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US Equities Forecast and the Anticipated Path of the Market

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The market continues to pull back on global macro problems, and conversely, trade higher on short-term debt solutions, robust Q2 earnings, and recent improving economic data.

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In early May my thesis on the market was setting up for a significant market crash, based upon an unsustainable bid occurring in equities. The damage manifesting under the hood was indicative of such a crash comparable to 1987; one that would result in testing the March 2009 lows. Since that time, the market has undergone a consolidation process through time rather than a function of lower prices. I see two distinct developments that will shape our direction over the short, intermediate and long term.

US Equity Market Forecasts and Key Assumptions

The market continues to pull back on global macro problems, and conversely, trade higher on short-term debt solutions, robust Q2 earnings and recent improving economic data. Beneath the surface, fundamental deterioration continues, despite central bank/government efforts to stimulate economic activity. Share prices benefit from record profit margins and high M&A activity, yet real GDP, income, and employment growth continue to fade. A concerning development surfaced last week regarding consumer credit spending habits. Rising inflation costs on daily necessities are forcing middle and lower class Americans to their credit cards for survival. Elevated unemployment and poor housing numbers will continue to have a lack of improvement.

It is now evident that government intervention will continue and the likely ramifications won't be felt until after the 2012 elections. With that said, the headline risk remains to the downside and the bogey to lower equity prices in the short to intermediate term is concentrated on the U.S. Debt ceiling. At some point, not only must all developed economies deal with marking down to the level of income, but we must restructure large amounts of excess leverage. Until we accomplish this, growth will be problematic.

Winston Churchill characterized the U.S. when he said, "You can always count on Americans to do the right thing after they've tried everything else." S&P said Friday that, even if Congress raises the debt limit in time to avert a default, it might lower the U.S. sovereign rating to AA+ with a negative outlook if it isn't accompanied by a "credible solution" on the debt level. This would be viewed anything less than $3 trillion and I'm looking for such a downgrade to come to fruition. S&P forecasts short-term interest rates would rise by 0.50 percentage points and long-term interest rates by 1 percentage point. The markets are clearly discounting eurozone debt restructuring and are not pricing in a domestic debt ceiling debacle. If the equity markets are to take issue with the inability to raise the debt ceiling, the bullish scenario will in fact become void. We will face continued pressure across equity markets until a resolution is offered. I expect to encounter a limit down futures market if the news of a failed debt ceiling passage comes out of market hours and a similar selling environment as to when TARP originally was vetoed, down 7.8 percent in one afternoon.

The Anticipated Path of the Market

Last week the S&P closed on an outside reversal week. The previous outside reversal on a closing weekly basis was the first week of December 2010. This led to seven consecutive positive weeks in the market. Please refer to the chart below for visual evidence. My preferred scenario is to witness a potent down day early next week as last week's Investors Intelligence readings showed only 21.5% bears. Readings under 20% are bearish for the market and we need to again work off short-term overbought sentiment.


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Thus far, 85% of companies have beaten second-quarter earnings expectations. While 71% have exceeded revenue estimates. Of the 345 companies that have reported, 5.8% have raised guidance, while 6.1% have lowered guidance. This suggests two things; corporations are executing at a high level, but are reluctant to extend a positive picture of future earnings based on mounting uncertainty in regard to global growth concerns and a still struggling consumer.

10-year yields at less than 3% are confirming how low valuations really are. Historically, with yields this low a P/E ratio closer to the low 20s would be appropriate. Yet stocks are trading with a multiple in the 13 times trailing 12 month profits. Stocks are potentially trading at a 30% discount, based on a risk adverse environment.

Money flows out of equity mutual funds are at 12 consecutive weeks. Year-to-date outflows stand at $18 billion, and interestingly $22 billion, have been pulled from equity mutual funds in the previous five weeks.

The 20-day buy-to-open put/call volume ratio for the SPY, QQQ, and IWM continues to move higher. This index is used to identify hedge fund manager equity accumulation levels based on the amount of protection being purchased to off-set single stock buying.

Looking at a long-term chart of the S&P, it is a market that exudes euphoric equity movement followed by market crashes. The pattern shows consistency in five year bull runs, met by sharp price declines. If this pattern is to continue we must first close above S&P 1257 at year end, giving way to potential positive equity returns for 2012 and 2013. An interesting fact to overlay on the viability for positive market returns in 2012 and 2013 is the upcoming presidential election. Michael Sedecca pointed out that markets have gone up in the third and fourth year of a presidential cycle. Since the 1930s, the market has followed this pattern without fail for every term.


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Within this theory, let's take a closer look at the well-defined channel the market has traded in during the three-year bull market. We have just tested the lower support channel with June's correction. With a clean break above S&P 1370, it is reasonable to believe we will embark on the next bull market upward trajection. 2011 year end price target, assuming $96 on S&P profits translates to 1418. The price objective would be S&P 1552-1576 on a 12-month forecast. A realized 12-month price target of 1552 reflects a 13.5% return from current S&P 500 levels.


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This price objective can be characterized from another vantage point. Looking at the "lost decade," it is plausible to conclude that we are coiling in the defined S&P 1260-1350 range to ultimately breakout and make a run to this level. (The below charts are courtesy of Todd Harrison.)


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What are the stocks that will lead the market to my desired price objective? The NASDAQ is showing its hand and following the lead of index component leader Apple (AAPL). What we have witnessed in the past 12 months is AAPL consolidating at its highs, prior to making a continued breakout higher, with the overall market following its path.


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The chart of AAPL below shows a similar consolidating environment to that of the summer of 2010, which began at the beginning of 2011, much like the S&P 500. I signify this "chart" because stocks do not base out in this manner, only to correct lower. The stock has broken out of this pattern and my target is $425.


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No positions in stocks mentioned.

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