I SHOULD HAVE!?
September 19, 2016
A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door, which he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back to the box, which would scare away any turkeys lurking on the outside.
One day he had a dozen turkeys in his box. Then one walked out, leaving 11. “I should have pulled the string when there were 12 inside,” he thought, “but maybe if I wait, he will walk back in.” While he was waiting for his 12th turkey to return, two more turkeys walked out. “I should have been satisfied with the 11,” he thought. “If just one of them walks back, I will pull the string.” While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return . . .
“I should have” sold at 2190! Many a trader and investor went home last Friday night uttering those words. The S&P 500’s (SPX/2139.16) 2190 level has really been frustrating since early August. To be sure, the SPX has tried numerous times to vault above that level for the past seven weeks with eyes for 2200. “Surely,” participants thought, “Following the strong upside breakout above the 2120 – 2130 zone, which had contained the SPX since March of last year, the next logical price target should be the round number of 2200!” “Such round numbers are typically money in the bank,” was the cry, but a funny thing happened en route to 2200.
In past missives we have chronicled various indictors and events that concurred with our timing model’s message that mid-/late-September was the first point of downside vulnerability for the equity markets. Most recently it has been interest rate worries that slugged stocks, as participants pondered a rate increase at this week’s FOMC meeting. For our part, Andrew and I have been quite adamant for five months that rates are not going to be raised until after the presidential election. Nevertheless, the world is expecting interest rates to eventually increase as yield curves everywhere appear to be steepening (chart 1). Typically, when that happens it suggests either a stronger economy, or a pickup in inflation, and maybe both. In last Friday’s verbal comments we noted that Thursday’s action, where bond prices declined (higher rates) and the U.S. dollar rose, it implied Mr. Bond wants interest rates to rise. Moreover, a steepening yield curve is a decided positive for the financial complex, which is why most of the financial-centric indices have broken out to the upside in the charts.
Speaking to higher interest rates, while a quarter point increase in the Fed Funds rate would likely cause a stutter-step in the equity markets, the impact on the overall economy should be de minimis. In fact, it just might cause a flurry of refi’s on the assumption the low water mark for the mortgage market is “in.” Interestingly, it was the surge in mortgage refinancing years ago that caused the consumer to buy more “stuff” and helped drive a pickup in the economy. Importantly consider this, an argument can be made that the Federal Reserve is not really “tightening” until they raise interest rates above the embedded rate of inflation. Until that happens it can be said the cost of money is still relatively “cheap” and abundant. In the current case that would mean Fed Funds would have to rise above ~2% before it should be considered a “tightening.”
Turning to the equity markets, I found this gleaning from my friend, and savvy investor Joe Monaco, Ph.D., pretty interesting:
I keep hearing, from almost every source, that the entire market’s returns are being driven by four stocks, Netflix, Amazon, Apple and Google. However, did you know that over the past 24-months both the Dow Jones Industrial Average and the S&P 500 have had almost the exact same return with almost the exact same volatility? And yet, Netflix, Amazon, and Google are nowhere to be seen among the Dow’s 30 stocks. As proof of my analysis, please look at the comparative chart of the Dow Jones Industrial Average along with the S&P 500 (I actually used the DIA and SPY ETFs for charting purposes), courtesy of Stockcharts.com (chart 2). I think this reasoning is just portfolio managers justifying why they have so very much underperformed.
We have touched on this underperformance point before by noting, “If the active portfolio manager (PM) doesn’t outperform the bogey index, but outperforms the ETF that is supposed to track said index, is that a win for active management?” Indeed, except for the S&P 500, whose ETF tracking error is small, the tracking error for most of the other ETFs is large. The problem is that you can’t buy the index! Further, there are implementation costs for any strategy and “cash drag” for the active managers since they all hold a position of the portfolio in cash, which is earning nothing. Consequently, if you view active performance through this ETF comparison lens, you find more than 50% of active PMs outperform their respective ETF. What we found is that when stocks are undervalued, and the index is going straight up, you want to own “cheap beta.” However, when the markets are neutrally valued, or overvalued, you want active management. The reason is the active manager can say, “I don’t want to play in that particular game.” But what are individual investors currently doing? They are doing the exact wrong thing. They are selling active managers’ funds and buying passive funds.
