Why are stocks rallying? Maybe it’s because for much of this year, corporate insiders have been stepping up to buy dips in the stock market. The purchases have occurred in the face of growing recession risk and apparent challenging valuations.
What does this group of “smart investors” know that we ordinary mortals don’t? An analysis of valuation and the technical backdrop reveals some pockets of value in the US equity market.
A challenging environment
This has become an increasingly challenging environment to be taking risk. The latest BoA Global Fund Manager Survey found that a recession is now the overwhelming consensus view among institutional investors.
The Citigroup G10 Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is nosediving.
As the Fed and other major central banks tighten monetary policy, yield spreads are widening, indicating tightening financial conditions.
Treasury settlement fails have increased to levels last seen during the GFC, indicating a severely compromised bond market liquidity. High yield spreads are especially sensitive to bond market liquidity, which has the potential to set off a doom loop in the credit markets.
The S&P 500 is trading at a forward P/E of 16.7, which is below its 5 and 10-year averages. However, the E in the forward P/E ratio is at risk of compressing as we progress through Q2 earnings season.
The latest update from earnings season indicates that both the EPS and sales beat rates are below historical averages, which raises the risk of earnings downgrades. Historically, stock prices have struggled whenever forward EPS has either flattened or fallen.
Why on earth would corporate insiders be buying the dips?
A valuation analysis
For some clues, I use the Morningstar fair value analysis tool
to calculate valuation. While it doesn’t represent the Holy Grail of valuation analysis, it is a consistent metric for comparing value over time and across different parts of the stock market. A preliminary analysis of the Morningstar stock universe shows that the market appears to be cheap, but it doesn’t represent screaming value compared to past major market bottoms in 2009, 2011, and 2020.
The intent of this analysis isn’t to exhaustively enumerate all the ways the Morningstar fair value tool measures different pockets of the market. Here are some highlights.
An analysis by sector shows several standouts. Technology stocks are more undervalued compared to the overall universe and they haven’t been this attractive since the GFC.
Communication services are at an “off the charts” undervaluation reading.
By contrast, the consumer defensive stocks that investors have bought for their low-beta characteristics, are slightly overvalued.
The other sectors, which consist of basic materials, consumer cyclicals, financial services, real estate, healthcare, utilities, energy, and industrials, don’t show as extreme in over and undervaluation. However, wide-moat companies, or high-quality companies with strong competitive positions, also show a high degree of undervaluation that was only exceeded by 2009.
A technical view
The Morningstar fair value analysis is consistent with SentimenTrader’s observation of heavy insider buying in NASDAQ 100 names. These stocks are concentrated in the technology and communication services sectors and they tend to be high-quality with strong competitive positions and cash flows.
The relative performance of the NASDAQ 100 to the S&P 500 is trading in a relative support zone that hasn’t been exceeded since the dot-com bubble bust. I would add the NASDAQ 100 is very different compared to the 2000-2003 period. Today’s companies have far stronger cash flows and competitive positions compared to their predecessors.
The technical position of technology stocks shows that the sector is bottoming on both an absolute and relative to the S&P 500. As well, the sector is enjoying strong positive relative breadth (bottom two panels).
The technical position of communication services stocks is not as strong, but they do show a similar bottom pattern and improving relative breadth.
Good reasons to be bullish
In conclusion, corporate insiders have good reasons to be bullish. Valuations are reasonable and there are pockets of value in the stock market concentrated in the large-cap NASDAQ 100 names. Here are selected large-cap stocks that have shown insider buying in the last six months: CHTR
, and PYPL
. This is not a complete list and it is only a quantitative screen. You are advised to perform your own due diligence.
From a technical perspective, the bull case for equities is institutions and hedge funds have all sold and the only sellers left are retail investors. The BoA Global Fund Manager Survey shows that risk appetite is lower than Lehman Crisis and GFC Crash levels.
Equity futures positioning tells a similar story of a historic crowded short reading.
Retail positioning is cautious, but it has room to capitulate further.
As I pointed out about a month ago (see Why last week may have been THE BOTTOM
), the mid-June breadth wipeouts are setups for a durable market bottom. While there is no guarantee that the major market indices won’t retreat and re-test the old lows, risk/reward has become increasingly bullish for equities.
Buy the dip.