Reading the technical tea leaves

What a rally!  The equity markets, and most risk markets, have advanced sharply from the lows of autumn 2011.  The market closed on Feb. 17 at 1,261.23, up more than 20 percent from the lows witnessed last October.  We had believed the S&P 500 was probably going to test the 1,258 to 1,370 range, as that range probably contained quite a bit of upside resistance.  This resistance level is proving less formidable that we had originally thought.

However, we feel that range is still in play with the market currently trading at 1,358.  We feel a new upside trend is being established in the market, with reasonably strong support (uptrend and triple bottom support along with 200-day moving average) all converging in the 1,250 point area.

With this in mind, we currently think the market may indeed test the high of the resistance range set forward in our past work (potential upside of 1,370).  If that level holds, and the market fails to penetrate that old “high” level, we believe the market will “consolidate” its recent gains.  We expect the market to trade in the 1,250 to 1,370 range.  If, on the other hand, the market penetrates the old one-year high of 1,370, the next reasonable resistance is seen at the 1,420 to 1,450 area.  From a technical standpoint, it will take some doing for the market to see new, all-time highs during this rally. 

It is fair to say that, strictly from a technical standpoint, the market has done some very heavy lifting over the past few months.  Since the low on Oct. 4, 2011, the S&P 500 has rallied 20.9 percent (as of Feb. 17).  This has been accomplished without a 10 percent (on a closing basis) correction.  Per Ned Davis Research, data going back to the 1930s suggests that during secular bear markets, the normal period between 10 percent price corrections has been 96 trading days.  We have not seen a 10 percent correction for 90 trading days.  So, if one believes as I do that we are in and have been in a secular bear market, we are statistically due for a
10 percent correction.

If this were to occur, the market could trade down to the 1222 area.  We won’t be too picky here – if the market were to start correcting from its current state, the downside support should be reasonably robust. 

Valuations Suggest Room for Upside Potential 

Both Jim Moffett, Scout Investments’ Chief International Strategist, and I agree that valuation is a poor market timing tool.  We need to be aware of current and projected valuation ranges as valuation tends to be a guide as to how “high is high” and “how low is low”.  In other words, valuation gives us a decent idea as to how, justifiably the market may move. 

We are looking for the companies within the S&P 500 to show an average of 6 percent – 8 percent earnings gains this year.  It appears 2011 earnings will come in at about $102.  With a 7 percent “target” growth rate, we believe S&P 500 earnings will be $109 for 2012.  By our reckoning, the S&P 500 is currently trading at 12.5x earnings.  Is this high?  Low?  The truth to this is in the eye of the beholder.  We believe at this level, the market has room for further upside potential.  We have been long suggesting that the justifiable valuation range of the S&P 500 is probably in the 10x to 14x earnings range.  We have written significant pieces on this subject, with many available on scoutinv.com. It appears to us that the current valuation is fair.   At 10x to 14x earnings, the “justifiable” valuation range for the S&P 500 is in the 1,090 to 1,525 area.

Bears in Hibernation – What May Wake Them

The bear camp has a hard time coming up with good reasons to be bearish.  Fundamentally, the economy and business flow is improving.  The Fed and ECB have been busy liquefying the banking systems – capital is available for expansion purposes (for those able to borrow).
It is hard to find short-term reasons why the market should decline significantly from this standpoint.  However, some of the items, short-term, which still go bump in the night include: 

 Iran.  Tensions are rising in the Middle East.  If the Iranians attempt to close the Straits of Hormuz, oil prices could spike (perhaps up 35 percent or more), igniting concerns about the sustainability of the economic expansion. 
 China.  Our base-case is calling for the Chinese authorities to start lowering interest rates.  We have not yet seen this, so it is feasible that they may delay this activity and thereby increase the probability that China’s economic growth may be slower than we, and others, currently envision.
 Europe.  This is possibly the most probable of the negative wild-cards.  Greece has significant levels of debt maturing next month; how, or will they repay these creditors?  At the same time, Italy will be in need of tapping the credit markets.  If Greece is in disarray (what else) will the credit markets not only discipline Greece but also Italy with higher interest rates?
 U.S. politics.  Washington tensions are high and may remain high for the majority of this year.  It is, after all, an election year.  With these tensions, it is possible consumers or business leaders become disillusioned with the fundamental economic outlook, reversing improvements we have witnessed recently in economic fundamentals. 

But it appears that many of the above issues have a lower probability of occurrence (at least over the short-term) than perhaps had been the case a few months ago.