Investment Strategy by Jeffrey Saut
A fictitious letter to Benjamin Graham, ERPs, Dudley Do-Right, Obamacare, & GaveKal
August 22, 2016
I recently read an article that suggested a lower earnings yield may explain why the stock market can continue to go up even though the economy and the S&P 500’s earnings remain sluggish. Moreover, how would you explain the Equity Risk Premium to an investor without a finance degree?
The concept of an Equity Risk Premium (ERP) is critical to the stock market, yet very few people understand the relationship. In essence, the equity risk premium is the return required to invest in the equity of a business above what would be the expected return from a risk free asset (such as a CD or T‘note). The greater the risk, the higher the expected return, and vice versa.
Entrepreneurs understand there are high risks to starting a small business, but the payoff can be huge. An individual who saves enough for a down payment on a house wants to know that 100% of their savings will be available when needed, and may therefore be comfortable accepting the lower interest rate provided by a savings account or a CD. In periods of low interest rates, the risk free return may barely provide any return at all.
Many strategists calculate the ERP for the stock market by taking the earnings yield on the S&P 500 and subtracting the interest rate on the "risk less" 10-year Treasury note. The earnings yield represents the inverse of the Price to Earnings ratio, the most common valuation measurement for the market. At current levels, the S&P 500 trades at a P/E ratio of approximately 16.5 times next year's estimate ($132.76e) for an earnings yield of about 6% (E ÷ P, or $132.76 ÷ 2184 = ~0.06). Subtracting the 1.5% yield on the 10-year Treasury note produces an ERP of 4.5%, slightly below the 5-7% average of recent years.
The lower ERP available today may suggest that stocks are fairly valued when compared to historical equity multiples and fixed income yields. As a result, some experts have suggested that investors may be willing to accept a lower premium on stocks if they are unable to find any other asset classes that produce enough return to justify the risk. This implies the stock market may not be anywhere near as overvalued as many suggest. If so, the stock market could continue to provide investors with attractive future returns for a lot longer than most expect. But remember Jeff, the essence of portfolio management is the management of risks not the management of returns. All good portfolio management begins and ends with this premise.
While a fictitious letter, the insight that stocks may not be all that expensive is not an unimportant point. And even though our proprietary model is “looking” for a near-term pullback attempt, our longer-term bullish stance remains intact. As we wrote in last Friday’s Morning Tack, “Sir John Templeton said, ‘Bull markets are born on pessimism, mature on optimism, and die on euphoria.’ So study a S&P 500 chart, and note that the upside breakout has come after nearly a two-year consolidation, or trading range (chart 1). Then ask yourself, ‘Are we anywhere near optimism, much less euphoria?’”
Turning to Dudley Do-Right, in this case we are not referencing the Canadian Mountie lionized in the “Rocky and Bullwinkle Show,” but rather the esteemed New York Fed President William Dudley, who said last Thursday (Dudley), "For the first time in quite a while, gains in middle-wage jobs actually outnumber gains in higher- and lower-wage jobs nationwide. . . . I believe this is an important development in the economy, because, if it were to continue, it would create more opportunities for workers and their families who have been struggling up to now.”
Of course those “strengthening economic” comments elicited this hawkish quip from the San Francisco Fed President John Williams (Williams), "If we wait until we see the whites of inflation's eyes, we don't just risk having to slam on the monetary policy brakes, we risk having to throw the economy into reverse to undo the damage of overshooting the mark and that creates its own risks of a hard landing or even a recession.”
B-A-N-G . . . those comments came out after Thursday’s closing bell and caused the 30-year T‘bond to follow the 10-year T‘note out above its 50-day moving average (DMA) early Friday morning (read: higher interest rates). Plainly stocks were paying attention to that interest rate action because the S&P 500 (SPX/2183.87) lost a quick ~8 points Friday morning. The Spoos’ slide took the SPX right down to the 2175 level that we have said, if violated, should lead to further selling. That would be consistent with what our proprietary model has telegraphed for over a week, as it looked for a very short-term trading top.
As for Obamacare, last week Aetna followed Humana and UnitedHealth by announcing it is going to reduce its participation in “public exchange counties” by 70% in 2017. Obviously, something is very wrong causing me to recall what Senator Orrin Hatch said back in 2013 (Hatch), “I will predict that within that year — now I may be wrong on this — but within the immediate future the Democrats are going to throw their hands in the air and say, 'It's not working. It's unaffordable. And we have to go to a single-payer system.’”
To be sure, something’s gotta give, but rather than rewriting the entire Obamacare bill, wouldn’t it be easier just to lower the age for Medicare participation to zero?!
