It now seems that last Wednesday’s Ebola-scare waterfall climaxed with the intra-day Dow down over 400 points and gapping down 10 points at a time. Bids were pulled as panicked sellers dumped into a falling market. The characteristics of a climactic event seem visible in retrospect.
This week, some took advantage of the tragic news from Canada to become short sellers or take a bearish market view. They now face a reversal again. It is not of the same magnitude as last week but it seems to have power. Positive earnings surprises certainly help.
- Sometimes it is luck. Sometimes judgments are made that turn out right. And sometimes the market will respond with a poke in the eye. No one ever knows for sure.
That said, we are all-in.
We think we will see new highs and above 2,000 in the S&P 500 Index before the end of this year. We think a market-priced at 16 times earnings is cheap in a climate of near 2% 10-year riskless US Treasury yields. $125 S&P 500 index earnings for 2014 multiplied by a 16 P/E equals a 2000 price of the index. Forward earnings (next year’s estimates) are expected to rise 6% to 8%, so the forward-looking P/E is lower. Thus, an equity risk premium (ERP) calculation suggests that this stock market can go higher.
Remember that ERP calculations take the earnings yield expected on the S&P 500 Index and subtract the riskless yield. Use short-term interest rates by subtracting near zero. That equals a huge ERP (about 6.5). Use the 10-year riskless Treasury note by subtracting a very low number. That equals a large ERP (above 4). In either case, the ERP calculation is a relative calculation. It works relative to the interest-rate reference.
Right now, the ERP suggests owning US stocks. They are cheap, relatively speaking, and are headed higher unless the market believes that interest rates are going to make a meaningful upward move. If you think interest rates are going to spike higher, stop reading here and sell your stocks.
We do not believe that will happen. We think interest rates at the short end of the yield curve will remain very low well into 2015 and then rise slowly. We do not see an inflation threat that would drive up long-term interest rates to threatening levels. Gradually rising interest rates are quite manageable.
Add to that US outlook the weakness in Europe, Japan, and other places in Asia. That combination says global interest rates are lower for a longer time.
Wholly Invested
Cumberland Advisors has four exchange-traded fund (ETF) strategies. The US ETF and International ETF (non-US) strategies are fully invested. The Sector Rotation ETF strategy is always fully invested. Sector rotation has no discretionary component that allows the accumulation of cash reserves. The Tactical Trend Allocation (momentum) strategy is 90% invested. Its techniques have evolved to deploy most of its cash reserves. Those techniques will be applied for the remaining cash reserves under some very strict disciplines.
We believe the bull market is intact. We believe the correction is over. We believe the US stock market is headed higher. We have re-balanced weights that favor the US over the rest of the world. In our balanced accounts we have taken up the weight for stocks and reduced the weight for bonds.
We think the rest of this year is bullish for financial assets.
David R. Kotok, Chairman and Chief Investment Officer