The Economic Backdrop
Let's start the new year by looking at the market's value, first by looking at the S&P 500's PE ratio from a historical perspective:
With an overall PE of a little under 20, the S&P 500 is historically expensive. As the economy is currently expanding at a strong rate, the downside potential of the market is somewhat limited (barring an extraordinary shock). However, corporate earnings and overall growth need to expand to move the market higher beyond say 5%-10%.
Other indexes are also pricey. The NASDAQ is at high levels as is the transportation index. The Dow is pretty expensive as well.
The above valuation metrics mean that if we want to see a strong upside move in the market -- one supported by fundamentals -- we need to see economic growth and an increase in corporate profits. This is more than likely.
The overall rate of economic growth is strong, coming in at a 5% annual rate in the latest reading. And, we've only seen one quarter of contraction in the last seven quarters -- a contraction that was largely caused by inclement weather. In addition, both the leading and coincident indicators are moving higher:
The Conference Board Leading Economic Index® (LEI) for the U.S. increased 0.6 percent in November to 105.5 (2004 = 100), following a 0.6 percent increase in October, and a 0.8 percent increase in September.
“Widespread and persistent gains in the LEI point to strong underlying conditions in the U.S. economic expansion,” said Ataman Ozyildirim, Economist at The Conference Board. “The current situation, measured by the coincident economic index, has been improving steadily, with employment and industrial production making the largest contributions in November.”
The Conference Board Coincident Economic Index® (CEI) for the U.S. increased 0.4 percent in November to 110.7 (2004 = 100), following a 0.2 percent increase in October, and a 0.3 percent increase in September.
And, corporate profits are also increasing:
Overall profits have increased from $1.4 trillion at the beginning of 2011 to their current level of a little under $1.9 trillion.
To conclude this introduction, the market is expensive. However, the economy is growing at a strong clip, leading to an increase in corporate profits which not only supports the current price levels but future price advances.
The Technical Picture
The weekly SPY picture is very bullish. There is a clear trend line connective lows of mid-2012 and the fall of 2014. There are nine "corrections" which are circled. And there is a clear trend of prices printing higher highs and higher lows.
The daily picture also show a solid rally with a trend line connecting the lows of early February and mid-December. There is a price drop through this trend line in early-mid October. However, the drop was extremely brief and prices rebounded almost immediately, making this a failed correction. There is also an upward sloping wedge pattern (outlined with two red trend lines). However, don't get too excited,
Rising wedges, especially for downward breakouts, are some of the worst performing chart patterns. Downward breakouts have unacceptably high failure rates and small post breakout declines. Also, pullbacks occur almost two-thirds of the time and throwbacks happen almost three-quarters of the time.
It's probably best to consider the wedge a consolidation pattern.
So, we start the year with an expensive market, but a solid economy with a strong corporate earnings environment. That means we have a higher likelihood of moving higher.