Author Archive for Lance Roberts

No One Will Ring The Bell At The Top

By Lance Roberts, STA Wealth

The market has had a rough start of the year flipping between positive and negative year-to-date returns. However, despite all of the recent turmoil from an emerging markets scare, concerns over how soon the Fed will start to hike interest rates and signs of deterioration in the underlying technical foundations of the market, investors remain extremely optimistic about their investments. It is, of course, at these times that investors should start to become more cautious about the risk they undertake. Unfortunately, the“greed factor,” combined with the ever bullish Wall Street “buy and hold so I can charge you a fee” advice, often deafens the voice of common sense.

One of my favorite quotes of all time is from Howard Marks who stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

That quote is truest at extremes as markets can remain “irrational” far longer than would otherwise seem logical. This is particularly the case when, despite clear signs of overvaluation and excess, central banks worldwide are dumping liquidity into economies in a desperate attempt to “resolve a debt bubble with more debt.”

It is interesting that when you ask most people if they would bet heavily on a “pair of deuces” in a game of poker, they will quickly tell you “no.” When asked why, they clearly understand that the “risk to reward” ratio is clearly not in their favor. However, when it comes to the investing the greater the risk of loss, the more they want to invest. It is a curious thing particularly when considering that the bets in poker are miniscule as compared to an individual’s “life savings” in the investment game.

However, that is where we clearly find ourselves today. There was never a clearer sign of excessive bullish optimism than what is currently found within the levels of margin debt. Even as the markets sold off sharply in February, investors sharply levered up portfolios and increasing overall portfolio risk.

MarginDebt-NetCredit-040814-2Even professional investors, who are supposed to be the “smart money,” are currently at the highest levels of bullishness seen since 1990.  (The chart below is the 4-month moving average of the net-difference between bullish and bearish sentiment.)

INVI-BullishSentiment-040814

Franklin Roosevelt, during his first inaugural address, made one of his most famous statements:

“So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself…”

However, when it comes to the stock market it is the “lack of fear” that we should be most fearful of.  Throughout human history, the emotions of “fear” and “greed” have influenced market dynamics.  From soaring bull markets to crashing bear markets, tulip bubbles to the South Sea, railroads to technology; the emotions of greed, fear, panic, hope and despair have remained a constant driver of investor behavior.  The chart below, which I have discussed previously, shows the investor psychology cycle overlaid against the S&P 500 and the 3-month average of net equity fund inflows by investors. The longer that an advance occurs in the market, the more complacent that investors tend to become.

Investor-Psychology-Cycle-040814Complacency is like a “warm blanket on a freezing day.”  No matter how badly you want something, you are likely to defer action because it will require leaving the “cozy comfort” the blanket affords you. When it comes to the markets, that complacency can be detrimental to your long term financial health. The chart below shows the 6-month average of the volatility index (VIX) which represents the level of “fear” by investors of a potential market correction.

S&P-500-VIX-6mo-Avg-040814

The current levels of investor complacency are more usually associated with late stage bull markets rather than the beginning of new ones. Of course, if you think about it, this only makes sense if you refer back to the investor psychology chart above.

The point here is simple. The combined levels of bullish optimism, lack of concern about a possible market correction (don’t worry the Fed has the markets back), and rising levels of leverage in markets provide the “ingredients” for a more severe market correction. However,  it is important to understand that these ingredients by themselves are inert. It is because they are inert that they are quickly dismissed under the guise that“this time is different.”

Like a thermite reaction, when these relatively inert ingredients are ignited by a catalyst they will burn extremely hot. Unfortunately, there is no way to know exactly what that catalyst will be or when it will occur. The problem for individuals is that they are trapped by the combustion an unable to extract themselves in time.

I recently wrote an article entitled “OMG! Not Another Comparison Chart” because there have been too many of these types of charts lately. The reason I make that distinction is that the next chart is NOT a comparison for the purposes of stating this market is like a previous one. Rather, it is an analysis of what a market topping pattern looks like.

S&P-500-MarketTop-2011-2014-040814

As you can see, during the initial phases of a topping process complacency as shown by the 3-month volatility index at the bottom remains low. As the markets rise, investor confidence builds leading to a “willful” blindness of the inherent risks. This confidence remains during the topping process which can take months to complete. With individuals focused on the extremely short term market movements (the tree) they miss the fact that the forest is on fire around them. However, as shown, by the time investors realize the markets have broken it is generally too late.

As Seth Klarman recently wrote:

“The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented.

But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to rainy markets and asset classes, and where caution seems radical and risk-taking the prudent course. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs.

Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

It is in that statement that we find the unfortunate truth. Individuals are once again told that this time will be different. Anyone who dares speak against the clergy of bullishness is immediately chastised for heresy. Yet, in the end, no one will ring the bell at the top and ask everyone to please exit the building in an orderly fashion. Rather, it will be a “Constanza moment as the adults (professionals) trample the children (retail) to flee the building in a moment of panic.

It is only then that anyone will ask the question of “why?”  Why didn’t anyone warn me? Why did this happen? Why didn’t we see it coming? Why didn’t someone do something about it?

 

 

 

The Problem With Forward P/E’s

By Lance Roberts, STA Wealth

In a recent note by Jeff Saut at Raymond James, he noted that valuations are cheap based on forward earnings estimates.  He is what he says:

“That said, valuations are not particularly onerous with the P/E ratio for the S&P 500 (SPX/1841.13) currently trading around 15.2x this year’s bottom-up estimate of roughly $121 per share. Moreover, if next year’s estimates are anywhere near the mark of $137, the SPX is being valued at a mere 13.4x earnings.”

As a reminder, it is important to remember that when discussing valuations, particularly regarding historic over/under valuation, it is ALWAYS based on trailing REPORTED earnings.  This is what is actually sitting on the bottom line of corporate income statements versus operating earnings, which is “what I would have earned if XYZ hadn’t happened.” 

Beginning in the late 90′s, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue.  However, the problem with forward operating earning estimates is that they are historically wrong by an average of 33%.  The chart below, courtesy of Ed Yardeni, shows this clearly.

Yardeni-Forward-Estimates

 

Let me give you a real time example of what I mean.  At the beginning of the year, the value of the S&P 500 was roughly 1850, which is about where at the end of last week.  In January, forward operating earnings for 2014 was expected to be $121.45 per share.  This gave the S&P 500 a P/FE (forward earnings) ratio of 15.23x.

Already forward operating earnings estimates have been reduced to $120.34 for 2014.  If we use the same price level as in January – the P/FE ratio has already climbed 15.37x.

Let’s take this exercise one step further and consider the historical overstatement average of 33%.  However, let’s be generous and assume that estimates are only overstated by just 15%.  Currently, S&P is estimating that earnings for the broad market index will be, as stated above, $120.34 per share in 2014 but will rise by 14% in 2015 to $137.36 per share.  If we reduce both of these numbers by just 15% to account for overly optimistic assumptions, then the undervaluation story becomes much less evident.  Assuming that the price of the market remains constant the current P/FE ratios rise to 18.08x for 2014 and 15.84x for 2015.

Of course, it is all just fun with numbers and, as I stated yesterday, this there are only three types of lies:

“Lies, Damned Lies and Statistics.”

With the continued changes to accounting rules, repeal of FASB rule 157, and the ongoing torturing of income statements by corporations over the last 25 years in particular, the truth between real and artificial earnings per share has grown ever wider.  As I stated recently in“50% Profit Growth:”

“The sustainability of corporate profits is dependent on two primary factors; sustained revenue growth and cost controls.  From each dollar of sales is subtracted the operating costs of the business to achieve net profitability.  The chart below shows the percentage change of sales, what happens at the top line of the income statement, as compared to actual earnings (reported and operating) growth.”

S&P-500-AccountingMagic-030414

“Since 2000, each dollar of gross sales has been increased into more than $1 in operating and reported profits through financial engineering and cost suppression.  The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth.  This has been achieved by increases in productivity, technology and offshoring of labor.  However, it is important to note that benefits from such actions are finite.”

This is why trailing reported earnings is the only “honest” way to approach valuing the markets.  Bill Hester recently wrote a very good note in this regard in response to critics of Shiller’s CAPE (cyclically-adjusted price/earnings) ratio which smoothes trailing reported earnings.

“More recently the ratio has undergone an attack from some widely-followed analysts, questioning its validity and offering up attempts to adjust the ratio.This may be a reaction to its new-found notoriety, but more likely it’s because the CAPE is suggesting that US stocks are significantly overvalued.  All of the adjustments analysts have made so far imply that stocks are less overvalued than the traditional CAPE would suggest.”

