The US 30 CFD sell strategy I posted leading into the FOMC meeting was triggered so I thought I'd post some thoughts on the outlook for the Dow and how this relates to the Wednesday's sell strategy.
One of the assumptions that often seems to be made in financial markets commentary I see is that the stock market rally over the past year has been all about the Fed forcing investors into shares with the market climbing into bubble territory.
This is not a simple argument. Stock market valuations depend on a lot of factors including the market's assessment of risk and earnings growth as well as the return available on other asset classes and inflation expectations. Even so, the sort of rough analysis I've done in the table below suggests to me that the market is not especially overvalued at the moment. The big rally from late 2012 has been more about valuations recovering from historically low levels as investors (rightly or wrongly) became more relaxed about the global risks posed by the situation in Europe than it has about the Fed.
The table below expresses the Dow Jones Index as a multiple of analysts' earnings forecasts for the current calendar year. At yesterday's close, the index was valued at 13.3 time earnings forecasts for 2013.
If you do the PE sum backwards it can be expressed as an earnings yield (i.e. the total earnings of all the companies in the index expressed as a percentage of their combined market value). This makes it easier to compare the earnings return on shares to bonds.
Looking at the figures above, there is still a much bigger difference between the yield on the Dow and 10 year bonds than there was back in 2006 and 2007 (i.e. theoretically, stocks are much cheaper in relation to bond yields now than they were in 2007). A lot of factors go into determining this difference but on a rough and ready basis this, I think this demonstrates that while stocks were expensive in 2007, they may not be too over the top at the moment.
The chart of the Dow below certainly suggests there is scope for a decent sized downwared correction. This could easily happen. It doesn't have to be all about the Fed and earnings yields. A worsening outlook in China or Europe or even a simple market overshoot could do the trick.
However, valuation analysis makes me want to be pretty conservative with a profit objective on the technically based FOMC sell strategy at this stage
The strategy I discussed in Wednesday's post involved selling on a clear move below the 20 day moving average. This is shown on the chart below.
The initial stop is placed just above the peak at the trend channel resistance.
If we are to get a fairly shallow correction here, one possibility would centre on the 38.2% Fibonacci retracement level and the potential trend line from the corrections early in the life of this trend. This would represent a pullback of about 7.5% from the 15,542 peak in the US 30 CFD.
A deeper correction might get back to the 50% retracement and 200 day moving average. This would be about a 10% pullback.
The strategy shown on the chart above bases an initial target on the 38.2% retracement. If price hits the green trend line first, the stop would be moved down close to protect profits in case that line is respected.
One approach might be not to take profit at 38.2% but to move the stop down not far above it once it's hit and then set a limit order to buy at the 50% retracement or 200 day moving average to capture a larger move if the down trend continues
A strategy like this also often also uses the technique of moving the stop down once a downtrend gets underway, for example behind any new corrective peaks or overlap points.