Which Market is Correct?

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Trust the Bond Market?



The fundamentalists are having a tough time justifying what's going on as the "Great Fake Rotation" in January taught us.  For years "experts" have called for the impending bond market top, but it has yet to surface.  If Japan (shown in the chart above) is an example, then it will be awhile before it ever does.

We were actually able to take advantage of falling yields on 2/15 in our ETF Profit Strategy Newsletter where we advised bonds were in a "pullback to be bought" and TLT was trading for $116.18.    We recommended taking profits on the iShares 20+ year Treasury Bond Fund (TLT) when it rose to $122.82 on 4/5. 

Bonds around the world continue to be bought and continue to not confirm the equities market rally.

What about Commodities?

Commodities peaked in price in 2008, and a number of them did manage new highs above those levels, suggesting an improving macro environment.  Precious metals, livestock, corn, soybeans, and lumber all managed to make new highs.

However, taken as a whole, commodities are still down in price since 2008, peaking at a lower level in 2011, and falling swiftly since.  

Copper, which is considered the barometer of the world's fundamentals has fallen 30% since its highs in 2011.  Coffee prices (JO) are down almost 50% in the last year alone.  Most commodity prices are down since 2011.  This too suggests the world's economic condition is not as rosy as the equity markets imply.   

The most recent example of a commodity not confirming the equity markets is lumber, which has fallen 20% the last two months.  

Homebuilding stocks (XHB) should be on the lookout as I suggested in the article I published on 5/15 titled "Timber! Watch Out for Falling Lumber Prices." 

Commodities are showing signs of a weak macro environment, not a strong one as equities suggest.  

Caution on Equities           

So are all the major asset markets except equities wrong?  Is this a new paradigm?  Do the equities markets know something the rest of the world doesn't?  I think you know where I am heading.

To me the table below sums up much of the reason for the equity markets continued rally.  The equity markets are up, but not because of improving fundamentals.  

Stock prices are rising because of expanding multiples, not because of a fundamentally better earnings backdrop.  

Multiples expanded 35x faster than earnings over the last year ended March 31, 2013 and 33x faster in 2012.  This means stocks are going up because people are chasing price, not because equity valuations have gotten any better (in reality they have gotten a lot worse). 



In December 2012 and again in the first quarter 2013, multiples expanded over 30x as much as earnings grew (outlined in the table above).  P/E ratios are up 15% over prior year, but earnings grew less than 1%.  At the 2012 year end, multiples expanded 13% over the previous year, and again operating earnings showed flat growth.

With June 2012's P/E at only 13.8, the multiple expansion ratio will likely only get worse, unless earnings really start to pick up (not expected), or the market starts to tank.

Previous to today Dec 1998 was one other time this phenomena occurred (and we all know what followed shortly after).  Besides that quarter, the only other example of another time multiples expanded this much without earnings confirmation was from 1989, which preceded a market pullback of 20% by Fall1990.

The equities market (DIA) has likely gotten ahead of itself and is the outlier of the asset classes.

This of course doesn't mean you should sell out of all your stocks today.  The previous example from 1998 saw prices continue their rise another year, before the multiple bubble burst and prices fell back to reality.  In 1989 the markets rallied another few months before their peak finally occurred. 

A better alternative is to wait for key price levels to warn of a market correcting this over expansion.  Currently we are keeping our eye on two key levels to warn us of a market that is ready to finally correct its overzealousness. 

The ETF Profit Strategy Newsletter uses common sense combined with fundamental, technical, and sentiment analysis to help stay ahead of the market's trends.

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