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns. But we decided to come to the aid of the CAPE ratio in this case because a few errors have slipped into the debate, and it’s important for investors who have previously relied on this ratio to understand these errors so they can judge the valuation metric fairly.  Importantly, the primary error that is being made is not even the fault of those making the arguments against the CAPE ratio. The fault lies at the feet of a misleading data series.

Hussman-Cape-031914

If I want to justify selling you an overvalued mutual fund or equity, then I certainly would try to find ways to discount measures which suggest investments made at current levels will likely have low to negative future returns.  However, as a money manager for individuals in retirement, my bigger concern is protecting investment capital first.  (Note: that statement does not mean that I am currently in cash, we are fully invested at the current time.  However, we are not naive about the risks to our holdings.)

The following chart shows Tobin’s “Q” ratio and Robert Shillers “Cyclically Adjusted P/E (CAPE)” ratio versus the S&P 500. James Tobin of Yale University, Nobel laureate in economics, hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets.  Currently, the CAPE is at 25.41x, and the Q-ratio is at 1.01.

Tobins-Q-Shiller-PE-031914

Both of these measures are currently at levels that suggest that forward stock market returns are likely to be in the low to single digits over the next decade.  However, it is always at the point of peak valuations where the search for creative justification begins. Unfortunately, it has never “been different this time.”

Lastly, with corporate profits at record levels relative to economic growth, it is likely that the current robust expectations for continued double digit margin expansions will likely turn out to be somewhat disappointing.

Profit-Growth-GNP-ForwardGrowth-030314

 

As we know repeatedly from history, extrapolated projections rarely happen.  Therefore, when analysts value the market as if current profits are representative of an indefinite future, they have likely insured investors will receive a very rude awakening at some point in the future.

There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long term means, “exuberance” is once again returning to the financial markets.  Again, as I stated previously, my firm remains fully invested in the markets at the current time.  I write this article, not from a position of being“bearish” as all such commentary tends to be classified, but from a position of being aware of the “risk” that could potentially damage long term returns to my clients.  It is always interesting that, following two major bear markets, investors have forgotten that it was these very same analysts that had them buying into the market peaks previously.

OMG! Not Another Comparison Chart

By Lance Roberts, STA Wealth

Enough with the comparison charts already. The current stock market cycle has been compared to everything from the 1920′s, 70′s, 90′s, you name it.  I will readily agree that, in all the comparisons, the price patterns are similar, however, correlation is not causation.  What is ALWAYS left out of the conversation are the fundamental underpinnings that either supported or impeded those previous market cycles as compared to today.

Today, Business Insider produced the following chart and commentary by Jeff Saut:

In his new weekly Investment Strategy comment, Saut notes that these things work in both directions. Here’s Saut:

“Accordingly, the alleged pundits that called for a “crash” four weeks ago have, at least so far, also been proven wrong, which I discussed when dissecting their comparison chart to 1929 showing that when comparing apples-to-apples the correlation totally breaks down (see chart 1 and 2). In fact, as proof that you can make ratio charts do just about anything you want, take a look at chart 3 that suggests this secular bull market has another 300% to 400% left on the upside.”

Saut-Stansberry-031814

There are two major issues with that statement.  First, Business Insider extracted selected verbiage which makes it seem as though Jeff Saut is suggesting that the markets have 300-400% more upside to go.  That is not exactly the case.  Below is actually what Jeff Saut wrote:

“A few weeks ago it was the correlation to the 1929 stock market rally that led to the ’29 crash that made the rounds. I wrote about that, noting that the folks making said comparison were using ratio-adjusted charts, which can make the charts show just about anything you want them to. The same thing happened with Japan’s Nikkei Index in the early 1990s and that also proved to be wrong. Accordingly, the alleged pundits that called for a ‘crash’ four weeks ago have, at least so far, also been proven wrong, which I discussed when dissecting their comparison chart to 1929 showing that when comparing apples-to-apples the correlation totally breaks down. In fact, as proof that you can make ratio charts do just about anything you want, take a look at that suggests this secular bull market has another 300% to 400% left on the upside.”

The point Jeff was trying to make is that you can take any multiple of data series, and with the right manipulation, you can torture the data into saying whatever you want.  As the old saying goes:

“There are three types of lies:  Lies, Damned Lies and Statistics.”

Secondly, and much more important, is that while it is true that history does “rhyme”, it does not repeat.  As I stated in the opening, there are specific fundamental underpinnings that supported the rampant secular bull markets that followed the major secular bear market lows of 1942 and 1974 which simply do not exist, as of yet, today.

One of the primary drivers that assisted in ending the “Great Depression” was the massive Government spending ramp, roughly 125% of GDP that was used to support WWII.  The surges in industrial production to support the war led to increased employment as women entered the work force while husbands, brothers and fathers were deployed overseas.  However, what drove the secular bull market of the 50′s and 60′s was “Johnny” returning home from war.  For years, everything had been rationed for the war effort, now the focus turned back to building families, homes and lives which lead to increased consumption as “pent up demand” was met.  However, more importantly, the United States became the industrial manufacturing powerhouse of the world.  With Europe, Japan and Russia in ruins following the war, the U.S. produced and shipped goods and products overseas for the rebuilding of war torn countries.  Government debt fell to historically low levels, household debt remained modest relative to incomes and personal savings rates were high which led to productive investment.  Even as interest rates rose, economic growth continued to rise giving a broad lift to prosperity.

This is something that I discussed at length in “Correcting Some Misconceptions Of A New Secular Bull Market:”

“The United States became the manufacturing center of the industrialized world as we assisted in the rebuilding of Germany, Britain, France and Japan.  That is no longer the case today as much of our industrial manufacturing has been outsourced to other countries for lower costs.  The chart below shows interest rates overlaid against the annual changes in economic growth.”

Interest-Rates-Economy-123013 (1)

The secular bull market of 80′s and 90′s is also something that we are unlikely to witness again in our lifetimes.  Unlike the secular boom of the 50′s which was driven by “healthy”consumption, the boom of the 80′s and 90′s was an unhealthy “debt driven” demand cycle which was fostered by an era of falling interest rates, inflation and financial deregulation.   As I stated in “Past Is Prologue:”

“The next chart shows the much beloved and hoped for, secular bull market of the 1980′s and 90′s.”

S&P-500-1960-secularbull-data-012014

“There were several contributing factors that drove that particular secular bull market:

1) Inflation and interest rates were high and falling which boosted corporate profitability.

2) The extreme negative sentiment of the late 70′s was finally undone by the early 90′s.  (At the turn of the century, roughly 80% of all individual investors in the market began investing after 1990. 80% of that total started after 1995 due to the investing innovations created by the internet.  The majority of these were “boomers.”)

3) Large foreign net inflows to chase the “tech boom” drove prices to extreme levels.

4) The mirage of consumer wealth, driven by declining inflation and interest rates and easy access to credit, inflated consumption, corporate profits and economic growth.

5) Corporate profits were boosted by deregulation of industries, wage suppression, outsourcing and productivity increases. 

6) Pension funding requirements and accounting standards were eased which increased corporate profits. 

7) Stock based executive compensation was grossly expanded which led to more “accounting gimmickry” to sustain stock price levels.

The dual panel chart below shows the economic fundamentals versus the S&P 500 and the change that occurred beginning in 1983.  (Red dividing line)”

S&P-500-EconomicVariables-012014

“I have also noted the expanding “megaphone” pattern in the current market as compared to that of the 60′s and 70′s.”

Conclusion

Despite much hope that the current breakout of the markets is the beginning of a new secular“bull” market – the economic and fundamental variables suggest otherwise.  Valuations and sentiment are at very elevated levels while interest rates, inflation, wages and savings rates are all at historically low levels.  This set of fundamental variables are normally seen at the end of secular bull market periods.

Lastly, the consumer, which comprises roughly 70% of economic growth is unable significantly increase their consumption, as a percent of the economy, as the capacity to releverage to their balance sheet is no longer available.  This “deleveraging” of balance sheets by the aging baby boomers, as they move through retirement, will further exacerbate the consumption side of the economic equation.

