Guest Author: Erik McCurdy is the senior market technician for Prometheus Market Insight Prometheus Market Insight and has been analyzing charts every day for over 15 years. The software program that he developed to monitor long-term stock market trends has correctly predicted over 90% of the turning points in the S&P 500 index since 1940. His Gold Currency Index has predicted every major trend change in the US gold market since its creation in 2005.
Cyclical Uptrend in Stocks Tests Previous High But Investment Outlook Remains Poor
At the beginning of this year, our computer models predicted the likely development of a long-term topping formation in the stock market. Following a speculative blow-off rally from February to April during which a bearish distribution pattern emerged a violent correction drove the S&P 500 index below several important support levels of the cyclical uptrend from early 2009, creating the anticipated potential reversal formation. However, the initial breakdown was never confirmed via a subsequent close below the late June low. Instead, stocks have rallied 20% during the course of four months and are now testing the previous long-term high of the cyclical uptrend.
A breakout above the late April high would reconfirm the cyclical bull market and forecast additional gains. In general, a long-term breakout is confirmed when price action closes at least 2.5% above the previous closing high, so a weekly close above 1,248 on the S&P 500 would constitute a confirmed breakout and reconfirm the long-term uptrend. As we noted last week, the daily chart also requires a close above 1,248 in order to confirm the breakout, so technical objectives are closely aligned across both short-term and intermediate-term time frames. Additionally, a strong congestion resistance zone exists in the 1,250 area as shown on the previous weekly chart, so a weekly close well above this level would be a major development. However, the short-term uptrend from early September is now extremely overextended as the S&P 500 has rallied 18% without experiencing a meaningful correction, so the likelihood of this advance continuing above the 1,250 resistance level without first undergoing a pullback or period of consolidation is very low.
Extent of the Next Pullback Will be Telling
Looking ahead, the character of the next short-term downtrend should provide a great deal of clarity with respect to long-term direction. If the next correction ultimately returns price action to congestion support in the 1,065 area, the topping scenario will reassert itself. On the other hand, if the next downtrend is relatively weak and holds well above congestion support at the 1,120 level, a breakout and reconfirmation of the cyclical uptrend will become likely.
Regardless of whether or not the current cyclical uptrend succeeds in breaking out to a new long-term high, it is important to note the character of the investment environment within which these technical developments are taking place. The distinction between investment merit and speculative merit is critical to understand in order to consistently profit over time, but the line between the two can often become blurred, especially during secular bear markets such as this one. In general, a long-term investment perspective requires a forecasting time frame of at least 10 years, meaning that if the expected return of a given asset or sector is poor during the next decade, the outlook is poor for investors in general. Back in April, we analyzed expected 10-year returns for the S&P 500 index given current valuation and dividend levels, demonstrating that it was one of the worst possible times to buy stocks from an investment perspective. Let’s take another look at those metrics and see where we stand seven months later.
Past Stock Returns from these Conditions Have Been Weak
In the first study, the average 10-year forward real return was calculated for the S&P 500 index based on both current valuation and dividend yield. In other words, pick a starting date somewhere in history, noting the P/E ratio and dividend yield of the S&P 500 on that day, and then calculate the associated real return of the index 10 years later. This relationship was compiled using all available data going back to 1871, so the research has a solid historical foundation. The two charts below summarize the results for both valuations and yields, aggregating starting points into five separate groups.
At a current P/E ratio of 18.3 and dividend yield of 1.89%, the S&P 500 index is expected to return less than 5.8% annually based on valuation and less than 2.6% based on yield according to the first study. The second study aggregated initial data into ten different groups and is summarized below.
At our current valuation and dividend yield, expected average annual returns during the next 10 years based on the second study are 5.0% and 0.7% respectively, even worse than the poor estimates provided by the first study.
Both studies above suggest that now is one of the worst possible times to buy stocks for the long run. However, as we often note, short-term volatility has very little to do with long-term investment merit. The S&P 500 index has surged 18% during the past two months, but this move was a speculative advance driven in great part by anticipation of the recently announced second round of quantitative easing from the Federal Reserve. As we noted last week, when you create a ratio chart by dividing the S&P 500 index by either the Continuous Commodity Index or gold, the recent returns do not look so impressive.