Timing Outlook Remains Positive, But Falls Significantly

1. Summary

After rising out of its tight December trading range and getting off to a good start in 2010, three straight days of double-digit losses this past week pulled the S&P 500 from a close of 1150 on Tuesday, January 19 (its highest close in the 10-month rally) all the way down to 1092 by Friday, January 22. In other words, the S&P 500 lost 5% in three trading sessions. Ouch.

The Timing Outlook falls from 8.5 last time to 6.0. While still positive by definition, the sudden drop over the last three trading days had the look of the index falling through a trap door. Recall that last time, for the first time since the rally began, a single component of the Timing Outlook turned negative: The P/E of the S&P 500 (as computed by Morningstar) hit 21.3, just above the neutral-range cutoff of 21.2. I asked then if that was the canary in the coal mine? Maybe it was.

I have been saying for months that the market rally was news-driven, with the “net news flow” seeming to herald what the stock market would do. This past week, the net news flow turned decidedly negative. Within just a few days:

• The major indexes suffered large losses for three straight days--what the indexes do is not only the result of news, it is news itself, as it affects investor sentiment and can stoke optimism or greed on the one hand, or fear and pessimism on the other;

• President Obama attacked the big banks twice, first by suggesting a tax on their trading profits, then again by announcing plans to regulate their size and risky trading practices;

• Some opposition surfaced in the Senate to the re-appointment of Ben Bernanke as head of the Federal Reserve;

• Word of a possible economic slowdown in China seemed to make some investors nervous, especially over the possibility that it might spread;

• Some earnings reports disappointed investors—-Kimberly-Clark surprised to the downside, annual revenue at McDonalds fell for the first time in at least 25 years (although the company’s profits rose), and Google’s results seemed to disappoint even though they reported record profits;

• Unemployment rose to the top of the heap among disappointing economic news.

To quote from the Timing Outlook last time, “As regular readers know, I think this whole rally has been news-driven, and I think it will continue to be that way. If we get positive news, on balance, I believe that the market will respond positively. If the news is overall negative—particularly if it suggests that the fledgling economic recovery is stalling out—then I think the market will fall back and the rally will be over.” I still believe that. While one week’s worth of bad news is not enough to make the overall news flow become negative from a longer-term perspective, another week or two could do so.

What I’ve been calling the fine print now turns into bold-face type: The market can turn on a dime, as last week proved. As always, sell-stops or some other form of downside protection is recommended on long stock positions. I generally exclude from this advice stocks held for their dividends rather than for price appreciation. My own practice is to evaluate dividend stocks on the basis of their dividend stream and apparent reliability, not on what the stocks are selling for at any given time.

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday 1/22/10)

Last Outlook (1/4/10): 8.5 (positive)

S&P 500 last time (1/4/10): 1115
S&P 500 now: 1092   Change: -2%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1092   Change in 2010: -2%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1091   Change since 3/9/09: +65%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The latest report issued in January showed the ninth consecutive monthly increase. Positive. +10

• Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

• S&P 500 Market Valuation: (Source: Morningstar’s calculation of P/E based on operating earnings.) The current P/E of the S&P 500 is not shown today on Morningstar, not sure why. Last time, it had jumped into the overvalued range, so with this week’s market drop, I will assume it has fallen back to neutral territory. +5

• Morningstar’s Market Valuation Graph. This indicator has been meandering small distances around 1.0 (“fair value”) since late July, 2009. It now stands at 1.00, down from 1.02 last time. That suggests the market is fairly valued right now. +5

• S&P 500 Short Term Technical Trend: This past week, after peaking at a close of 1150 on Tuesday 1/19, the S&P 500 experienced three straight double-digit drops, closing at 1092 on Friday 1/22. That pulled the index down through its 20-day AND 50-day simple moving averages (SMA), although it happened so fast that the 20-day SMA is still above the 50-day SMA. So the relationship of the index to its key SMAs is: 20-day SMA > 50-day SMA > Index > 200-day SMA. This is considered neutral, although if the market drops continue, the 20-day SMA will fall through the 50-day SMA soon and make this indicator negative. Neutral. +5

• S&P 500 Medium Term Technical Trend: This trend, which uses the 50-day and 200-day SMAs, falls from positive to neutral. +5

• DJIA Short Term Technical Trend: Same configuration as with the S&P 500. Neutral. +5

• DJIA Medium Term Technical Trend: Neutral. +5

• NASDAQ Short Term Technical Trend: Same pattern as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: Neutral. +5

TOTAL POINTS: 60    NEW READING: 60 / 10 = 6.0 = POSITIVE