As I have said many times in the past I am currently maintaining fully allocated portfolio models.  As a money manager, I must participate with rising markets or suffer career risk.  However, while being a “stark raving bull” going into 2014 is certainly fashionable currently; as investors, we should place our faith, and hard earned savings, into the reality of the underlying fundamentals.  As I said at the beginning of the missive, it is disingenuous to manipulate the data to support a bullish thesis.

In my opinion, this is the wrong way to view the markets.  Participating with rising markets is the easy part. As investors, we should focus our analysis on what can go wrong.  The “glass is always half full” commentary leads investors into taking on substantially more investment risk than they realize as markets are rising.  It is the unwinding of that “risk” that leads the majority of investors to unrecoverable losses.  Most importantly, one absolutely unrecoverable commodity that is lost during mean reverting events is our most precious form of investment capital - “time.”  The reality is that we will not live forever.  By allowing “greed” to drive investment decisions the eventual “mean reversion” destroys our singularly most precious form of investment capital.

On that note, it is entirely conceivable that stock prices can be driven higher through the Federal Reserve’s ongoing interventions, current momentum, and excessive optimism.  However, the current economic variables, demographic trends and underlying fundamentals make it currently impossible to “replay the tape” of the 80′s and 90′s.  These dynamics increase the potential of a rather nasty mean reversion at some point in the future.  The good news is that it is precisely that reversion that will likely create the “set up” necessary to launch the next great secular bull market.  However, as was seen at the bottom of the market in 1974, there were few individual investors left to enjoy the beginning of that ride.  

5 Things To Ponder: Macro Investing Thoughts

By Lance Roberts of STA Wealth Management

This past week has seen the market struggle due to continued weak economic data, rising tensions between Russia and the Ukraine and an extended bull market run.  As I discussed in yesterday’s missive, the market internals are showing some early signs of deterioration even though the longer term bullish trajectory remains intact.  Therefore, this week’s “Things To Ponder” wades through some broader macro investment thoughts from the safety of your investments to how market tops are made.

1) The Delusions Of Real Returns by Brett Arends, WSJ

This is a topic that I discuss very often with clients.  Past performance is no guarantee of future results, and making investment decisions based on such is likely going to leave you very disappointed.  Extrapolating 110 year historical average returns going forward is extremely dangerous.  First, you won’t live 110 years from the time you start saving to achieve those results, and starting valuation levels are critical to your expected returns.  Brett does an excellent job discussing this issue.

“Money managers point to historical data going back to the 1920s to show that in the past stocks have produced total returns of about 10% a year over the long term and bonds, about 5%—meaning a standard “balanced” portfolio of 60% stocks and 40% bonds would earn just over 8% a year. (Naturally, their legal departments quickly add that the past is no guide to the future.)

Are these forecasts realistic? Are they sensible? Are they even based on actual logic or a correct reading of the past data?

A close look at the data reveals a number of disturbing errors and logical flaws. There is a serious danger that investors are deluding themselves and that returns from here on may prove far more disappointing than many hope or believe.

This has happened before. Money invested in a balanced fund of stocks and bonds at certain points in the past—such as in the late 1930s, or during the 1960s and 1970s—ended up losing money for many years, after accounting for inflation.

Far from making an annual profit, investors went backward in real, purchasing-power terms. And those losses were even before deducting costs or taxes.”

2) Lessons From The Bull Market by Jason Zweig, Joe Light and Liam Pleven

If you do nothing else this weekend - read this article.  There are simply too many nuggets of wisdom for me to summarize, but here are a couple of my favorite points.

“Every day, in the newspapers, on financial-news shows and online, dozens of market strategists make bold predictions about the direction stocks are heading. Take their forecasts with a mound of salt. After all, current prices already reflect the sum of stock-market buyers’ and sellers’ opinions. If one investor is bullish, there must be another investor on the other side at the current price.”

“In a speech about intellectual honesty 40 years ago, Nobel Prize-winning physicist Richard Feynman said, ‘The first principle is that you must not fool yourself—and you are the easiest person to fool.’

What they should be asking is this: Am I fooling myself into remembering my losses as less painful than they were? Am I itching to take risks that my own history should warn me I will end up regretting? Am I counting on willpower alone to enable me to stay invested and to rebalance through another crash?”

“Investors who hear the phrase ‘bull market’ might decide it is time to get in on the rally. On the other hand, investors who hear the current bull market in stocks has been running for five years might worry it will soon end. In either case, investors would do better to tune out the chatter. The definition of a bull market is arbitrary, and the term tells investors little about what will happen next.”

3) How Market Tops Are Made by Barry Ritholtz via Bloomberg

This is a great follow up to my articles this past week on ”10 Signs Of Exuberance” and “Market Internals.”  Barry interviews Paul Desmond, the Chief Strategist and President of Lowry’s Research, who has spent the past five decades analyzing markets.  From Barry:

“I spoke with him [Paul Desmond] recently, chatting about his work in identifying market tops. Rather than focus on the usual noise, Desmond suggests anyone concerned about a top should be watching for very specific warning signs. He notes the health of a bull market can be observed by watching internal indicators that provide insight into the overall appetite for equity accumulation.

These four include:

1. New 52-Week Highs

2. Market Breadth (Advanced/Decline Line)

3. Capitalization: Small Cap, Mid Cap, Large Cap

4. Percentage of Stocks at 20 percent or greater from their recent highs”

4) New All Time Highs = Secular Bull Market? by Cam Hui via Humble Student Of The Markets Blog

I wrote an article recently entitled Correcting Some Misconceptions About A New Secular Bull Market“ as the markets pushed toward new highs at the end of 2013.  At that time, there was a flurry of articles suggesting that the markets had entered into a new secular bull market.  However, my argument against this thesis revolved around the fact the no secular bull market in the history of the known universe has ever started from peak market valuations.  Cam Hui brings forward an excellent point:

“Here is a difficult question for those in the secular bull camp. What’s the upside from here? Ramsey of Leuthold Weeden Capital Management projects limited upside under a secular bull scenario, even assuming that everything goes right:

If the current cyclical bull unfolds into a secular one that is perfectly average in duration and magnitude (a very tall achievement, in our book), the annualized total return over the next ten years will still be a bit below the long-term average return of 10%. Frankly, we don’t find this all that compelling, considering all that must go according to plan for the market to achieve it (i.e. sustained EPS growth at a healthy 6% and an inflated terminal P/E multiple).

He added some of these gains depends on assuming the resumption of a stock market bubble:

Based on the relative positions of these time-tested measures, secular bulls seem to be implicitly betting on the reflation of a multi-generational stock bubble less than 15 years after it popped. The pathology of ‘busted bubbles’—which we’ve detailed at length in the past—doesn’t support that bet.

When he puts it all together, my inner investor thinks that, if we are indeed seeing a new secular bull market, the extraordinary measures undertaken by global central banks in the wake of the Lehman Crisis has front-end loaded many of the gains to be realized in this bull.

5) Does Shiller’s CAPE Still Work? by Bill Hester, Hussman Funds

It is becoming more difficult for more mainstream commentators, analysts and managers to justify their arguments for a continued bull market when having to contend with rising valuation levels.  However, as would be expected, at the peak of every major bull market in history there have always been those that have suggested “this time is different.”  In 1929, stocks had reached a new permanent plateau.  In 1999, old valuation measures didn’t matter as it was about “clicks per page.”   In 2007, subprime credit was “contained” and it was a “goldilocks economy.”  In 2014, old valuation metrics simply don’t account for the new economy.  We have always heard the same “sirens song” during every major bull market cycle and, as the sailors of the past, we are ultimately lured toward our demise.  Bill Hester does an excellent job breaking down the arguments against Shiller’s CAPE valuation metrics.

“More recently the ratio has undergone an attack from some widely-followed analysts, questioning its validity and offering up attempts to adjust the ratio. This may be a reaction to its new-found notoriety, but more likely it’s because the CAPE is suggesting that US stocks are significantly overvalued. All of the adjustments analysts have made so far imply that stocks are less overvalued than the traditional CAPE would suggest.

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns. But we decided to come to the aid of the CAPE ratio in this case because a few errors have slipped into the debate, and it’s important for investors who have previously relied on this ratio to understand these errors so they can judge the valuation metric fairly.

LR-140314-Fig-1

Importantly, the primary error that is being made is not even the fault of those making the arguments against the CAPE ratio. The fault lies at the feet of a misleading data series.

EXTRA:  Just Good Stuff To Know

I use Google for just about everything.  Email, picture uploads, all of my spreadsheets that I use for blogging, analysis, newsletters, etc.  From my phone to my computer, Google has just about all of my data.