Turning to GaveKal, as most of you know I love the sagacious folks at GaveKal and I own their mutual funds. They have a way of rotating the prism 180 degrees in an attempt to glean net worth-changing insights. They are the ones that first turned me on to the concept of “intangible capital” (Capital), which has led to so many profitable investments for all of us. My friend Steve Vannelli, GaveKal’s lead portfolio manager, is a really smart guy and a great investor. You will get a chance to hear from him, as well as myself, this coming Wednesday when we do a joint conference call to discuss the current “state of the state” and GaveKal’s relatively new GaveKal Knowledge Leaders Developed World ETF (KLDW/$27.08), which is now available on the Raymond James platform (KLDW). The call is at 4:15 p.m. (ET) on August 24th with the dial-in number of (877) 525-8156 and the passcode 60116738.
The call for this week: While there are numerous economic releases this week, by far the key event for the week is Janet Yellen’s speech this Friday (10:00 a.m.) at the Kansas City Fed’s annual Jackson Hole Forum. Her topic will be “The Federal Reserve’s Monetary Policy Toolkit.” Certainly the various markets will put on “rabbit ears” for clues as to what it means for interest rates and consequently stocks. As often expressed in these missives, “Nobody can consistently ‘time’ the markets, but if one ‘listens’ to the message of the market you can certainly decide if you should be playing hard or not so hard.” Since our model targeted the February lows, we have been playing pretty hard. Last week, however, we began playing less hard as our model was calling for a short-term trading top into Friday’s option expiration. We further opined that if the SPX breaks below 2175, more selling should ensue. The quid pro quo is that if the recent intraday high of 2193.81 is taken out to the upside, all downside bets are off. Of course this is merely a finesse “trading call” because our model shows the first point of any real vulnerability comes in mid-/late-September as the equity markets transition from an interest rate-driven bull market to an earnings-driven bull market (chart 2). And don’t look now, but the energy sector is breaking out to the upside (chart 3).
August 15, 2016
So, last week I gathered up Harry Katica (Director of the Equity Advisory Group) and Nick Lacy (Chief Portfolio Strategist of AMS) and left for a tour of the Northeast corridor. Our mission was to raise the Raymond James “flag” for our new friends at Alex Brown (AB), a firm we are purchasing from Deutsche Bank. Having lived and worked in the Baltimore area, where AB was originally based, I have very fond memories of arguably the best boutique research firm in the country. We arrived in Washington, D.C. mid-day Sunday. Harry and Nick were hungry and went off to eat while I ate lunch with some beltway insiders that I have known for years. One of the first words out of one of their mouths was, “kakistocracy.” “Huh,” I said, “What the #$%& is that?!” She said it is Greek and means, “Government by the worst possible persons.” She then questioned how, in a country with over 311 million people, these are the two best candidates we can find to run for president. Many other things were discussed like scuttlebutt about political rumblings inside the beltway, Brexit, the economy, electoral votes, the fact that Putin had massed three forces 170 miles north of Kiev (an event that was elevated in the news late last week), China’s provocative moves in the China Sea, North Korea, the forthcoming release of last minute “October Surprises” for both presidential candidates, etc. The insights from this meeting were awesome.
Comes Monday morning, we walk from the Hay Adams Hotel (behind the White House) to the nearby AB office to present the Raymond James case to their financial advisors (FAs). Afterwards, I took our crew to a hedge fund in Northern Virginia to meet some portfolio managers (PMs) and discuss various issues as well as stocks. Nick and Harry were great at that meeting. Then it was off to Baltimore to have lunch with more PMs followed by a meeting with Bill Miller, legendary PM of the Legg Mason “Value Trust Fund” and now captain of his Legg Mason Opportunity Trust (LGOAX/$17.62). I didn’t think there was anyone more bullish than I am, but I was wrong, and I am going to buy his fund. Bill is a VERY smart guy and a great stock picker! As a sidebar, we all mentioned our favorite stock ideas. Shortly thereafter, we met with AB’s Baltimore office and took them to dinner with a subsequent drive to Philly, because the next morning we were going to meet with that city’s AB folks before riding a train to NYC.
I love NYC, and to a shocked Harry and Nick, we took the subway to Wall Street for a confab with AB’s downtown-based FAs. After a great meeting, we adjourned to Bobby Van’s for the nightly FOF meeting (Friends of Fermentation). Regrettably, my dear friend Arthur Cashin was not there, but the best MLP portfolio manager in the biz (Eric Kaufman of VE Capital fame) was indeed in attendance and accompanied us to dins at Capital Grill with the Alex Brown folks. The next morning, it was off to Greenwich Connecticut’s AB offices and then another meeting with the mid-town Alex Brown folks before our train ride to Boston. That night was yet another dinner at my favorite, not-North End, restaurant in Boston (http://www.teatroboston.com/) with friends.
