ignore the fundamental risks when implementing these types of algorithmic strategies in your portfolio.
The RUT, SPX, and NDX all broke their bullish 2-month trendlines last week. In addition, my relative strength timing indicator just turned negative. The warning signs are flashing again.
Print and Kindle Versions of Brian Johnson's 2nd Book are Available on Amazon (75% 5-Star Reviews)
Print and Kindle Versions of Brian Johnson's 1st Book are Available on Amazon (79% 5-Star Reviews)
Trader Edge Strategy E-Subscription Now Available: 20% ROR
The Trader Edge Asset Allocation Rotational (AAR) Strategy is a conservative, long-only, asset allocation strategy that rotates monthly among five large asset classes. The AAR strategy has generated annual returns of approximately 20% over the combined back and forward test period. Please use the above link to learn more about the AAR strategy.
Copyright 2016 - Trading Insights, LLC - All Rights Reserved.