That makes me a little more than uncomfortable. If you are like me, then you will find the following links very useful in adjusting things from what Google knows about you to archiving the stuff you put on the site.

Here are 10 important links that every Google user should know.

Have a fabulous week.

10 Warnings Signs Of Stock Market Exuberance

By Lance Roberts, STA Wealth

Imagine that you are speeding down one of those long and lonesome stretches of highway that seems to fall off the edge of the horizon.  As the painted white lines become a blur, you notice a sign that says “Warning.”  You look ahead for what seems to be miles of endless highway, but see nothing.  You assume the sign must be old therefore you disregard it, slipping back into complacency.

A few miles down the road you see another sign that reads “Warning: Danger Ahead.”  Yet, you see nothing in distance.  Again, a few miles later you see another sign that reads “No, Really, There IS Danger Ahead.”  Still, it is clear for miles ahead as the road disappears over the next hill.

You ponder whether you should slow down a bit just in case.  However, you know that if you do it will make you late for your appointment.  The road remains completely clear ahead, and there are no imminent sings of danger.  So, you press ahead.  As you crest the next hill there is a large pothole directly in your path.  Given your current speed there is simply nothing that can be done to change the following course of events.  With your car now totalled, you tell yourself that there was simply “no way to have seen that coming.”

It is interesting that, as humans, we fail to pay attention to the warnings signs as long as we see no immediate danger.  Yet, when the inevitable occurs, we refuse to accept responsibility for the consequences.

I was recently discussing the market, current sentiment and other investing related issues with a money manager friend of mine in California. (Normally, I would include a credit for the following work but since he works for a major firm he asked me not to identify him directly.) However, in one of our many email exchanges he sent me the following note detailing the 10 typical warning signs of stock market exuberance.

(1) Expected strong OR acceleration of GDP and EPS  (40% of 2013′s EPS increase occurred in the 4th quarter)

(2) Large number of IPOs of unprofitable AND speculative companies

(3) Parabolic move up in stock prices of hot industries (not just individual stocks)

(4) High valuations (many metrics are at near-record highs, a few at record highs)

(5) Fantastic high valuation of some large mergers (e.g., Facebook & WhatsApp)

(6) High NYSE margin debt

Margin debt/gdp (March 2000: 2.7%, July 2007: 2.6%, Jan 2014: 2.6%)

Margin debt/market cap (March 2000: 1.8%, July 2007: 2.3%, Jan 2014: 2.0%)

(7) Household direct holdings of equities as % of total financial assets at 24%, second-highest level (data back to 1953, highest was 1998-2000)

(8) Highly bullish sentiment (down slightly from year-end peaks; still high or near record high, depending on the source)

(9) Unusually high ratio of selling to buying by corporate senior managers (the buy/sell ratio of senior corporate officers is now at the record post-1990 lows seen in Summer 2007 and Spring 2011)

(10) Stock prices rise following speculative press releases (e.g., Tesla will dominate battery business after they get partner who knows how to build batteries and they build a big factory.  This also assumes that NO ONE else will enter into that business such as GM, Ford or GE.)

All are true today, and it is the third time in the last 15 years these factors have occurred simultaneously which is the most remarkable aspect of the situation.


The following evidence is presented to support the above claim.

Exhibit #1: Parabolic Price Movements

Kumar-IBB-030714

 

Exhibit #2: Valuation

Tobins-Q-Shiller-PE-111113

 

Excerpt from a recent report by David J. Kostin, Chief US Equity Strategist for Goldman Sachs, 11 January 2014

The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock:

(1) The P/E ratio;

(2) the current P/E expansion cycle;

(3) EV/Sales;

(4) EV/EBITDA;

(5) Free Cash Flow yield;

(6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of inflation; nominal 10-year Treasury yields; and real interest rates.

Kostin-Chart1-030714

Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of Operating EPS and about 45% overvalued using As Reported earnings.

Reflecting on our recent client visits and conversations, the biggest surprise is how many investors expect the forward P/E multiple to expand to 17x or 18x. For some reason, many market participants believe the P/E multiple has a long-term average of 15x and therefore expansion to 17-18x seems reasonable.But the common perception is wrong. The forward P/E ratio for the S&P 500 during the past 5-year, 10-year, and 35- year periods has averaged 13.2x, 14.1x, and 13.0x, respectively. At 15.9x, the current aggregate forward P/E multiple is high by historical standards.

Most investors are surprised to learn that since 1976 the S&P 500 P/E multiple has only exceeded 17x during the 1997-2000 Tech Bubble and a brief four-month period in 2003-04. Other than those two episodes, the US stock market has never traded at a P/E of 17x or above.

A graph of the historical distribution of P/E ratios clearly highlights that outside of the Tech Bubble, the market has only rarely (5% of the time) traded at the current forward multiple of 16x.

Kostin-Chart2-030714

The elevated market multiple is even more apparent when viewed on a median basis. At 16.8x, the current multiple is at the high end of its historical distribution.

The multiple expansion cycle provides another lens through which we view equity valuation. There have been nine multiple expansion cycles during the past 30 years. The P/E troughed at a median value of 10.5x and peaked at a median value of 15.0x, an increase of roughly 50%. The current expansion cycle began in September 2011 when the market traded at 10.6x forward EPS and it currently trades at 15.9x, an expansion of 50%. However, during most (7 of the 9) of the cycles the backdrop included falling bond yields and declining inflation. In contrast, bond yields are now increasing and inflation is low but expected to rise.

Incorporating inflation into our valuation analysis suggests S&P 500 is slightly overvalued. When real interest rates have been in the 1%-2% band, the P/E has averaged 15.0x. Nominal rates of 3%-4% have been associated with P/E multiples averaging 14.2x, nearly two points below today. As noted earlier, S&P 500 is overvalued on both an aggregate and median basis on many classic metrics, including EV/EBITDA, FCF, and P/B.”

Exhibit #3: Selling Of Company Stock By Senior Managers

Excerpt from a recent article by Mark Hulbert

“Prof. Seyhun – who is one of the leading experts on interpreting the behavior of corporate insiders – has found that when the transactions of the largest shareholders are stripped out, insiders do have impressive forecasting abilities. In the summer of 2007, for example, his adjusted insider sell-to-buy ratio was more bearish than at any time since 1990, which is how far back his analyses extended.

Ominously, that degree of bearish sentiment is where the insider ratio stands today, Prof. Seyhun said in an interview.

Note carefully that even if the insiders turn out to be right and the bull market is coming to an end, this doesn’t have to mean that the U.S. market averages are about to fall as much as they did in 2008 and early 2009. The one other time since that bear market when Prof. Seyhun’s adjusted sell-buy ratio sunk as low as it was in 2007 and is today, the market subsequently fell by ‘just’ 20%.

That other occasion was in early 2011. Stocks’ drop at that time did satisfy the unofficial definition of a bear market, and the insiders’ pessimism was vindicated.”

Exhibit #4: Investor’s Confidence

AAII-Bull-Bear-030714 AAII-INVI-Bearish-13wk-030714

 

Exhibit #5: Ownership Of Stocks As % Total Financial Assets

Flow-Of-Funds-Equity-TotalAssets-030714

 

The point my money managing friend wishes to make is simply that the “”warning signs” are all there. However, since the road ahead seems clear, it is human nature that we keep our foot pressed on the accelerator.

As the Federal Reserve extracts liquidity from the markets, the “Bernanke Put” is being removed which leaves the markets vulnerable to a “mean reverting event” at some point in the future.  The mistake that many investors are currently making is believing that since it hasn’t happened yet, it won’t.   This time is only “different” from the perspective of the “why” and“when” the next major event occurs.

Of course, despite the repeated warning signs, the next correction will leave investors devastated looking to point blame at everyone other than themselves.  The question will simply be “why no one saw it coming?”

5 Things to Ponder: Serious Stuff

By Lance Roberts, STA Wealth

There were so many good things to read this past week that it was hard to narrow it down to a topic group.  After a brief respite early this year, the markets are hitting new highs confirming the current bullish trend.  As a money manager, this requires me to increase equity exposure back to full target weightings.  After such an extended run in the markets, this seems somewhat counter-intuitive.  It is, but as Bill Clinton once famously stated; “What is….is.” 

However, while the current market “IS” within a bullish trend currently, it doesn’t mean that this will always be the case.  This is why, as investors, we must modify Clinton’s line to:“What is…is…until it isn’t.”  That thought is the foundation of this weekend’s “Things To Ponder.”  In order to recognize when market dynamics have changed for the worse, we must be aware of the risks that are currently mounting.

