Can it continue? Should I be concerned? What about the risks? Is it a top?
Domestic U.S. Market – It is impossible to pick up a newspaper or listen to any broadcast news without hearing about the market reaching new highs. All of the losses from the mortgage crisis have been recovered and the #1 question is, Where is the top? The magical top has been discussed since market creation in 1792 by the Buttonwood Agreement. Any discussion about tops and bottoms should have time frames attached to them. If someone said the top was going to be reached in the next year, does it matter that the market has a 300-point downward movement at some time within the next 3 months? Was the point just before the correction a top, a pause or a new bottom?
Instead of tops and bottoms, maybe we should be concerned with the portion of the market that reflects current solid profitability and the amount that reflects future opportunity? Fair value is a great benchmark that can be used to determine how much opportunity (speculation) is in the market price. Fair value is represented in the price and reflects the profitability of the company. A price above fair value represents an increasing proportion of future opportunity, while a price below fair value reflects doubt by the market that the company can continue to capitalize on the future.
The wonderful thing about the market is that there are as many opinions on the future, as analysts and investment managers. There is value in knowing when the opinions are too optimistic and when they might be too pessimistic. One way of determining these extremes is by looking at how far away the actual prices are from fair value. This method also has the benefit of seeing how extremes have developed over time. In this way, the short term tops and bottoms are seen as smaller movements and most likely, not major market changes that require asset allocation modifications.
The chart above (Chart 1)shows the DOW index in terms of fair, over and under value. The market is currently approximately 8% above fair value, but well within the two upper market extremes.
The first upper extreme is a caution level where prices have reached 120% of fair value. At this level the probability of the price continuing in an upward direction is getting lower, but caution should be used.
When the price exceeds the overvalued level, it is time to seriously consider the probability that the stock is at a level where the market expects too much, and downward pricing pressure will build as expectations are not reached.
Is the entire market at new highs?
Sometimes the headlines can be misleading, or at least tilting the story to bring the investor to a bad conclusion. Details are important.
The opposite is true when stock prices fall below fair value so far that they are considered undervalued, at only 80% of fair value (green bar). The market has low expectations, but the profitabilityis showing a more promising level. Is the overall market mispricing the true value of the stock? Most likely this is true.
As you can see from the chart, the current market is within the fair value range even though it is above fair value. It has a way to go before it reaches the caution level. The market appears to have more opportunity on the upside before being considered overpriced. This is partly being created by a reduction in subjective factor probabilities and increasing favorable factor probabilities. A revised risk matrix of the subjective factors impacting the market is shown above (Chart 2).
Details are important in understanding why the market most likely has more room to move in a positive direction over the near term. Only onesector is well above fair value and one is moderately above fair value. Consumer Discretion (Chart 3) is well above fair value. It is not within the caution area, but is above fair value more than any other sector. Next in line is Materials (Chart 4). This sector is only slightly above fair value, well within fair value.
Can the Market go Higher?
With two major sectors above fair value, six at fair value, and only one sector lower than fair value, a condition is created where a new high can be reached in the market.
Six of the nine sectors that make up the domestic largecap market are at fair value and moving upward. Chart 5 shows the healthcare sector, which is reflective of the other five fair value sectors. The other five are: Financial, Industrials, Technology, Consumer Staples, and Utilities.
There is one sector that is slightly undervalued. Energy has struggled and improved more slowly that other sectors. The energy sector chart (Chart 6) is within the fair value range, but slightly under the 100% bar.
Having two major sectors above fair value, six at fair value, and only one sector lower than fair value creates a condition where a new high can be reached in the market. Can the market go higher? Based on fair value and expectations, the answer would be yes. While there are no guarantees and no absolutes, it appears there is a strong probability that the market can continue in an upward direction, with earnings showing more opportunity available.
This does not mean there couldn’t be a correction based on one of the subjective factors identified in Chart 2. Even though the probabilities are moving lower, the chance of occurrence of any one of the factors still exists. Given the economic conditions around the world and pricing levels seen in the markets with earnings strength, the market has a good opportunity to move in a positive direction over the near term.
Wouldn’t it be nice if the market would move only upward without any downward movement?