During our sojourn, the most frequently asked question was about passive versus active portfolio management. To repeat said question, “Since very few active portfolio managers have been able to beat the index over the past five years, is active management investing dead?” To answer that question, we asked it another way. To wit, “What if the PM didn’t outperform the index but outperformed the Exchange Traded Fund (ETF) that allegedly “mirrors” the index? Is that a win for active management?” The answer is a resounding yes. Consider this, you cannot buy the index. You have costs to implement any strategy. So, while with the S&P 500 (SPX/2084.05) you can come close to matching the index’s returns with an ETF, using most of the other ETFs (small and mid-cap ETFs, sector ETFs, high-yield ETFs, emerging market ETFs, etc.) the tracking error is large. When one drills down using this lens, active managers outperform by a large percentage. As stated, there are costs to implement these various strategies that are not associated with an index. Moreover, active managers not only have similar costs, but many of them have a “cash drag” because they tend to hold at least a modicum of cash, which has zero return. All said, when the market is cheap, and the index is going straight up, it is very tough to outperform, so what you want to own is “cheap beta.” However, when the market is fairly valued, or expensive, you want to employ active management where the PM is not forced to buy everything in the index and is not afraid to hold cash. Indeed, as my dearly departed father used to tell me, “Cash is an asset class, because if you think the investment opportunity sets that are available to you today are as good as any that will present themselves next week, next month, or next quarter, you are naïve. Manifestly, you always need to have some cash to take advantage of new investment opportunities.”
Obviously, between the PMs and the advisors, we got a lot more questions, but another one of the other more ubiquitous was regarding Low Volatility investments, or what I have termed “chicken longs.” To me, Kimberly Clark trading at a P/E multiple of 24 is expensive given that Intel trades at 16x earnings. Speaking to Low-Vol ETFs, our friends at JP Morgan have done a lot of work on the subject and concluded, “This style is now up ~74% relative to the market since the beginning of this cycle in 2009, pushing its valuation to reach a new record high. Additionally, Low Volatility has become even more correlated to Momentum, a vulnerable trade that has become increasingly crowded. This suggests Low Volatility may be in a bubble and subject to negative tail risk. The high valuation multiples for Low Volatility are becoming unjustified based on fundamentals.”
The call for this week: From our Boston-based studios last Thursday morning, I told CNBC’s Becky Quick that my proprietary model is currently somewhat confused. The ideal very short-term pattern would be for a pullback into late this week, which would reenergize the equity markets. However, it does not look like that is what is going to happen. Therefore, if we rally into late week, it would set the market up for a garden variety pullback (3-5%). Of course, any pullback should be viewed within the construct of a secular bull market that has years left to run. Our model suggests the first “timing target” for a more important “polarity flip” comes in mid-/late September, which would leave markets susceptible to a more meaningful retracement. As for stock ideas, companies that have beaten both earnings and revenue estimates and guided forward estimates higher, and which have favorable ratings from our fundamental analysts and screen positively on my algorithms, include: Essex Property (ESS/$229.42/Outperform), Harman (HAR/$84.81/Strong Buy), MarineMax (HZO/$20.42/Strong Buy), and ServiceNow (NOW/$75.77/Strong Buy). Speaking to earnings, as we surmised, they are coming in above the “lowered bar” expectation. With the strong U.S. dollar no longer a headwind, as of last Friday, more than 2,400 companies had reported 2Q16 earnings with 64% of them beating the earnings estimate, while 56% beat the revenue estimate. According to Bespoke, the earnings “beat rate” versus the average price reaction by sector this season shows Technology to be the clear winner (see chart). However, Industrials and Financials are not far behind. And don’t look now, but many of the financial indexes are breaking out to the upside in the charts as the equity markets transition from an interest rate-driven bull market to an earnings-driven bull market.
August 8, 2016
“It’s like Déjà vu all over again.”
. . . Yogi Berra
I loved Yogi Berra! First as a baseball player, who in his 19-season career played in 18 All-Star games and on 10 World Series Championship teams, and then as a manager and coach. He always had a way of turning a phrase with such famous quotes as:
“When you come to a fork in the road, take it.” “You’ve got to be very careful if you don’t know where you are going, because you might not get there.” “If the people don’t want to come out to the ballpark, nobody’s going to stop them.” “We made too many wrong mistakes.” “You can observe a lot by just watching.”