1) Fisher Warns Fed’s Bond Buying Could Be Distorting Markets via Reuters

While this article falls in the “no s***” category, Dallas Fed President Richard Fisher points out areas that we should be paying closer attention to for signs of change.

“There are increasing signs quantitative easing has overstayed its welcome: Market distortions and acting on bad incentives are becoming more pervasive,” he said of the asset purchases, which are sometimes called QE.

“I fear that we are feeding imbalances similar to those that played a role in the run-up to the financial crisis.”

Here are his main points:

1) QE was wasted over the last 5 years with the Government failing to use “easy money” to restructure debt, reform entitlements and regulations.

2) QE has driven investors to take risks that could destabilize financial markets.

3) Soaring margin debt is a problem.

4) Narrow spreads between corporate and Treasury debt are a concern.

5) Price-To-Projected Earnings, Price-To-Sales and Market Cap-To-GDP are all at “eye popping levels not seen since the dot-com boom.”

“We must monitor these indicators very carefully so as to ensure that the ghost of ‘irrational exuberance’ does not haunt us again,”


In order to make it in professional sports, you have to be an elite athlete.  What is amazing, is that among all of the elite athletes, there are always one or two that rise above all others.  Players like Michael Jordon, Tiger Woods, Nolan Ryan and many others have elevated their game to inexplicable levels.  In the investment game, there are a few individuals that have done the same.  The follow three pieces are views from some of these men Howard Marks, Jeff Gundlach and Seth Klarman.

2) Howard Marks: In The End The Devil Usually Wins via Finanz Und Wirtschaft

“Our mantra at Oaktree Capital for the last few years has been: «move forward, but with caution». Although a lot has changed since then I think it’s still appropriate to keep the same mantra. Today, things are not cheap anymore.  Rather I would describe the price of most assets as being on the high side of fair. We’re not in the low of the crisis like five years ago.”

“Let’s think about a pendulum: It swings from too rich to too cheap, but it never swings halfway and stops. And it never swings halfway and goes back to where it came from. As stocks do better, more people jump on board.  And every year that stocks do well wins a few more converts until eventually the last person jumps on board. And that’s the top of the upswing.”

“But there actually are two risks in investing: One is to lose money and the other is to miss opportunity. You can eliminate either one, but you can’t eliminate both at the same time.”

“There are two main things to watch: valuation and behavior.”

3) Seth Klarman: Downplaying Risk Never Turns Out Well via Value Walk

““In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,” he wrote. “What investors see in the inkblots says considerably more about them than it does about the market.”

“If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about.”

“We can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences.”

“Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?”

“There is a growing gap between the financial markets and the real economy,”

“Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth.”

“In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,” he wrote. “A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?”

4) Jeff Gundlach & Howard Marks: Beware Of Junk Bonds via Pragmatic Capitalist

 ”There’s been some cautionary commentary in recent months from some bond market heavyweights.  Most notably, Howards Marks and Jeff Gundlach. In a Bloomberg interview today, Marks said you need to be cautious about low quality issuers:

‘When things are rollicking and the market is permitting low-quality issuers to issue debt, that’s when you need a lot of caution,’

And just a few weeks before that Jeff Gundlach referred to junk bonds as the most overvalued they’ve ever been relative to Treasury Bonds.”

5) Bernanke Unleashed: What He Can Say Now That He Couldn’t Say Before via Zero Hedge

Now that Ben Bernanke is no longer the head of the Fed, he can finally tell the truth about what caused the financial crash. At least that’s what a packed auditorium of over 1000 people as part of the financial conference staged by National Bank of Abu Dhabi, the UAE’s largest bank, was hoping for earlier today when they paid an exorbitant amount of money to hear the former chairman talk.

“The United States became ‘overconfident’, he said of the period before the September 2008 collapse of U.S. investment bank Lehman Brothers. That triggered a crash from which parts of the world, including the U.S. economy, have not fully recovered.

‘This is going to sound very obvious but the first thing we learned is that the U.S. is not invulnerable to financial crises,’ Bernanke said.

“He also said he found it hard to find the right way to communicate with investors when every word was closely scrutinised. ‘That was actually very hard for me to get adjusted to that situation where your words have such effect. I came from the academic background and I was used to making hypothetical examples and … I learned I can’t do that because the markets do not understand hypotheticals.

The complexity though arises because in order to help the average person, you have to do things — very distasteful things — like try to prevent some large financial companies from collapsing.  The result was there are still many people after the crisis who still feel that it was unfair that some companies got helped and small banks and small business and average families didn’t get direct help.  It’s a hard perception to break.”

I guess the real question is now that the markets are once again over confident, over extended and excessively bullish – have we actually learned anything?

Have a great weekend.

Revisiting Why Benchmarking Is A Bad Strategy

By Lance Roberts, STA Wealth

Just recently my friend Cullen Roche wrote a great piece entitled “Can we All Agree to Stop Comparing Everything to the S&P 500″ in which he stated:

“Benchmarking is a pernicious thing in financial circles.  Not only because it disconnects the way the client and a fund manager understand the concept of ‘risk’, but also because the concept of benchmarking seems to be misunderstood.”

Risk is rarely understood by investors until it is generally too late.  Take, for example, a call I received the other night during a broadcast of the “Lance Roberts Show.”   The caller didn’t understand why people didn’t just buy an S&P 500 index and then just leave it alone.  When I asked him when he started investing he proudly stated that he had been investing for the almost 5 years and had more than doubled his money.  The problem is that this particular individual has no functional idea of what “risk” entails.

The chart below is an inflation adjusted return of $100,000 investment in the S&P 500 from 1990 to present.  The reason that 1990 is important is because that is when roughly 80% of all investors today begin investing.  Roughly 80% of those began after 1995.  If you don’t believe me, go ask 10 random people when they started investing in the financial markets and you will likely be surprised by what you find.

S&P-500-Inflation-Returns-022514

 

As shown, there is certainly a case to be made for buying and holding an index.  However, it is quite clear that “buying low” and “selling high” would have been much more beneficial from 2000 until present.

Unfortunately, the reality is that investors rarely do what is “logical” but react “emotionally” to makret swings.  When stock prices are rising instead of questioning when to “sell” they lured in near market peaks.  The reverse happens as prices fall leading first to “paralysis” and“hope” that losses will soon be recovered.  Eventually, near market bottoms the emotional strain is too great and investors “dump” shares at any price to preserve what capital they have left.  Despite the media’s commentary that “if an investor had ‘bought’ the bottom of the market…” the reality is that few, if any, actually did.   The biggest drag on investor performance over time is allowing “emotions” to dictate investment decisions.  This is shown in the 2013 Dalbar Investor Study which showed “psychological factors” accounted for between 45-55% of underperformance.  From the study:

“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”

In other words, investors consistently bought the “tops” and sold the “bottoms.”  The other two primary reasons of underperformance from the study related to a lack of capital to invest.  This is also not surprising given the current economic environment.

There are many reasons why you can’t really beat the S&P 500 index over time and why you see statistics such as “80% of all fund underperform the S&P 500.”   The impact of share buybacks, substitutions, lack of taxes and trading expenses all lead to outperformance by the index over everyone else that is actually investing and doesn’t receive those benefits.  Furthermore, any portfolio that is allocated to to lower volatility, create income or provide for long term financial planning and capital preservation will underperform the index so comparing your portfolio to the S&P 500 is “apples to oranges.“   Cullen makes this point very clearly:

“But it gets worse.  Often times, these comparisons are made without even considering the right way to quantify “risk”.  That is, we don’t even see measurements of risk adjusted returns in these “performance” reviews.  Of course, that misses the whole point of implementing a strategy that is different than a long only index.

It’s fine to compare things to a benchmark.  In fact, it’s helpful in a lot of cases.  But we need to careful about how we go about doing it.”

recently wrote a fairly deep study on the perils of benchmarking and why, despite your best intentions, it was highly unlikely that you will ever “beat the market” over the long term.

“While Wall Street wants you to compare your portfolio to the “index” so that you will continue to keep money in motion, which creates fees for Wall Street, the reality is that you can NEVER beat a “benchmark index” over a long period.  This is due to the following reasons:

1) The index contains no cash

2) It has no life expectancy requirements – but you do.

3) It does not have to compensate for distributions to meet living requirements – but you do.

4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.

