Now That the Honeymoon Is Over

With the election, QE2, and jobs data finally out of the way, this week should see markets move back to a more ‘normal’ trading environment.  By that I mean fundamentals, earnings, and economic prospects should again constitute the drivers of price action.  And I as I mentioned in previous posts, we are likely to begin to see how investors truly view the implications and likely outcomes of the Federal Reserve’s stimulus measures.  To be sure, the initial reaction appears to have been positive.  But as is the case with unconventional government actions, the knee-jerk reaction is often more tied to whether or not the announced measures coincided with expectations rather than the longer term economic impacts. This is why the next few weeks will likely prove more directionally insightful than anything seen last week, especially since the economic releases expected over the next few days are relatively benign data points.

Once again, I’m keeping a close eye on the U.S. Dollar Index (DXY) and gold for a sense of where things are likely headed.  So far this morning the DXY is continuing the strength that was seen on Friday, but has yet to break back above its longer-term trend line (around 77.25).  As such, the near-term bias for the DXY remains on the downside.  But just as I mentioned that the equity markets would begin passing judgment on the implications of QE2 on share prices today, so too will currency traders be judging the relative strength of the greenback.  From a technical standpoint, the DXY remains in near-term oversold territory, so a bounce like that which we are seeing this morning is certainly within the realm of possibility (weekly chart shown below).  Whether or not this a short-term bounce or the beginning stages of a major bottom remains to be seen.  For my part, the price action of the past four weeks still suggests a consolidation/bottoming condition for the Dollar.  And with the significant support level of about 74.25 lying a relatively short distance from current prices, I continue to believe that risk is shaded to the upside.

One other item worth mentioning this morning.  As most regular readers of this blog are aware, I’ve been pretty negative on equity prices for some time now and have expressed real concerns over the long term prospects for corporate earnings growth.  While Q3 earnings coming in as strong as they have, I’ve begun reevaluating this stance in light of these developments.  And while I’m not yet ready to move completely into the equity bull camp as yet, I would say that I’m getting closer by the day.  That said, I took a look at the earnings estimates for the S&P 500 (obtained from the Standard & Poor’s website) and noted and interesting data point.  Many market pundits have been commenting that the equity market appears quite inexpensive based on forward earnings estimates.  Putting aside the fact that most of these comments are based on operating earnings rather than diluted earnings, the current diluted earnings estimate for the S&P 500 in 2011 stands at $85.31/share.  That implies a 16.5% increase from expected 2010 earnings.  And while we can debate whether or not this earnings growth rate is correct, the more interesting element of this estimate is that it exceeds the $81.51/diluted share level that was actually reported in 2006 (this marked the earnings peek prior to the financial meltdown)!  I find it very difficult to believe that this estimate will prove correct as high unemployment and reduced consumer spending did not comprise the economic environment of 2006.  I will concede that corporations have pared operating expenses sharply since 2006, which will help boost earnings and that emerging economies are providing a source of revenue growth.  But I think that if you view this estimate in its larger context, one must conclude that this estimate is probably overly optimistic.  As such, the current forward P/E ratio of 14.28, which appears slightly inexpensive, could simply be a mirage. Coupled with the overbought condition that currently exists in the equity market and I find it hard to be a buyer at present levels.

Until later…..