Million Dollar Question, What's Next for S&P 500 Stock Market Index

By: Prasoon_Gopal

S&P 500 has rallied over 40% in the last 3 months. It takes over 5 years under "normal" circumstances for such a rally to occur. But again, folks will say, it takes as many years for 50% downside as well. So, i will rest this discussion at peace.

When you are trading stocks, etf's, mutual funds or any other instrument, you always have a plan. Plan comprises of Entry and exit strategies. Apart from this, the most important factor is the risk/reward ratio. Meaning, what do you think is most favorable trend. For example, if you believe stocks have more than 60% chance of going up, you go long with strict stop losses. If you believe that there is more than 90% chance, then you probably will go "all in" with more wider stop loss in place. Direction is irrelevant as you can go long or go short.

With all the indices up over 40% without any correction, you will default to shorting stocks/etf's at these levels, or at least tempted to. But is that the right step. Nobody knows as this is the million dollar question. I won't even go about discussing how Goldman Sachs and other financial institutions now control US stock markets. But only from purely traders perspective.

I believe too that the best option right now is to short. But is this really an emotional trade or does it have legs? To assess my own conclusions, i decided to take the "other side of the story" into consideration. Let us consider the bullish case.

1) Technically Long term moving averages are now showing extreme bullishness.
2) Golden cross (50 dma crossing above 200 dma) occured in late june.
3) The strength (for whatever reason, manipulation or whatever) in financial sector and stocks in the last 3 months tells us that govt will probably not let them repeat their late 2008 performance anymore. Which means obviously they will perform better than expected.
4) Banks have had the single most important thing to fix things. No it is NOT TARP or TALF, it is TIME. They bought time to fix their mess in more ways than one.
5) Green shoots or whatever the new acronym that comes out these days has made people believe that things are changing for good.

So where does that leave us, an average inestor? Should you be in bullish camp after all this analysis? I can go on and give you as many and even more bearish points to be short this market. But i don't have to go that far. Just one single point will be sufficient enough to take on the above 5 and even 100's more bullish stances.

Are you up for it???

Fundamentals. Yes, you got it right. Fundamentally S&P 500's P/E has been in the range of 16-18. Currently it stands at 20 as per S&P itself. So, why would that be a bad sign?

1) Bear markets do NOT bottom until the P/E is extremely attractive, usually in low single digits.
2) There hasn't been a single V shaped recovery as far as we can remember.
3) Most importantly, The current P/E is even POSITIVE because of all the gory accounting rules created to cover bad toxic assets and shield losses from them and other investments. NONE, yes NONE of the banks could have shown profits in the first quarter had they NOT been allowed to manipulate their books. Did ever think even once, if ALL the banks were this healthy, why on earth did we have $2 trillion worth of stimulus and multi-trillion $$$ FED guarantees on assets that are worth pennies on the dollar? Something doesn't sound right. In fact, even today, if you search google/bing you will see that there is a THIRD Stimulus already being discussed. If all is so good and green shoots working, then why would you need further bailouts again???

Bottom line is, to maintain S&P 500 P/E in the positive, banks were allowed to maniuplate their books using accounting rules that only they can understand. Had this NOT been the case, S&P P/E would have been negative for the first time in it's history. May be they even don't have programs to handle a negative P/E.

Ok, enough of my analysis. Let's get down to the numbers.

S&P 500 P/E at the end of 2008 as reported by S&P 500 (http://www2.standardandpoors.com/spf/xls/index/sp500pe_ratio.xls) was above 60. And this was on earnings of about $50 per share(http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS). Earnings estimate in 2009 is around $55 per share. How on earth can 500 premium companies in the country earn MORE in 2009 than 2008 with over 10% and over 22% REAL unemployment (if we take into account part-time employment/unemployment) leading to lesser income and sales tax revenues with states struggling to keep up and so on. I have no idea. But even if we assume that this is correct, somehow, s&P 500 would be over 70 P/E (accordingly to S&P 500 calculations). I am not sure how are they computing this, but...

In realty though, if we take REAL financial numbers, S&P 500 P/E is way over 100.

Conclusion is, if the reported earnings are allowed to manipulate then nothing can really be done. But fundamentals will have to kick in at some point and when that happens we will go back to fair value of S&P 500 way below 500 taking away previous lows. So, i would say, if anything this is the best Shorting opportunity of your lifetime with assured returns in th next few months. Stop out if S&P 500 crosses 1050 and stays above this level for at least 1-2 weeks. Target 500.

You risk about 13 to gain 46. Ratio being well over 3.5 (Reward/Risk). A very strong ratio indeed. Imagine if the ratio is this high for an index, then shorting stocks that have gone up 800-1000% in the last 3 months is beyond your imagination.

By Prasoon Gopal

For further reading, you can track me @ http://www.stocksbuddy.com/blogs/?author=36

prasoon_gopal@yahoo.com

I have been trading for over 15 years and have been mostly involved with Technical Analysis. I love to dig into Macro-Micro economics as it gives us a heads-up of where the market is headed for. Some of my work and articles have been published on various websites and magazines over the past decade. I love to write articles before something happens rather than after the fact.

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