5) It has no taxes, costs or other expenses associated with it – but you do.

6) It has the ability to substitute at no penalty – but you don’t.

7) It benefits from share buybacks – but you don’t.”

For all of these reasons, and more, the act of comparing your portfolio to that of a“benchmark index” will ultimately lead you to taking on too much risk and ultimately making emotionally based investment decision making.  The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals.  Investing is not a competition and, as history shows, there are horrid consequences for treating it as such.  So, do yourself a favor and forget about what the benchmark index does from one day to the next.  Focus instead on matching your portfolio to your own personal goals, objectives, and time frames.  In the long run you may not beat the index, but you are likely to achieve your own personal investment goals which is why you invested in the first place.

Chart Of The Day: S&P Tracing A Top?

By Lance Roberts, STA Wealth

Chart comparisons predicting the next major market crash have abounded as of late.  Is this a repeat of 1929, 1974 or 1994?  The truth is that we are all guessing at what will happen next in the markets as no one really knows what will happen tomorrow much less six months from now.  I say that to qualify today’s chart because the market is behaving very similarly to what we witnessed beginning in late 2010.

S&P-500-2011-2014-022014

 

What is interesting about the chart above is that in late 2010 the markets were rising strongly as the Fed’s second quantitative easing program was fully engaged.  Complacency among investors was high as the economy plugged along.  Much the same as we are witnessing currently.  Then, in March of 2011, the Japanese trifecta of economic disaster struck as an earthquake caused a tsunami which led to a nuclear plant chain reaction.  The only thing missing was a 90 foot tall lizard sending citizens fleeing from the city.

The domestic economy was quickly impacted by the shutdown of Japanese manufacturing.  Economic data began to wane at the same time as the Fed’s liquidity program approached its early summer expiration.  As the market anticipated the reduction in liquidity flows from the Federal Reserve, stock prices began to struggle. However, for a while they managed to hold above important support.  Then, in the middle of summer, President Obama squared off with Congress over a heated debt-ceiling debate.  Threats of a government default filled media headlines while market participants watched helplessly from the sidelines.  While there was never any real threat of a default, as witnessed by the plunge in U.S. interest rates to record lows at the time, the markets plunged sharply over just a few short weeks causing investors to flee for safety.

That was then.  Interestingly, we are currently witnessing similar events.

The Fed is once again tapering their current liquidity program.  The most recent commentary from the Federal Reserve suggests that the current path of reduction in bond purchases will continue which suggests the program will end by October, 2014.

While the U.S. has not yet witnessed an “abominable snowman” threatening Manhatten, the series of “polar vortexes” are exacerbating already weaker trending economic data.  As Idiscussed previously, the pop in economic data in Q3 of 2013 was an inventory restocking cycle.

“It has been a ‘Summer of Recovery’ for the U.S. economy with GDP growth rising from 1.1% in the first quarter to 2.5% in the second and manufacturing surveys showed sharp jumps in new orders and outlooks.  The same occurred in the Eurozone with Markit’s PMI reports showing sharp bounces higher and hopes that the recession that has plagued the region was finally coming to an end.  The question of sustainability remains.

I have noted several times as of late, most recently here, that the recent bumps in economic activity, particularly in the survey and sentiment data, is most likely due to short term restocking activity rather than actual economic improvement.”

That point was reaffirmed by the NFIB’s Chief Economist, Bill Dunkleberg, just recently:

 “Last year finished with a fair uptick in economic activity, but probably not as strong as the ‘headline’ GDP numbers made it look. Overall, GDP was up only 1.9 percent in 2013, down from 2.8 percent in 2012. But the second half of the year posted above trend growth numbers, a rare showing in our 5 year recovery. Exports were strong, that’s good for manufacturing output, but less so for jobs – productivity looking good. A huge share of the growth was in inventory building, nice while it is happening, but usually followed by sub-normal production later as excess stocks are worked off. That will depress activity in the first half of 2014 and keep some prices down.”

With that restocking cycle now complete, the economic data was already showing signs of weakness.  However, the exogenous shock of the extraordinarily cold winter has sent utility costs surging, slowed production and reduced incomes.  While not as economically damaging as the “Japan shutdown,” when the effect of the winter impact is combined with the rising costs, taxes and uncertainty created by the Affordable Care Act, the economic drag will likely be exacerbated.

Lastly, we are in a mid-term election year which typically does not bode well for markets just prior to the November election.  This is an issue I discussed previously stating:

“Midterm election years are also notoriously weaker when Democrats are in control, but in the last 13 quadrennial cycles since 1961, 9 of the 16 bear markets bottomed in the midterm year.

As stated, on average all midterm years have returned 4.16%. However, when the midterm year followed a strongly positive post-election year, as in 2013, that return fell to just 2.4% on average.  The chart below, from Stock Trader’s Almanac, shows the mid-year correction that generally accompanies a mid-term election year.”

DJIA-Midterm-Election Years

While mid-term election years have typically finished on a positive note, it is important to note the corrections that tend to occur prior to the election in the chart above.

So, while there have been plenty of charts comparing this year to that, the current combination of both the technical setup and economic backdrop should raise a cautious view.  Since no two periods are ever alike, it leaves us guessing at the future when making investment decisions.  Unfortunately, while psychics and fortune tellers have the “crystal ball”market cornered, the rest of us are forced to take our ques from what has happened in the past.

5 Things To Ponder: Cash, QE, Investing & 1929

By Lance Roberts, STA Wealth

The market correction that begin in January appears to be subsiding, at least for the moment, as Yellen’s recent testimony gave markets the promise of the continuation of Bernanke’s legacy.  A synopsis of her “accommodation supportive” comments (courtesy of Bill King) is below:

* The recovery in the labor market is far from complete.

* The hope is that by stimulating more borrowing and spending, lower interest rates can jumpstart the economy.  [Of course, we are still waiting for that to actually happen]

* QE tapering is “not on a preset course. The Committee’s decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.”

* Asset prices are not at “worrisome levels.” [This statement caused the midday surge.]

* The Fed will have to keep rates near zero “well past the time” that unemployment crosses below the 6.5 percent threshold; and the Fed will be an active participant in increased bank regulation, specifically focusing on avoiding the too-big-to-fail problems

With the markets back into rally mode, for the moment, this week’s “Things To Ponder” focuses on some of the bigger issues concerning the effectiveness of QE, investing and that chart of 1929 that has been making the rounds.

1) QE Is A Mistake – A Big One by Allan Meltzer of E21

If you review the Yellen’s comments above, she stated that the ”hope” of QE was to stimulate more borrowing and spending.  Unfortunately, as shown in the chart of M2V below, it has simply not been the case.

Velocity-of-Money-021414

 

Allan Metzer wrote a terrific article for E21 driving home this point:

“The Fed deserves high praise for the first round of QE in 2008. However, the benefits ended long ago. More than 95 percent of the reserves that the Fed supplied under QE 2 and 3 sit idle on bank balance sheets. M2 money growth for the year to the end of January 2014 is less than 5.5 percent. There is no mystery about why inflation remains low.

The mistaken results of QE policy include Federal Reserve financing of outsize budget deficits. No one should require a tutorial about the longer-term consequences of using central banks to finance government deficits. Sooner or later the results are inflation, always and everywhere.”

2) The Cash On The Sidelines Myth by Pater Tenebrarum via Zero Hedge

In a recent interview by JP Morgan’s Tom Lee, he asserted that:

“This could be only the middle innings of what could be one of the longest bull markets in history,” Lee said in a “Squawk Box” interview.“There is a lot of firepower to fuel this rally. There is a lot of cash on the sidelines, consumers have delevered.”

Pater dismantles this very ill-founded argument, a pet peeve of Cliff Asness as well, in great detail.

“Let us think about this statement for a moment. What is ‘cash on the sidelines’ even supposed to mean? We submit that it is a meaningless concept. All stocks are owned by someone at all times, and all cash is held by someone at all times. When people trade stocks, all that happens is that the ownership of stocks and cash changes hands. There is as much ‘cash on the sidelines’ after a trade concludes than there was before. There are no owner-less orphan stocks flying about in the Wall Street Aether, waiting to suck up cash.

In other words, the ‘cash on the sidelines’ argument is a really bad argument, or rather, it’s not an argument at all.”

