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Local and Global Tops in Stocks

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With the S&P 500 tracing out a late July path each day to new highs, it begs the question: Is this broad U.S. stock market index going to top soon?  And if it does, what should a stock investor do?

To answer this question, I want to start by motivating some language. There is a big difference between a local top and a global top.  A local top is a transient valuation phenomenon.  A global top in stock price indexes reflects a deeper economic downturn.

It is kind of like watching waves on a beach in California.

Waves keep on rolling in off the Pacific, one after the other.  Once in a few years, though, a really big wave comes in.  An earthquake, or something similar in top-down character, typically causes this.

A global top starts out looking like just another wave, or local top.  You can be lulled to sleep watching for them, seeing one local top after the other. But if you hear there has been an earthquake in Japan (akin to U.S. non-farm payrolls printing negative for two months in a row), start paying closer attention!  That last local top is likely a global one.  Any global top is much more dangerous to an investor in risk.

Here is how to draw a distinction between local and global tops.

(1) A local top happens when the market's valuation get ahead of itself. This is a very common occurrence.  The stock market is always moving forward in time, as hundreds of analysts constantly update its underlying forward earnings picture.

This, by definition, is an uncertain prospect. A local top can happen when longer-term price trend lines operating for the past few months are broken cleanly.  And/or you as strategist become uncomfortable with the fundamental earnings numbers needed to justify the current price index level of the market.

Either condition is sufficient to cause a local top.

Remember, there are a few quality broad, long-term market trend lines to draw, and a few technical people who do this well. But the point is, draw a long-term price trend line (or have a computer do it for you) to pick out the short-term tops.

As to locating quality consensus earnings numbers for the S&P 500 index?  I read top down earnings reports each month produced by FactSet (FDS - Free Report) , Zacks, and S&P.  They set out quite clearly a set of consensus earnings numbers for the S&P 500 index. That would be where I get comfortable.  The market gets its numbers from here.

Example: Using $112 for a consensus S&P 500 earnings base now and 1700 for an S&P 500 price level leaves me with 15.2 as a forward 12-month valuation. I am comfortable with everything in this picture. Therefore, I believe there is no local top on the S&P 500 operating in this moment in time.

The S&P 500 index hitting 1747 would be 15.6 times forward 12-month earnings.  That is a little frothy to me, given the macro risks.

(2) A global top happens when underlying macro indicators, led first and foremost, if not exclusively, by non-farm payrolls rolls over in a final, revised form into negative numbers, for two months running.

Then, head for the hills on all forms of risk.

Macro-economic issues, i.e. fundamental issues, drive global tops. Transient valuation issues can precede global tops.  But a look over the historic events that really tank broad stock indexes (aka global tops) -- the big -30% moves down in stocks – shows it is almost always a recession.

The duration of time passing between global tops is not relevant.  

We have seen 52 months of time pass from the beginning of an upward turn in payroll numbers.  The National Bureau of Economic Research (the NBER) marks these turns, by the way. An average bull market/expansion is 56 months.  That average becomes meaningless in the context of a 7.5% unemployment rate (aka we have plenty of un-utilized resources) and +2% annual real GDP growth (aka this isn't a ripping expansion).

In this context, the U.S. economy can grow payrolls for a couple years easily. But we can also see a macro economic tsunami come in from $200 per barrel oil, or a sudden closing of China trade.  Either event would produce a global stock top in four months time.

Give the year 2000 example to me:  We got to absurd S&P 500 valuations, in fits and starts, by printing one local pricing top after another. A global top happened when the non-farm payroll numbers rolled over.  That made that last local top a global one.  It was time to get out and take profits.

Now let’s come back to the present time:  July 2013.  

We have seen final, revised, Federal, non-farm payroll numbers reach +200K levels the last two months.  We can safely conclude we are not going to print a global top, and recklessly lose -30% in stock values.  

However, we could see a valuation issue -- a fresh local top -- emerge at any time. That would temporarily take prices for the S&P 500 index down -5% or more.   We saw the last local top on May 21, a little over two months ago.
Happy investing!

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