When Fear Is High, It is Time to Buy
Over the last few months I have been approached by many of my friends, family members and neighbors wanting my opinion about the stock market. The pullback we have seen since the market peaked at the end of April has gotten the attention of those that don't usually pay that much attention to the market.
Here is the long answer I usually give. I look at the market from three different perspectives. There is technical analysis, there is fundamental analysis and there is sentiment analysis. Two of the three look pretty good right now and the third one is neutral to bearish.
Fundamental analysis tells us what is happening within a particular company or within the market as a whole. Are earnings growing or shrinking? Are costs increasing or declining? How is the demand for products, and so on? Right now the fundamentals look great.
Looking at a chart of the P/E ratio for the S&P 500 where we look at the past 12 months of earnings and divide by the current price, we see a that stocks are cheap right now. Taking the data from the S&P website, I built this chart showing the P/E Ratio since 1988. I used operating earnings rather than reported earnings because this eliminates write-offs and charges.
What we see is that the ratio dipped down to 14.53 at the end of the second quarter. This is only the fourth quarter in the last 20 years that has produced a P/E ratio below 15. If you look at the last reading on the chart, it is the projected earnings for the quarter that just ended on September 30 and it is divided by the price of the S&P 500 on September 30. As you can see, if the earnings estimates are accurate, the P/E ratio will dip below 12 for the first time since 1989.
One concern investors have is that earnings will miss estimates and the denominator (earnings) will drop in value. I decided to run another calculation but instead of using the current earnings estimates I discounted the estimates by 10 percent. The calculation based on the discounted estimates and the closing price on September 30 of 1,131.42 would give us a P/E ratio of 12.38. This would still produce the lowest P/E Ratio since the first quarter of 1989.
When Fear Is High, It is Time to Buy
Turning our attention to the sentiment picture, we see that investors are more bearish now than they have been for several years. One measure of sentiment is the Investors Intelligence report. This report surveys newsletter publishers and the results are released showing what percentage are bearish and what percentage are bullish. In recent years it has been a decent sign when the bearish percentage exceeded the bullish percentage, but it has been a better sign when the ratio of bulls to bears dropped below 0.8.
The ratio reached the point of equilibrium with the report on September 14 with 40.9 percent maintaining a bearish stance while only 35.5 percent maintained a bullish stance. The most recent release shows that 45.2 percent are now bearish and only 34.4 are bullish, giving us a ratio of 0.76.
Another measure of bearish sentiment is the Rydex Nova/Ursa Ratio. The Rydex family of funds has the Nova Fund which is a bullish fund and targets a return that is 150% of the return of the S&P 500. The Ursa fund is a bearish fund and targets a negative 100% correlation of the S&P 500. The ratio is simply the assets of the Nova fund divided by the assets on the Ursa fund. The higher the ratio, the more bullish investors are and the lower the ratio, investors are more pessimistic.
The recent readings on the Nova/Ursa Ratio have been under 0.20 and they have been there for over a month now. These are the lowest readings on the ratio in ten years, even lower than the readings during the bear market of 2007-2009.
Between the Investors Intelligence report and the Rydex Nova/Ursa ratio, the suggestion is that investors are extremely bearish and from a contrarian viewpoint this is a good thing.
A Mixed Picture from the Charts
The technical picture is the one form of analysis that presents a mixed message. The S&P has dropped below almost all major moving averages and the 13-week moving average (one quarter) has made a bearish crossover of the 52-week moving average (one year). The 13-week is on the verge of crossing below the 104-week moving average as well. These bearish crossovers are signs of a weak market and could be indicative of further losses.
On the other hand, the S&P is in oversold territory on a daily and weekly basis and the monthly overbought/oversold indicators are at their lowest levels since the spring of 2009 as the market was coming out of the bear market.
The S&P has been in a range for the last 10 weeks, but the lower rail of the trading range was breached on October 3, but the index bounced back immediately. We could see the index rally over the coming weeks and then it will face overhead resistance. If this happens, we will need to re-evaluate where the overbought/oversold indicators are and what the tone of the overall market is.
⁞ The bottom line is that the fundamental picture is bullish, the sentiment picture is bullish based on investor fear and the technical picture is mixed. With two of the three analysis styles pointing to the market moving higher, I think it is time to start wading back in to stocks. I say wading because the technicals are not on the bullish side. If the technical picture starts to improve it will be a sign that investors should move even more money back in to stocks.
Until Tomorrow,
Article contributed by Rick Pendergraft, ETF Master Portfolio
Disclosure: None
