S&P 500 Analysis: The ‘Chopping Zone’ Explained

S&P 500 analysis: Since late 2013, the S&P 500 has been ‘boxed in’ by well-defined support/resistance levels. This explains 4-months of range bound trading activity. Here is the S&P 500 ‘chopping box zone’ along with key near-term support and resistance.

Buy-and hold investors know that the S&P 500 (SNP: ^GSPC) hasn’t gone anywhere since the beginning of 2014. Why and when will this aimless back and forth stop?

Here are four charts that will progressively shed some light on the issue:

The first chart is a plain weekly S&P 500 bar chart. At the top we see an index that has stalled.

The second chart is the same S&P 500 chart with some simple annotations.

  1. Solid black trend channel going back to March 2009
  2. Dashed black trend channel going back to October 2011
  3. Green support/resistance line going back to April 2010
  4. Green support line going back to November 2012
  5. Fibonacci projection level going back to 2002

The third chart is a daily bar chart going back to October 2011.

The fourth chart zooms in on the most recent market action in correlation to the various support/resistance (S/R) levels mentioned above.

The blue lines show an S&P 500 that has been boxed in by its own S/R levels.

Each blue circle represents a tidbit of ‘insider information’ available to investors familiar with such levels.

S/R conscious investors didn’t chase the S&P 500 when it touched the upper resistance rim and didn’t sell when it touched the lower boundary.

The Profit Radar Report combines those simple S/R levels with technical analysis, seasonality patterns and sentiment analysis.

Here’s an actual recent example of sentiment analysis combined with S/R levels and seasonality:

In the beginning of May, the financial media delivered a wave of bearish headlines, such as:

“Why investors expect to sell in May and go away” – Investors Business Daily
“This Chart Says we’re in for a 20% correction” – CNBC
“I’m worried about a crisis bigger than 2008: Dr Doom” – CNBC
“Risk of 20% correction highest until October” – MarketWatch

Merely based on those headlines, it became clear that the market will shake out premature bears with a drop and pop punch. Via the May 4 Profit Radar Report, I shared this outlook:

“The ‘chart detective’ inside of me favors a shallow dip (1,874 – 1,850) followed by a pop to 1,900 or 1,915 before we see a 10%+ correction. This bold prediction is mainly based on what the ‘chart detective’ thinks will fool the maximum number of investors.”

Resistance at 1,900 was composed of short-term pivots and a long-term Fibonacci projection level. The brief pop above 1,900 no doubt stopped out all the weak bears that followed the media’s doom-and gloom talk. Was it enough of a pop?

Thus far the S&P 500 has followed our script, however it continues to trade within the ‘blue box chopping zone’ and above double trend line support.

This week’s high and today’s low are now the new short-term support/resistance box for the S&P 500.

I often get asked: “But what about valuations?”

Do valuations matter? Quite possibly. But how do you determine whether stocks are cheap or expensive? Not even the so-called pros can agree on valuations. Here’s an objective look at three objective valuation metrics and why the pros passionately disagree about valuations.

Are Stocks Cheap or Overpriced? Here’s why Analysts Passionately Disagree

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

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The S&P 500 is Overvalued Based on P/E Ratio

Do valuations matter in today’s market? Just as you look at a Blue Book before buying a car, you should look at valuations before buying a stock. Even though it doesn’t mean stocks are ready to decline right now, P/E ratios suggest stocks are priced for long-term pain.

Are stocks overvalued? That’s a good question, but a better question is whether stocks are priced for long-term gains?

An individual stock – or the entire stock market – can be overvalued and still increase in value. A drunk driver may still be able to operate a vehicle, but the odds of a drunk driver or overvalued market to crash is much higher.

Buying an undervalued stock (or staying out of an overvalued market) on the other hand, places the odds in favor of the investor.

When dealing with probabilities – which is what investing is all about – having the odds in your favor is the best you can do.

Having that in mind, we ask again: Are stocks set to delivery long-term gain or pain?

Before we get to the valuation analysis, keep in mind that valuations are a long-term guide. We don’t use long-term indicators for short-term trades. A number of shorter-term indicators point to still higher prices ahead.

Pain or Gain?

Today we’ll look at valuations based on P/E ratios.

The current P/E ratio (based on Robert Shiller’s cyclically adjusted P/E ratio) is 21. The average P/E ratio going back to the year 1900 is 16.9. In other words, the P/E ratio is 26.9% above its historic average.

