Market psychology shows improvement (page 1 of 2)

USA

Market psychology has improved, which is attributable to the passage of corporate governance legislation, aggressive prosecution of lawbreakers, and the SEC requirement for corporate CEOs to vouch for the accuracy for their financial statements.

Nevertheless, equities ran into profit taking on Friday, prompted by analysts' cautious remarks on Intel and on the chip equipment sector as well as by questions surrounding Citigroup's handling of the AT&T wireless IPO. Also, the rise of the market since late July has already discounted the better than expected 2Q results.

Of the 488 S&P 500 companies that have reported, 60% showed positive earnings surprises, compared to 17% that gave negative earnings surprises and 23% no surprises. Actual earnings were 2.9% above estimated earnings. Furthermore, the rally has been the most overbought rally in the current bear market phase. Short-term momentum indicator like MACD (daily) shows overbought extreme, which is consistent with conditions leading to a correction.

The longer-term outlook for equities remains constructive. So far, equities have been bolstered by money inflows from bonds that appear to be significantly expensive than equities. Based on yield gap analysis, the U.S. market is about 30% undervalued vs. bonds, with prospective earnings yield much higher than 10-year bond yield.

Investors simply cannot ignore the higher yield from assets other than bonds. Although absolute PE levels are high relative to their long-term average, PEs often deviate from their long-term for long periods and therefore is less useful as a short-term market timing tool.

Also, in low inflation periods like now, higher PEs are associated with markets because earnings are more certain than in high inflation periods like 1970s and early 1980s. In addition, the longer-term momentum indicator remains favorable, as measured by the MACD (weekly) suggesting the market is inexpensive on a longer-term basis.

Technically, the S&P 500's positive tone remains within the four-week bull channel with 919 as the lower boundary of the rising channel. The resilience of the market will be tested when the 3Q pre-announcement season begins in September and when crucial economic reports on the labor and manufacturing sectors are delivered.

It is certain that the lack of macroeconomic clarity will persist for a while, which could lead investors to over-react to new pieces of economic data, thereby exacerbating market volatility.

Europe

Much of the industrial and sentiment data, in both the U.S. and Europe, surprised on the downside in late July and through August, reflected by share price falls in European industrial cyclicals, leading to their earnings downgrades in 2002-2003.

However, European stock markets ended the week higher after the rally in Wall Street. Technology, food and airlines drove the gains while drugs were weaker after AstraZeneca was hit by news of a disappointing drug trial.

Nestle, the Swiss food maker, rose after citing continued growth in full-year profits and sales and reporting a 7.2% rise in first-half sales and 79% jump in net profits. German airline Lufthansa jumped after reporting a trebling of first-half operating profits and raising full-year operating profits forecast.

British Airways rose on news that they would not participate in a A$800m share sale at Qantas, the Australian airline. Oil stocks gave up their gains after crude oil was unable to stay above a rise above $30 per barrel.