And the bear growled: Recent indicators of stock market direction

June 6, 2011 / Jeff McAllister

This past week the markets fell significantly, giving up almost half of this year’s gains. Where is the market going from here? Lets look at some of the recent indicators of stock market direction.

Investors need to look at the bigger picture to answer that question. What are the recent indicators of stock market direction currently driving investor sentiment and, therefore, the broader market’s performance? Greece? The European Union? A slowdown in economic recovery? Job growth less than expectations? Yes, yes, yes, and yes. I have to ask you, though, in the long run is investor sentiment what really drives a stock’s price, or is this a near-term phenomenon?

Those who have studied the behavior of the markets know near-term price fluctuations can be dramatically affected by changes in sentiment. In the mid-to-longer term time frames the same investors know it’s economic growth and prosperity which truly drives the longer-term trend. With that in mind, most investors recognize near-term movements of the marketplace generally revert back to the norm as fears give way to realities. A couple of very significant facts suggest this near-term weakness in the markets will be short-lived and not so dramatic. The two facts I’m referring to are the actual Q1 2011 reported earnings for the S&P 500 and the current behavior of the CBOE VIX.

Another recent indicator of stock market direction are 478 of the S&P 500 companies having reported Q1 earnings, we find over 70 percent reported increases in Q1 2011 versus Q1 2010 sales (top-line) and 72.5 percent exceeded their Q1 2010 earnings per share (bottom-line). Further, we find almost 62 percent beat their revenue estimates for the quarter, and nearly 72 percent exceeded their sales estimate. Of the 478 firms that have reported, 53 percent of them beat both their revenue estimate and last year’s EPS. Almost 61 percent exceeded Q1 2011 estimates and 2010 performance in sales. These are significant indications of the health of corporate America. These are not indications of an economy slipping into recession. Corporate America is holding nearly $3 trillion of cash on its balance sheets.[i] The question is: when will they start spending it?

Savvy investors also look to CBOE’s VIX as an indication of future market volatility. The commonly accepted line of demarcation is when the VIX closes above 20. A very strange thing happened on Thursday and Friday of this past trading week; while the markets trended lower, so did the VIX. This is not usually the case. Typically, there is an inverse relationship between the direction of the S&P 500 and the VIX. Recently, they both moved in the same direction. To me, this suggests “smart money” is not anticipating a significant movement in either direction by the broader markets.

Note: if you are unfamiliar with CBOE’s VIX, follow this link to a white paper that explains the VIX thoroughly: http://www.cboe.com/micro/vix/vixwhite.pdf.

In conclusion, while the market action last week was very bearish, my longer-term expectation remains unchanged after reviewing the recent indicators of stock market direction. After a bit of short-term selling I expect the markets will trend sideways through the summer and then start to climb in the fall of the year. Our economy does have issues it’s facing as well as the economies of other countries throughout the world. There will always be issues. Economic growth, along with the performance of the stock market, is based on a healthy corporate America. With record earnings and solid growth potential for corporate America, my expectation is our economy will continue to improve and prosper over the long run.

Jeff McAllister
OptionsANIMAL Instructor

[i] (Source: http://www.standardandpoors.com/indices/market-attributes/en/us )