3) Can Earnings Get Better Than This? by Tom McClellan via Pragmatic Capitalist

“The conventional stock market analysis world revolves around earnings.  ‘Earnings drive the stock market,’ they say.  This myopic view is akin to the belief that carbon dioxide is the driving force behind the greenhouse effect(water vapor actually accounts for 90-95% of it, but you don’t hear that).  People believe that earnings are everything because they have been told that it is so, and everyone thinks so,  therefore it must be so.  Circularity of logic and contradictory evidence do not seem to be significant impediments to the acceptance of this belief system.

This week’s chart looks at the BEA’s data on corporate profits.

Corp_Profits_per_GDP

Why doesn’t everyone look at earnings this way? My answer is that Wall Street has a fascination with its own forecasts of earnings, and with the reported earnings of listed companies stocks. But those are a pair biases which excluded private company earnings, and which also accept earnings estimates which are notoriously subject to revision. I prefer to deal in hard data. The next BEA report on earnings is not due out until Feb. 28, so using these data means accepting the inherent reporting lag.

What we see now is an indication that the reading for overall corporate profits as a percentage of GDP is at one of the highest levels of recent years. And when it cannot get higher, it can only get lower. It is true that this measure has been higher in the distant past, but that was back in the 1960s and earlier, when GDP was a bit different than it is now, and when accounting standards for measuring profits were also different. The current high reading has only been exceeded once in the past 46 years, and that was at the real estate bubble top for earnings back in 2006. And we all know how that ended.

 

4) Everything I Know About Investing I Learned From Drivers Ed by Jason Zweig

Jason’s articles are always a must read as he has a brilliant ability to very complex issues into an understandable, and enjoyable, format.  His recent piece on investing is no exception and well worth your time to read.

“Only recently did I realize that his messages apply at least as much to investing as they do to driving. Here are the pithy expressions Mr. Terry taught us about driving – and how I think they apply to investing as well.

Put Your Head on a Swivel - Risk is all around you, and the likeliest places to look for it are the places that appear to be the safest. That’s where the next danger will come from – just where and when nobody is looking.

Edge On, Edge OffMaking a sudden change in your plan is usually a mistake. Making a sudden, big change in your plan almost always is.

Get in the Ground-Viewing Habit - It’s what is beneath eye-level that matters

Give Him Room and Let Him Zoom - People who try to get rich quick don’t end up any farther along – and take a lot more risk, and incur a lot more cost, to get there. You don’t get bonus points in investing for arriving at your destination ahead of time. The only thing that matters is getting there in one piece.”

5) The 1929 Scary Chart via Bill King, The King Report

The chart below, which compares the 1929 stock market to today, has been making the rounds stirring up quite a bit of angst.  I thought Bill did a good job of dispelling some of these concerns.

“There is another factor that drove stocks higher on Tuesday – some of the 1928-1930 algorithm followers are now covering their shorts. [Especially after the S&P 500 blew threw 1800]“

1929-2014-Scary-Chart-021414

“In our missive on Monday we stated: We believe that the current stock market will now diverge from the 1928-1930 algorithm. For the near future we cannot see or fathom a catalyst for a stock market crash. Plus, it’s the wrong time of the year for a dramatic decline in stock prices.

PS- Several people voiced irritation with our forecast that stocks would not tank in coming days.

Apparently a critical mass of traders now realize that stocks are diverging from the 1928-1930 algorithm. This unleashed massive short covering on Tuesday.

This story by Mark Hulbert appeared yesterday on Drudge: Scary 1929 market chart gains traction

There are eerie parallels between the stock market’s recent behavior and how it behaved right before the 1929 crash…

Tom Demark [has a huge hedge fund and institutional following] added in interview that he first drew parallels with the 1928-1929 period well before last November. ‘Originally, I drew it for entertainment purposes only,’ he said—but no longer: ‘Now it’s evolved into something more serious.’”

I agree with Bill.  Statistically speaking, the odds are high that the markets will diverge from the pattern.   While history does indeed rhyme, it often does not repeat exactly.  Do I think that eventually the markets will have another major reversion?  Absolutely.  The natural ebb and flow of market dynamics tells us this will be the case.  Unfortunately, we just don’t know when or what will cause it.

Bonus Reading:  77 Reasons You Suck At Managing Money by Morgan Housel

“People usually get better at things over time. We’re better farmers, faster runners, safer pilots, and more accurate weather forecasters than we were 50 years ago.

But there’s something about money that gets the better of us. If you look at the rate of personal bankruptcies, financial crises, bubbles, student loans, debt defaults, and savings rates, I wonder whether people are just as bad at managing money today as they were in previous generations, maybe even worse. It’s one of the only areas in life we seem to get progressively dumber at.”

Yes, there are indeed 77 charming nuggets of wisdom contained within the article, all of which are worth every minute you spending reading them.  They are funny, enlightening and humbling with insights like:

“You get upset when you hear on TV that the government is running a deficit. It doesn’t bother you that you heard this on a TV you bought on a credit card in a home you purchased with a no-money-down mortgage.”

He concludes with the most salient point:

“You nodded along to all 77 of these points without realizing I’m talking aboutyou. That goes for me, too.”

 

 

Complacency Rapidly Returns To The Market

By Lance Roberts, STA Wealth

The markets have bounced nicely over the last several days as the recent “crisis” in the emerging market countries has subsided.  Furthermore, Janet Yellen smoothed over many of the financial market’s concerns with promises of continued accommodative support.  As shown in the chart of the volatility index below, these events led to the rapid decline from“panic” to ”complacency” within just a few days.

VIX-vs-SP500-021214

 

I have noted the spikes in volatility with related market declines.  The last real sign of investor panic ws in 2011 during the debt ceiling debate.  Since then, primarily due to a conviction that the “Fed will do whatever is necessary to bail out the markets,” each spike in volatility has been to lower levels.  As a consequence, the market declines have also been very muted.

Another measure of complacency is the total put/call options ratio from the CBOE.  The chart below shows, that despite the “panic” from the emerging market crisis, there was very little movement in the put/call ratio indicating real “fear” in the markets.  Currently, this indicator is at levels that have been historically associated with bigger corrections.  I believe this to be the bigger concern for the markets in the next few months.

CPC-SP500-021214

 

What is interesting though is that the bond market does not seem to be supporting the return of exuberance in the stock market.  The chart below shows the 10-year treasury rate versus the stock market.

Stocks-vs-Bonds-021214

 

Previously. when stocks were in rally mode, bonds were selling off (causing rates to rise) as risk was preferred over safety.  However, during the most recent correction, the flight to safety accelerated and pushed yields down to 2.6% on the 10-year.   Despite the quiet emanating from emerging markets along with Yellen’s soothing comments, the surge in stocks is not being fully accounted for by a substantive rise in interest rates.

The question on everyone’s mind is simply whether the recent correction is over?  I think a bulk of the answer lies behind the closed doors of the Federal Reserve.  The recent rout, as discussed yesterday, was triggered by the Fed’s “tapering” of their bond purchases as leverage was unwound.  While Yellen stated that she would continue to monitor incoming data, will the issue of continued bouts of soft economic data be enough to change her stance on monetary policy?  Or, will the “tapering” continue with an estimated exit as early as October of this year?

One thing is for sure.  Despite much rhetoric to the contrary, the stock market is as dependent today on the Fed’s interventions as ever.  Fundamental valuations are no longer cheap, margin debt is near record levels, and retail investors are all in.  This leaves little room for error at a point where small changes in Fed policy has an immediate impact on the financial markets.

The recent “dip” in the markets may have indeed been a short term buying opportunity.  However, that only means that the eventual reversion, and the real long term investment opportunity, is still yet to come.

Have We Reached “Peak Employment”?

By Lance Roberts, STA Wealth

The latest employment report was filled with something for just about everyone needing to spin the data for either a “bullish” or “bearish” viewpoint.  Joe Weisenthal wrote for Business Insider that:

“After accounting for the annual adjustment to the population controls, the civilian labor force rose by 499,000 in January, and the labor force participation rate edged up to 63.0 percent. Total employment, as measured by the household survey, increased by 616,000 over the month, and the employment-population ratio increased by 0.2 percentage point to 58.8 percent.”

On the opposite side was the NY Times stating:

“Wages are stuck, and barely rose at all in 2013. They were up 1.9 percent last year, or a mere 0.4 percent after accounting for inflation. Not only was that increase even smaller than the one recorded in 2012, it was half the normal rate of wage gains in the two decades before the last recession.

