As the S&P 500 index reached a new all time high, analysts went to work determining the likelihood of future gains. Some analysts are reviewing fundamental data including earnings and economic growth. Here, the picture is generally bullish.
Standard & Poor’s estimates that earnings per share (EPS) for the S&P 500 index will be $170.52 next year and $193.36 in 2020. Using an average price to earnings (P/E) ratio of 17, the index could move significantly higher in the next two years.
Now, the market price today is based on expectations for the future. That means traders are pricing future earnings into the current market price. Next year, in the summer of 2019, the S&P 500 should be trading based on expectations for 2020 earnings, so a reasonable target for that time is 3,287.
EPS forecasts indicate the S&P 500 could gain more than 14% in the next twelve months. Economic data, with robust growth in GDP and low inflation, confirms that outlook. Fundamentals tell us that this bull market could continue.
Problems With Fundamental and Economic Data
There are some problems when using solely fundamental or economic data when developing a market outlook.
Earrings estimates tend to be optimistic. Analysts almost always project earnings to trend. So, in an economic expansion we tend to see EPS estimates that are upward biased. This is a problem, but it is not as large a problem as it may appear to be at first.
In finance, there are some numbers that are, in essence, “agreed upon fictions.” For example, there are GAAP and non-GAAP earnings. GAAP stands for generally accepted accounting principles. But, companies still report non-GAAP numbers and investors often find them useful.
GAAP is a set of conventions that investors have agreed to follow. The same is true of non-GAAP earnings in some sectors. The same is also true of earnings estimates. Investors often take action based upon what earnings are expected to be and it seems as if a majority of investors accept the published estimates.
Since many investors are familiar with the estimates, they do become meaningful even if they will not be accurate. This means earnings in 2020 are likely to be different than what is estimated now and investors will react to changes in estimates and actual EPS as the data becomes available.
Just like with earnings, analysts expect trends in economic data to remain in place until they clearly reverse. This means markets will react suddenly when the trend in the economy changes. But, investors are unlikely to react until after economic changes are evident.
Turning to Technical Analysis
To overcome the difficulties of fundamental and economic data, many analysts turn to technical analysis which is a study of the price action. This study often involves the use of charts like the one shown below which shows recent price action in the S&P 500.
The index is now at the highs last seen in January. This raises concerns of a potential double top pattern. An example of this type of pattern is shown in the next chart which highlights a similarity between recent price action and the pattern seen in 2015.
In both time frames, the index reached a new high and then dropped about 12%. That is where we are right now so we can use the 2015 example as a possible precedent.
In that case, the index traced out a double top pattern and a decline that followed the second top lasted into 2016. It was not a bear market but it was a time when investors grew frustrated by market action as the index failed to move higher for almost a year.
This pattern that could be forming right now, a double top, is considered to be one of the most reliable patterns according to one of the most exhaustive studies of chart patterns. That means investors should be cautious for now, despite the bullishness of fundamentals and economic data.
The next chart shows possible trading tactics right now.
The trend line indicates the trend is up. But a break of that line would signify a potential reversal. That indicates traders should consider holding bullish positions and investing aggressively until the trendline is broken.
The blue rectangle also shows that 2,800 is an important level on the chart. This is a price level that briefly presented resistance in the left section of the rectangle and then served as support later with price returning to that level twice after moving higher.
Now, a break below 2,800 would indicate caution is needed and perhaps could signal a reversal. This could serve as a stop level for the most conservative investors.
But, a break of that level would not be a sell signal for all traders. It could indicate no new buys should be initiated. A break of 2,525 would likely indicate the end of the bull market. That is the level that marked the low in February.
Although the chart shows where to take caution, the chart pattern is also clear that the trend is up for now and traders should expect further new highs in the short term. This could be an ideal time to add to positions if traders have been raising cash in the recent past.
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