US Stock Market -- Some Thoughts

Correction In Place
The SPX fell about 12% from its peak before recovering substantial ground later in the week.
Peak to trough so far, the SPX fell to a sharp and trade worthy oversold of 6.2% against the
25 day m/a earlier in the past week but has bounced to a moderate short term oversold of 3.2%.
It is an open question of how serious the correction is. The SPX has fallen below its 200 day m/a
and the 200 day has rolled over for the first time since 2011. Moreover, like the deep 2011 price
decline, both the RSI and MACD measures have been trending down for several months as lead-ins.
On the plus side, all the sharper down moves in the SPX since the 2011 correction have seen 'spike
low' patterns where recovery has been fairly rapid and where new highs were attained. SPX Daily

Room For Another And Perhaps Final Leg Up?
The cyclical bull is six years old, but there are capital resources -- idle capacity, labor, and credit
availability -- which remain untapped or underutilized and which are sufficient to carry economic
expansion into 2017 if exploited. Bull markets normally do not end until the economy is overheated.

But, to get this last up leg in the market, the economy must continue to transition to a credit driven
expansion which is far less reliant on continued growth of monetary liquidity. The failure of the
stock market to sustain the new highs in 2015, as modest as they were, means there are plenty of
second thoughts among investors concerning whether it is advisable to pay premium p/e ratios
for US stocks in an environment that may be more risky on a global basis (It could be argued that
risks are no higher than they were months ago, but that many players, smitten with the idea of
sustaining high valuations because inflation is so low, have taken off their blinders and have
broadened their focus).

As it stands now, I would be very reluctant to deny another up leg which carries the SPX to new
historic highs. On the face of it, such a continuation of the bull would seem to be modest in
potential. With accomodative monetary policy nearly global in scope now, and with China
especially set to push hard for faster economic growth, US stocks may get strong competition
from foreign markets, oil and other commodities. One offset could be if bondholders, seeing
that the Fed intends to raise short rates gradually but with persistence, elect to trim long dated
maturities and move some of these very large funds into equities.

China -- Stock Market Profile

To benchmark the China stock market, I use the S&P China SPDR (GXC) ETF based on the
S&P BMI China Index. The GXC holds over 600 stocks ranging from major cap. size to small.
The CXC has roughly $6.00 in net per share and trades around 11x eps. It is much less volatile
than the more notorious Shanghai Composite. GXC Daily 

Since its inception in early 2007 at a price of $50, earnings for the GXC have grown nearly 15%
per annum. Corporate profit growth in China has slowed down in the wake of the large 2009 -
2010 fiscal stimulus program and the p/e ratio for the GXC has naturally eroded. With China
struggling to meet its 7% per year growth target, the growth of earnings for the GXC in the
future will continue to be more moderate than in prior years. I would rate the stock as reasonably
priced at $65 (The stock is currently $69+).

The GXC caught the speculative fever for China stocks which began to ramp up around mid - 2014.
GXC shot up from the $70 area to close to $100 this year, but has retreated back to the $70 level
in the recent big China sell - off.

It is foolish to think China can become a broadly diverse, stable consumer led economy so soon
in its development. That has to be a long term objective to be worked at. In the meantime, to
stabilize growth, China has devalued the Yuan, is cutting interest rates and bank reserve requirements,
and is accelerating the growth of its basic money supply. The China economy is in deflation and
the PBOC is having to take stronger action to reverse economic growth deceleration. With more
monetary and fiscal support ahead, the GXC is probably fairly near to sold out.

The bottom panel shows the relative strength of the Shanghai to the  GXC. In my view the Shanghai
would probably be reasonably  priced against the GXC at a little below 40x or about 2700. Since
the Shanghai can be very flighty, the 2700 level has to be taken as a very approximate approximation.

Rome was not built in a day and neither will China be.

Stock Market -- Risky Business

I have been cautious on the stock market since the latter stages of the huge Fed QE program.
Historically, programs like this represent sustained emergency easing and they are very supportive
of investor and private sector confidence. There have been few of them, but when they terminate,
the absence of the strong tail wind they provide to the economy and the markets can susbstantially
diminish confidence. In the absence of large QE, the economy must transition to a credit driven
recovery / expansion and away from one that is liquidity driven, and so must a stock bull market if
it is to survive.

US economic growth has again slowed down over the past year, but consumer, business and banker
confidence has remained relatively solid. Profits have contracted  moderately on low sales volume
growth and pricing power and have taken a large hit from weaker oil and gas prices with lower
costs for net energy consumers only partially offsetting resource provider bottom line erosion.

The stock market had been using the idea that low inflation and interest rates reduce the equity
investment hurdle rate which should entitle investors to enjoy a higher p/e ratio on earnings. In
fact, the vast proportion of the advance in the in the stock market since the autumn of 2011
reflects the progressive rise of the p/e ratio.

My view on the stock market has been that primary and secondary fundamentals, while they have
eroded, are still positive, but that the termination of the powerful liquidity tailwind from QE 3
reduces positive return potential and raises risk.