The stagnation helps explain why many people feel apprehensive… white-collar workers did a bit worse than blue-collar workers last year in terms of wage growth…”

The markets have come under pressure since the Fed beginning withdrawing monetary accommodations.  Therefore, the only thing that matters to market participants currently is whether the jobs report was “weak” enough to make them stop.

However, from a larger perspective the recent spate of employment data may be signaling something much more important.  It is also something that I have discussed recently and was confirmed via a note from Goldman Sachs last week:

“It is hard to avoid the reality that the overall macro data picture is bleaker now than a few months ago,” says Aleksandar Timcenko, a vice president on the global macro strategy team at Goldman Sachs.

Since employment is a reflection of economic activity, the data is suggesting that economic growth may indeed be slowing.  However, it is hard to get an accurate picture of the underlying employment data due to the statistical manipulations of seasonally adjusting the data.  For example, we are currently experiencing one of the coldest winters in years with record levels of snowfall.  Such weather will directly impact construction related employment that is primarily done outdoors.  Yet, in the January report it showed a seasonally adjusted increase in construction jobs of 48,000.

There is also the Birth/Death Model adjustments which seeks to account for the starts and failures of small businesses that occur in the economy each month.  In January, that model adjustment to employment showed a decrease of only 307,000 jobs.  Yet, in January of 2013 it reduced employment by 315,000 while the 5-year average has been 377,000.   In other words, had the BLS used the 5-year average of the January Birth/Death adjustment the employment report would have only showed an increase of 43,000 jobs instead of the already disappointing 113,000.

Early last year I wrote ”I Can Handle The Truth On Employment.” In this missive I presented an alternative method for analyzing employment data utilizing the non-seasonally adjusted data to remove some of the obfuscation.  I stated:

“With the system of measuring employment being overly complicated, and subject to a wide degree of interpretation and manipulation, it is not surprising that the monthly reports draw such emotional arguments.  In reality what we all want to know is whether employment is getting better or worse?  Are businesses hiring people and putting them work at a rate faster than growth of the working age population and what is the trend of employment overall?  To do this, I suggest we throw out the seasonal adjustments, do away with the birth/death adjustments and just look at the raw data.

The seasonal adjustments are used by the BLS to smooth otherwise very volatile data.  However, using a simpler approach, such as a 12-month moving average, will accomplish the same result without the “mathematical Olympics.”  The chart below shows the long term analysis comparing the BLS seasonally adjusted data on an annual net change basis as compared to using the 12-month average of the non-seasonally adjusted data.

Employment-12mth-MA-021014

 

As you can see, there is an extremely high correlation between the two measures.  However, what is most notable is that it appears that the growth in employment has slowed and stagnated.  The next chart is the same data but only from 1995 to present.

Employment-12mth-MA-021014-2

 

You can clearly see that employment growth has not only peaked, but declined over the last couple of months.  That softness aligns with the recent spate of weakness in the STA Economic Output Composite Index as shown below. (For details on its construction read this)

STA-EOCI-Index-020414

 

The trend of economic growth has deteriorated in recent months despite hopes by the majority of economists.  I have labeled events that have contributed to the rolling recoveries and slowdowns in recent years.

The current bouts of freezing weather, combined with the onset of the Affordable Care Act, will likely suppress employment in the months ahead.  Is the current overall employment picture improving – the unadjusted data says “yes,”  but we may be witnessing the limits of the current economic expansion.

The non-seasonally adjusted data can tell us a story if we allow it to.  Maybe, it is time to get rid of seasonal adjustments for a more normalized smoothing process.  If you are like me, we can handle the “truth” and are likely to make better decisions because of it.

5 Things To Ponder: Market Correction Over Or Just Starting

By Lance Roberts, STA Wealth

Over the last year, investors have been lulled to sleep wrapped in the warmth of complacency as the Federal Reserve stoked the fires of the market with $85 billion a month in liquidity injections.  I have written many times in the past that investors were likely to be rudely awakened by an unexpected event of which was likely not even on the majority of mainstream analysts radars.  That occurred this past week as a revulsion in emerging markets sent the“carry trade” running in reverse.  As I quoted this past week in “Putting The Market Mayhem Into Perspective”:

“Hedge funds have been borrowing money in Japan (again) at very low Japanese interest rates, obviously denominated in yen. They then convert those yen to, say, the Brazilian real, Argentine peso, Turkish lira, etc. and buy Brazilian bonds or Turkish bonds using 10:1+ leverage. Accordingly, when such countries jacked up interest rates overnight, their bond markets collapsed. Concurrently, their currencies swooned, causing the ‘hot money’ investors to not only lose on their leveraged bond positions, but on the currency as well.  If you are leveraged when that happens, the losses add up quickly and those positions need to be sold. So the bonds were sold, and the pesos/lira/real that were freed up from those sales had to be converted back into yen (at currency losses) to pay back the Japanese loans. And as the bonds/currencies crashed, the ‘pile on’ effect exaggerated the downside dive.”

What we will need to ponder this weekend is whether the current correction is simply just a dip within an ongoing uptrend OR have the “bears” finally awakened from their winter hibernation?

1) Is A Bear Market Hanging Over Our Head?  By Robert Lamy via Advisor Perspectives/Dshort.com

“Given the recent performance of the stock market, there is increased uncertainty among individual investors and stock market brokers about the prolongation of the actual bull market into its sixth year. Many of them are asking themselves if the declines over the past thirteen business days is the signal of the near end of the fifth longest bull market since WW II and the beginning of a new long bear market.   A very plausible answer to their interrogations is no. The stock market cycle model predicts that the current bull market will extend through March.”

Robert-Lamy-140207-fig-2

2) Coppock Curve Turns Down by Tom McClellan via PragCap

“A classic technical indicator gave a rare bearish signal for the DJIA with the down move seen in January.  The Coppock Curve has turned down.  More importantly, it has done so after a second big top, which seems to be the important set of dance steps to mark a major market top.”

CoppockUnchdFeb2014

3) Retail Panic? via Zero Hedge

I have written many times over the last year that interest rates would rise ONLY as long as complacency ruled investors behavior.  However, with real economic growth remaining extremely weak as deflationary pressures continue to rise, it is only a function of time until investors seek the safety of bonds over risk.   We are now seeing this occur.

“Last week it was the largest equity outflow in over two years. This week, following the Monday drubbing which had the temerity to push the S&P to an “unprecedented” 5% from its all time highs, the timid retail investor said enough, and ran for the hills resulting in the largest equity outflow. Ever.

Zero-hedge-equity-outflows-020714

According to Bank of America, aAfter a 5% loss on the S&P 500 over the last two weeks (through February 5) equity funds reported the largest weekly outflow on record. Outflows from equity funds accelerated to $27.95bn this week from a $12.02bn outflow last week, again led by ETFs.” Sure enough, what goes out (here), must come in (somewhere over there), which is why at the same time all fixed income funds reported a record $14.09bn inflow.“Mutual fund investors were clearly seeking the safety of bonds, as three quarters ($11.05bn) of the total net bond fund inflow went into government funds and another $3.48bn into high grade.” The great unrotation has officially begun, and unless the downward momentum in stocks is halted (think USD/SPY upward momentum ignition), the party may be coming to an end.”

4) 4 Numbers About The Correction by Michael Santoli

“Having entered the year riding an excess of certainty about the steadiness of global economic growth, strength of the corporate sector, attractiveness of stocks over bonds, and scripted predictability of central-bank policies, investors have been greeted with upended expectations on most of these fronts.

None of these notions have been decisively refuted. But capital spilling from emerging markets, staticky messages on the pace of global growth and concerns about the duration of developed-world central bank generosity have been just enough to thwart risk-seeking. Recently yields on safe, under-owned U.S. Treasury notes were sent to a multi-week low of 2.6%.

Now, as the crowd tries to come to terms with a 5.8% drop in the Standard & Poor’s 500 index over the first 22 trading days of 2014, many seek the “key number” to handicap whether this is a mere frightful pullback that resets investor expectations — or something worse.

This is always tricky, because the onset of a “correction” of any depth is hard to distinguish from the opening phases of a more damaging bear market.”

5) US Stocks May Unravel Quickly via Bloomberg

Tom DeMark, the chief executive officer of DeMark Analytics LLC, said in an interview on CNBC that U.S. stocks have reached an “inflection point” that resembles the period prior to the 1929 stock-market crash.

Chart Of The Day - Putting Stock Market Correction Into Perspective

S&P500-Corrections

 

With our intermediate term sell signal now issued, it could likely mean that next week will prove to be interesting.