A reversion to the mean would imply a 26.9% drop in stock prices or a dramatic increase in earnings.

Is there a correlation between P/E ratios and the S&P 500? The chart below plots P/E ratios against the S&P 500. The vertical red and green lines highlight the correlation between P/E ratios and market tops/bottoms for the S&P 500.

Current P/E ratios are not at extremes that have historically marked major tops or bottoms, but P/E ratios do at best suggest sluggish growth going forward.

The visually illustrated study below shows the correlation between P/E ratios and their respective forward return.  The study covered the period from 1871 – 2010 and is based on the S&P 500 (S&P predecessors prior to 1957). P/E ratios are based on rolling average ten-year earnings/yields.

P/E ratios and the corresponding ten-year forward returns, were grouped into five quintiles in 20% intervals. As the chart shows, the cheapest quintile had the highest ten-year forward return while the most expensive quintile had the lowest return.

The projected 10-year forward real return for the S&P 500 (and SPY ETF) with a P/E ratio of 21 stocks is around 4.5%.

Keep in mind that the 1871 – 2010 span hosted multi-decade bull markets where P/E ratios remained in overvalued territory for extended periods of time. During a bear market, the forward return is likely to be much lower than the study suggests.

There are other factors that influence earnings, P/E ratios, and ultimately stocks’ performance. Those factors will be the subject of an upcoming article.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Are Stocks Overvalued? Yes, According to Dividend Yields

In a world of iPhones, social media, and twitter, it’s easy to forget about time proven market forecasting techniques. But just because there isn’t an app for dividend-based value analysis doesn’t mean it’s not working anymore.

Nobody likes to get trapped. Animals don’t like traps, humans don’t like traps, and investors hate money traps. But how do you distinguish a profit opportunity from a profit trap?

From October 2011 to September 2012 the S&P 500 gained 37%. Was this the beginning of a new bull market or the final leg of the QE bull market?

From March 2009 to September 2012 the S&P 500 soared 121%. Is this rally a new bull market leading to new all-time highs or a monster counter trend rally?

Charles Dow, the founder of the Wall Street Journal and original author of the Dow Theory, said that: “To know values is to know the market.” Yes, valuations might well hold the key to the above questions.

I follow four metrics to determine fair value:

1) Dividend yields
2) P/E ratios
3) The Gold Dow
4) Mutual fund cash levels

A special report analyzing all four valuation metrics was sent out to Profit Radar Report subscribers on Thursday. This article will look at one metric: Dividend yield.

What Dividend Yields Teach about Value

What connection is there between fair value and dividend yields? To illustrate:

Company A trades at $100 a share and pays a dividend of $5 per share. Company A’s dividend yield is 5%.  If company A’s shares soared to $200 a share without dividend increase, the yield will fall to 2.5%.

There’s a direct correlation between a company’s share price and its dividend yield. Higher stock prices lead to lower yields. Low dividend yields are a result of pricey stocks.

Dividend yields are probably the purest measure of valuations. Unlike P/E ratios, they can’t be fudged and massaged (although the current dividend yield is likely inflated by the Fed’s low interest rate policy, which makes it easier for companies to accumulate the cash needed to pay dividends).

Since the year 1900 dividend yields for the S&P 500 have averaged 4.25%. The SPDR S&P 500 ETF (SPY) currently yields 2.02%, 52.5% below the historic average.

The current yield is much closer to the all-time low of 1.11% (August 2000) than the all-time high of 13.84% (June 1932).

The chart below juxtaposes the S&P 500 (log scale) against dividend yields and shows that every major market top coincided with a yield low, and every major market low coincided with a yield high.

Dividend yields aren’t currently at an extreme that requires an immediate drop in stocks, but they do suggest that stocks are overvalued.

What Does this Mean?

What do low yields mean for investors? Valuation metrics are long-term forecasting tools, they shouldn’t be used to enter or rationalize short-term trades.

The long-term message of dividend yields is that the down side risk is greater than the up side potential. The next big move will likely be on the down side.

The best entry point for long-term trades is usually discovered by shorter-term market timing tools. Every prolonged decline starts on the hourly and daily chart.

The Profit Radar Report monitors long-and short-term market timing indicators to identify low-risk high probability trading opportunities.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.