But by far my favorite Yogism is, “It’s like Déjà vu all over again,” which is appropriately the title of today’s strategy report. Déjà vu because harken back to near the February 2016 “lows” when The Royal Bank of Scotland’s strategy team said to “sell everything.” At the same time a major brokerage firm in this country was advising clients not to sell everything, but to sell most of your stocks. Other firms trumpeted that same theme. Well, here they go again, for two weeks ago I was pounded by clients, advisors, and portfolio managers with, “Hey Jeff, did you hear that DoubleLine Capital's Gundlach is telling investors to ‘sell everything’ and Goldman Sachs’ market strategist just put out a report calling for a 10% correction?” My response to those queries was, “Of course I heard about them, but just like at the February lows I do not believe them.” It reminds me of the old Groucho Marx line where his wife sees him with another woman and he tries to explain to her that nothing is going on by saying, “Who are you going to believe, me or your own eyes?” The same thing can be said about the stock market.
Recall, it was just last Monday when I wrote:
Years ago award-winning strategist Stan Salvigsen wrote some of the best strategy reports ever penned on the Street of Dreams. One of them in 1982 was titled ‘Surf’s Up’ where he showed a picture of hundreds of surfers standing on the beach in Hawaii watching 40-foot waves roll in, yet only a few were brave enough to surf them. Stan’s tag line was, ‘If you want to catch a wave you need to grab a board and get in the water!’ The allegory was that although you are afraid, you need to buy stocks. At the time investors could get a 20% return in a money market fund, so there was little interest in equities. Verily, the stock market had decoupled from the fundamentals with the SPX trading below book value with a dividend yield of roughly 7%, ignoring improving geopolitics, the improving economy, etc. The same thing happened in 1997 with astronomical equity valuations that stayed that way for over three years. The equity markets are doing it again here. You can either take that as a few years from now we are going to be in a bear market, or that the stock market is ‘telling’ us things are going to get better. I am ‘long’ . . .
Now, I really do hate quoting myself, but it does test one’s patience having to repeat the same thing over and over again on the phone and in emails. So here is the sixth time I have written this, and this is the last time I am going to use it:
“In all the previous times when the S&P 500 has made a new all-time high, following at least 52 weeks below the old high water mark, the average return over the next 12 months has been 12.28% (median +12.30%) with an average pullback of 5.48% (median 2.73%).”
Additionally, consider this: the Coppock Curve is a technical indicator that measures how fast the S&P 500 is currently rising, versus 11 and 14 months ago, to identify good buying opportunities. When it moves from a negative to a positive position, like now, it is considered a buying opportunity. And, according to the good folks at LPL:
On July 29, 2016, the S&P 500’s monthly Coppock Curve once again moved from negative to positive territory, recording a value greater than 1.0, and increasing the likelihood for a long-term bullish trend for stocks. It is interesting to note that this is only the third time in more than 20 years that this long-term momentum indicator has triggered a buy signal. Looking at historical data going back to 1950, when the monthly reading on the S&P 500’s Coppock Curve moves back above zero, subsequent long-term price levels on the index tend to rise. Since 1950, this happened only 15 times. Six months later, the S&P 500 was higher 87% of the time, with average and median returns of 7.8% and 7.1%, respectively. Going out nine months, the returns are higher 93% of the time, with average and median returns of 11.1% and 14.0%. Looking out one year, the returns were higher 100% of the time, with average and median returns of 14.9% and 14.8%.
Meanwhile, back at my perch from holiday, I am getting emails like this:
Jeff, it seems to me that you are the only bull out there. The money flows out of equity mutual funds. The mood of individual investors and a lot of market pundits are so negative. The cash levels of money managers are at pretty high levels. What will be the catalyst that will lift the equity market to new highs based on your internal energy buildup scenario? It is hard to see with August, September and early October being very volatile months in my experience. Did I mention that Goldman Sachs Market Strategist just put out an article in the last week calling for a 10% correction? Your thoughts?
Indeed, “If the people don’t want to come out to the ballpark, nobody’s going to stop them!” Just substitute “investors” for the word “people” in that quote and you have the current stock market sentiment. However, since the February “lows,” and again at the Brexit “lows,” Andrew Adams and I have tried to tell investors that the equity markets are going to go a lot higher than most expect. Our model actually “called” the February low of 1810 on the S&P 500 (SPX/2182.87) and targeted new all-time highs. Moreover, Andrew and I “called” the “Turning Tuesday” low following the Brexit vote again with the mantra of “New all-time highs.” We have consistently written about stocks, mutual funds, and ETFs for consideration in portfolios. In this business when you are wrong, you say you are wrong, yet you need to be wrong quickly for a de minimis loss of capital. To wit, “We made too many wrong mistakes.” However, “You can observe a lot by just watching;” and our observation that “The stock market has decoupled from the fundamentals” since February has been net-worth changing. Or as another great markets observer once opined, “The stock market can stay irrational longer than you can stay solvent” (a tip of the hat to John Maynard Keynes).
The call for this week: “When you come to a fork in the road, take it!” We did . . .
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