I am not smart enough to explain exactly why the market has been so shaky since China cut its
dollar peg shortly back, but I suspect that without the big US liquidity tailwind, investor confidence
is more vulnerable to contrary economic developments. Even so, I have been surprised by the
powerful wave of selling.

The SPX is wildly oversold, and because the economy is muddling along positively, I must say
something I may very probably regret, but this kind of panicky action looks crazy, stupid to me.
SPX Daily

SPX -- Daily Chart

I have been cautious on the outlook for the stock market since  the roll up stage of QE 3 last
autumn and have argued this year that the bull market was on tenuous grounds from both
fundamental and technical perspectives. The key directional fundamentals in toto remain
positive but have been deteriorating up until recently when there has been slight improvement.
But, I cannot take any credit for the sudden, sharp selloff so far this week. Even though the SPX
is pricy and many solid observers are looking for a sharp price correction, the basic fundamental
framework for stocks has yet to turn negative. So, a tip of the hat to the other guys. SPX Daily

The SPX has entered a short term downtrend. 2015 price support has been has been taken out,
the 25 day m/a is rolling over and RSI and MACD, which have both been trending down, are
weak. The SPX is moderately oversold at a 2.8% discount to the 25 day m/a with RSI also
approaching an oversold position. So, it will prove instructive presently to see how much fire
power the bears are carrying since there is a moderate short term oversold condition in place.

SPX -- Weekly

Fundamentals & Valuation
Core fundamentals remain positive, but continue to erode. The slippage in the growth of monetary
liquidity continues but at a milder pace and there has been no liftoff yet in short rates. Secondary
fundamentals have slipped slightly but remain in plus territory. Shorter term leading economic
indicators, which turned up in Mar., are moderately positive on balance.

SPX  net per share is running at an annualized rate of $112 compared to $102 for mid - 2011. Thus,
most all of the large gains in the market since the autumn lows of 2011 reflect a sizable increase in
the p/e ratio. Players have slashed the market's discount or hurdle rate to reflect a sharp deceleration
of inflation and a continuation of the Fed's ZIRP just as they did beginning in the 1960's when the
inflation rate began to factor more prominently in market valuation measures (By this token, if
there is faster economic and profits growth ahead, gains in the SPX price level may be subdued if
inflation accelerates and investors elect to scale back the p/e of the market accordingly). The
prospect of faster inflation likely bothers few players now as with excess global production
capacity and slow demand growth, investors are more concerned about mild deflation tendencies.

Technical
The indicators with the weekly SPX chart show that momentum last hit a peak at the end of 2013.
The market has advanced since then, but momentum readings have persistently eroded and by
extension suggest the SPX will end up 2015 on the flat side. That is not a forecast, but it is where
we will end up without a substantial positive or negative change to investor psychology. SPX weekly

Afterthought
I have not abandoned the idea that global economic growth will strengthen as the year progresses.
If the global economy does improve, the Fed would likely abandon its ZIRP, commodities prices
would rise some, the dollar would weaken and the SPX could get competition from commodities,
PMs and selected foreign equities markets. Interestingly, China, which has been exporting
deflation for a good several years because of slowing growth and sizable idle capacity, has again
turned more sharply expansive with monetary policy and a change in Its currency value regimen
toward a weaker yuan.

Stock Market Sentiment

In measuring market sentiment, I prefer to watch the equities put / call ratio simply because
it reflects real money down on the table and not advisory opinion where many of those polled
may have no 'skin in the game'. $CPCE Dailyhttp://stockcharts.com/h-sc/ui?s=%24CPCE&p=D&yr=5&mn=0&dy=0&id=p62224920975

I use the put / call as an inverse indicator which becomes interesting at extreme levels. The current
chart shows a recent very sharp rise in the put / call ratio as players have become rapidly more
bearish on the outlook for stocks based on the 30 day m/a. I classify the stock market as oversold
when the 30 day p / c ratio rises above .70. This measure may obviously go higher particularly if
the market weakens in the short run, but note that a .70 plus has often signified that a positve
price reversal lies not too far ahead.

Stock Market

The Fed began to tighten policy last autumn with the close out of QE 3. Now, there is intense
speculation the Fed will begin the next step in the tightening process with an initial increase to
short rates as soon as its Sep. meeting. The Fed is promising that once it begins the process of
raising rates, It will do so in a gradual fashion. Since all players know It is likely to raise rates a
couple of times at the least, investors are assessing how even a gradual and gentle process will
affect not just the economy but their rate of return assumptions as well. So, there are questions,
and when there are, it is normal to expect some trepidation in the market until one can get a
fuller sense of how the Fed is planning to proceed with the process. The market has been on the
flat side this year with intermittent quiet bouts of profit taking along with short and rather shallow
rallies. The market has been discounting the event of a change to a further tightening of policy
and I sure do not know whether the discounting process is just winding up or whether it will
proceed further until the event is at last upon us. Assurances from the Fed that short rates are
likely to remain low for a good while may have a countering force in the elevated p/e ratio
which has given little ground since earlier in the year.


Daily SPX