Investors are euphoric again this week, according to Citi’s PULSE Monitor, having quickly recovered from the January correction. This rediscovered bullishness was backed up by fund inflows across the board. Citi analysts Tobias Levkovich, Lorraine Schmitt, and Christina Wood still think markets are slightly undervalued, even though they warn that another correction could hit the market before the end of the quarter.

Investors Euphoric

Different market valuations give mixed results

The normalized earnings-yield gap went down slightly to 1.6 standard deviations below its long-term average. This is also 0.47 standard deviations above the rolling mean, which would imply that the market is slightly overvalued, but when Treasury 10-year bonds are replaced by Baa corporate bonds the gap falls to 0.01 standard deviations, which implies that the market is fairly priced right now with a 16.7x PE multiple based on S&P 500 operating EPS.

“Market still appears modestly undervalued based on a variety of metrics,” they write, even though neither of the models they present show it being undervalued. “One of our highly correlated valuation metrics argues that the S&P 500 is roughly 20% undervalued, but several other measures are less attractive.”

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Sentiment turns euphoric once again

Sentiment ticked up from 0.5 to 0.56 on the panic/euphoria scale, implying an 83% historical probability of a correction in the next twelve months. The cyclical expectations model, which leads the market by one to three weeks, fell sharply, implying that another correction is just around the corner. Composed of credit spreads, steepness of yield curve, Redbook retail sales, copper and oil prices, and railroad freight – total carloads the CEM model doesn’t depend directly on investor sentiment like the panic/euphoria model does.

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This sentiment was backed up by $4.16 billion worth of inflows to domestic equity funds, $3.10 billion to foreign equity funds, and $1.16 billion to bond funds last week. The four-week moving average for equity funds fell from $5.40 billion to $5.21 billion, and the four-week average of M2 rose from 11.38% to 13.11%.

Upward revisions fell this week, now at 43.1% so far in February compared to 43.6% for January, and only three of ten S&P 500 sectors had net upward revisions so far this month. Citi still thinks that a 5% – 10% correction could come sometime this quarter considering the euphoric sentiment, falling CEM, and soft earnings revisions, though this doesn’t change Citi’s year-end S&P 500 target of 1,975 with $117.50 EPS. They single out emerging market weakness, inflation, and sovereign debt risks as some of the near term risks that investors are facing.

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