Are there levels where the technical and fundamental investment disciplines converge? What price levels, if any, will fundamental and technical buyers return to the marketplace?
Fundamental Valuation:
Fundamental analysts value securities and markets using such financial data as Revenue, Sales, Earnings Per Share (EPS), P/E Ratio, and other ratios. We will focus on SPX Earnings (GAAP) as the trailing twelve months of GAAP earnings per share for the S&P 500 Index (SPX) is generally more accurate and reliable than operating earnings, which tends to exclude some expenses, leading to the value appearing higher than expected.
Enclosed below is the monthly price chart of SPX dating back to the 1920s. Accompanying the SPX price chart are three SPX valuation levels showing where the SPX would be if the P/E ratio is trading based on three Earnings Per Share (EPS) values. The three levels are SPX P/E of 20 (overvalued), SPX P/E of 15 (fair value), and SPX P/E of 10 (undervalued).
Since 1925, SPX has rarely traded above its P/E of 20 and consistently maintained above this P/E level. The two exceptions are the late-1990s ahead of the Tech/Telcom dot.com bear decline of 2000-2002 and 2016 to the present timeframe. At its recent 1/4/22 all-time high (4,818.62), SPX traded to an extreme overvalued level or nearly 1,311.22-points above the valuation of 3,507.40 based on P/E ratio of 20 (overvalue), at least based on the current Earnings Per Share (EPS) valuation.
If SPX P/E returns to the P/E ratio at 20, this implies an SPX price at 3,507.40. The caveat to this call is that this is a cyclical bear decline rather than a structural bear market. If a structural bear develops, then SPX may need to revisit a P/E of 15 (fair value) at 2,640.55, and under the worst-case scenario, it may lead to a P/E of 10 (undervalue) at 1,753.70.
Technical Valuation:
Technical analysis is both an art and a science. Technical investment discipline relies on identifying dominant and prevailing trends, Fibonacci retracements, moving averages, and a host of technical and sentiment indicators. Some indicators have more weight than others and depend on the type of market environment (i.e., uptrend, downtrend, and sideways trending). The technical levels increase in importance when many indicators converge near similar levels, suggesting more traders and investors are acting upon the same technical signals. It is analogous to two or more streams forming a river.
Trend line analysis – Identifying the dominant and prevailing trend is critical to successful trading and investing. Despite the near-term market volatility, the SPX Index retains its 2009/2010 uptrend channel between 3,400-3,500 and 4,839. The bad news is SPX failed at 4,818.62 (1/4/22) or near the top of its 12-plus year uptrend channel, now at 4,839. SPX may need to fall further, possibly toward the bottom of its uptrend channel (3,400-3,500), before technical buyers return. The good news is the primary uptrend remains intact, implying that this is a cyclical bear decline and not the start of the dreaded structural bear market.
Moving Averages – Moving average indicators smooths the fluctuations in the index, providing less noise and a clearer picture of the dominant trend. There are various moving averages, including 50-day, 200-day, 10-week, 30-week, 40-week, 10-month, 30-month, and 40-month. The monthly moving averages can best identify the longer-term trends such as structural trends (8-20 years) and generational trends (35-42 years). Violation of the 10-month ma, currently at 4,455 for SPX, warns at a decline to the 30/40 month moving averages at 3,748 and 3,520, respectively.
Fibonacci Retracements – Common Fibonacci numbers are created by taking the high and low points on a chart and applying the golden ratio to arrive at Fibonacci retracement levels of 38.2%, 50%, and 61.8%. After a rally or decline, the security tends to retrace a portion (38.2%, 50%, or 61.8%) of its previous move. The emphasis is on 38.2% and 61.8% levels.
In an irrational market environment as represented by extreme volume, panic selling, wholesale selling, and liquidation, the Fibonacci retracement levels can act as psychological comfort zones (support/resistance) where buyers or sellers appear. When large numbers of investors and traders converge at Fibonacci retracement levels, they can influence market trends leading to collective buying or selling pressure.
Three (3) key Fibonacci retracements will become increasingly important in the days/weeks/months ahead. From the Mar 2020 SPX pandemic market bottom (2,191.86) to the Jan 2022 all-time high (4,818.62), a 38.2% retracement brings SPX to 3,815.20. The 50% retracement is not as important as the 38.2% retracement based on the Fibonacci sequence series. However, it is simple to compute – you add the high and low and divide by 2 to arrive at the 50% level. The press and media will be reporting on the 50% retracement as it nears 3,505.24. The 61.8% retracement is the most important retracement level based on the golden ratio principle. The ability to maintain above this retracement signals the resumption of the primary uptrend. A 61.8% retracement brings SPX to 3,195.28. Violation of this pivotal level confirms the end of the current structural bull and warns at the start of the next structural bear decline (8-20 years).
Technical breakdown projections – The head and shoulders top pattern and the subsequent violation of neckline support at 4,279/4,222.62 (Oct 2021 and Jan 2022 lows) warns at 596 points decline or an SPX projection near 3,627.
Conclusion:
Fundamentally speaking, SPX has been trading at overvalued levels for the past few years, at least based on the historical overvaluation P/E of 20, which translates to an SPX price of 3,507.40. It is trading at fair value when P/E falls to 15 or SPX price of 2,630.55. And it is undervalued with a P/E of 10 or SPX price trades at 1,753.70. SPX is likely to fall further toward 3,507.40 before fundamental buyers return.
Technically speaking, 3,500-3,800 is pivotal support as it coincides with numerous technical convergences. For instance, the bottom of the structural uptrend channel dating back to 2009/2010 resides near 3,400-3,500. The pivotal 38.2% and 50% Fibonacci retracements from Mar 2020-Jan 2022 rally are 3,815 and 3,505, respectively. The violation of the 10-month ma (4,455) during Jan 2022 warns at a retest of the 30-month ma (3,748) and the 40-month ma (3,520). The head and shoulders top breakdown below the neckline at 4,279/4,222.62 (Oct 2021 and Jan 2022 lows) also warns at 596 points or a downside projection at 3,627.
The two schools of investment disciplines, fundamental and technical, converge when the SPX Index falls toward 3,500-3,800. Will fundamental and technical buyers emerge to defend the market, signaling the resumption of the structural bull trend?
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