Tobias Levkovich, Chief U.S. Equity Strategist at Citi Research, uses the price, unanticipated, liquidity, sentiment, and earnings (PULSE) framework to forecast direction of U.S. equity markets. The price (valuation) part indicates that the market still appears undervalued based on a normalized earnings yield gap analysis between the 5 year future of 10 year U.S. Treasury minus the S&P 500 earnings yield.
Potential gains for S&P 500 in the next 12 months
Such analysis suggests a 91% probability of S&P 500 (INDEXSP:.INX) gains over the next 12 months but only a 63% chance of gains (slightly below random) over the next three. On the other hand, the earnings yield gap is now 0.31 standard deviations above the rolling mean pointing to a slight overvaluation.
The alternate model, that uses the difference between Baa yields and the S&P 500 earnings yield, shows the market is close to fair value at 0.09 standard deviations below the mean. The trailing fourth quarter 2013 Price/Earnings (P/E) ratio is at 16.34x, while the forward P/E ratios for 2013 and 2014 are at 16.04x and 15.11x, respectively. Such P/E levels have resulted historically in average returns of 5.4% and median returns of 9.1% over the next 12 months. Data series to estimate returns starts on 1940 and was provided by Haver Analytics and Citi Research. Overall, the valuation component of PULSE points to positive S&P 500 returns over the next 12 months. Citi’s S&P 500 price target is at 1,650 for 2013 and 1,900 for 2014.
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Unanticipated component is neutral on U.S. equities
The unanticipated event component has a neutral impact on the S&P 500 (INDEXSP:.INX) over the next 12 months. The impact of positive macro developments, such as mutual fund inflows, earnings resilience, employment growth, and strengthening in certain economic sectors including housing and industrial are being offset by risks of Federal Reserve tapering, economic/earnings disappointments, and adverse government policy actions like the U.S. government shutdown. This indicator suggests challenges in the next 3 months as employment data and a shorter holiday season for retail may be disappointing overshadowing improvements in industrial production and credit conditions in the U.S.
Liquidity conditions remain neutral
M2, which includes checking accounts, coins and currency in circulation, negotiable order of withdrawal (NOW) accounts, time-related deposits, savings deposits, and non-institutional money market funds, is used by Citi Research to measure amount of money in circulation and to explain part of variations in equity market. M2 increased last week and the four week moving average increased from 17.19% to 19.19% this week on an annualized basis.
The Investment Company Institute (ICI) found that $13.54 billion was added to equity funds for the week ending on October 23, 2013. $9.19 billion went into domestic equity funds and $4.36 billion went into foreign funds. Bond funds experienced outflows of $2.32 billion. The four week moving average for total equity fund flows ended at $2.5 billion. Flows have slowed relative to the beginning of 2013.
Citi’s proprietary Panic/Euphoria model is close to euphoria
The Panic/Euphoria model is getting closer to neutral territory at its latest reading of 0.42. That increased from the reading of 0.36 last week, and it is the highest reading in nearly five years. The level suggests sentiment is optimistic, which implies that expectations are high and that disappointment is possible. The Panic/Euphoria indicator is contrarian, meaning that if the indicator reaches euphoria levels it acts as a caution signal for future prices. The components of the model include NYSE Euronext (NYSE:NYX) short interest ratio, margin debt, NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) daily volume as a percentage of NYSE volume, a composite average of Investors Intelligence and the American Association of Individual Investors bullishness data, retail money market funds, the put/call ratio, CRB futures index, gasoline prices, and the ratio of price premiums in puts versus calls.
Earnings trends are positive for S&P 500
Upward revisions as a percentage of total revisions for the S&P 500 were up thus far from September to October with eight sectors showing revisions to the upside. Drivers of upward revisions include:
- Consumer Staples: Beverages, food products, and household products propelled upward revisions.
- Financials: Banks, diversified financials, and insurance led positive revisions.
- Industrials: Airlines, building products, and commercial services and supplies drove upward revisions.
- Materials: Metals and mining and paper and forest products had the most upward revisions
- Telecom Services: Diversified telecommunication had the majority of upward revisions
Financials, information technology, and materials appear to be leading in terms of upside earnings surprises. In aggregate, earnings results for the third quarter of 2013 are beating expectations by 4.34% on a share-weighted basis. Excluding financials, share-weighted earnings are topping expectations by 3.87%.