Speaking to active management, I have always found Thomas Lee’s market insights to be net worth-changing; first, as J.P. Morgan’s Chief Investment Strategist, and now at his own firm (Fundstrat.com), where he currently makes a compelling case for buying the recent pullback. He writes, “Has our conviction changed about markets staging gains into yearend (YE)? No. Since 1940, to gauge what stocks do between 9/15 and YE is simply look at YTD performance. When stocks are up 5% or better, they rally into YE 87% of the time (90% when between 5% and 20%). In other words, we believe this 3% pullback NEEDS TO BE BOUGHT aggressively.”
The byline to his report reads, “Why we are buyers of this pullback and see 6%-8% gains into yearend: History says 90% likelihood of YE rally – 12 stock ideas.” Of course readers of these reports know that we too have stated the current pullback is unlikely to be anything more than a 3% - 6% drawdown setting the stage for a year-end rally. As a sidebar, MarketWatch’s Barbara Kollmeyer writes, “The crowd wants this stock market correction too badly for it to happen,” which inferentially bolsters our shallow correct “call,” but I digress. Parsing Thomas’ 12 stock ideas, which are also favorably rated by our fundamental analysts and screen positively on our proprietary algorithm, for your consideration include: Cisco (CSCO/$30.84/Outperform), Praxair (PX/$117.68/Strong Buy), Texas Instruments (TXN/$69.36/Outperform), Microsoft (MSFT/$57.25/Strong Buy), Xilinx (XLNX/$53.36/Strong Buy), Kinder Morgan (KMI/$21.47/Outperform), Union Pacific (UNP/$92.38/Strong Buy), and Apple (AAPL/$114.92/Outperform). To paraphrase Thomas, sell the outperformers over the past few years and buy the underperformers.
The call for this week: To discuss the current state of various markets, my friend Rich Bernstein (ex-investment strategist at Merrill Lynch and now eponymous captain of Richard Bernstein Advisors) and I will conduct a joint conference call tomorrow (Tuesday 9-20-16) at 4:00 p.m. The dial in number is (866) 393-4306 with the password Eaton Vance. Tactically speaking, this week the Fed and the BOJ (Japan) will provide their latest views on monetary policy. We think both will be a non-event. And then there was this from BlackRock’s Rob Kapito, “Stocks globally could continue to rise as interest rates remain low as investors who have stockpiled some $70 trillion in cash seek higher returns from the market. People are tired of earning zero," Kapito said at the Barclays Global Financial Services Conference in New York, “There's more cash in the system than ever before.” And don’t look now but tech has broken out to the upside in the charts (chart 3). Be optimistic my friends . . .
Time or timing?!
September 12, 2016
“Hey Jeff,” an emailer wrote on Friday as we arrived in Quebec City from Cape Cod to have dinner with some family and Insitutional friends, “I thought you said it would not be until mid/late-September before a point of vulnerability would arrive! Today is merely September 9, what gives?” I responded, “As often expressed in our missives/comments, the short/ intermediate-timing models ALWAYS have a 3-5 session margin of error. That implies anywhere within 3-5 sessions of that mid/late-September ‘call’ is close enough for government work.” Subsequently, Friday’s Dow Dive (-395 points) was attributed to a myriad of things that have been rehashed so many times by the media, and false pundits that never saw it coming, there is no need to repeat them here. Suffice it to say, anyone reading these reports should have treaded cautiously going into September. Still, if past is prelude, I would not look for anything more than the ~3% to a little over 5% pullback as we have suggested countless times for numerous stated reasons. So, the title of today’s report is “Time or Timing.” For over 40 years, one of my market mantras has been, “Nobody can consistently ‘time’ the markets, but if one listens to the message of the market, you can certainly decide if you want to be playing hard or not playing so hard (that’s timing). Time, however, is a totally different animal.
“Time” is the Archimedes’ lever of investing. Archimedes is often quoted as saying, “Give me a place to stand and a lever long enough, and I shall move the earth.” In investing, that lever is time. The length of time investments will be held, the period of time over which investment results will be measured and judged, is the single most powerful factor in any investment program. If time is short, the highest return investments – the ones an investor naturally most wants to own – will be undesirable, and the wise investor will avoid them. But if the time period for investing is abundantly long, the wise investor can commit without great anxiety to investments that appear in the short run to be very risky.
Given enough time, investments that might otherwise seem unattractive often become highly desirable. Time transforms investments from least attractive to most attractive – and vice versa – because, while the average expected rate of return is not at all affected by time, the range or distribution of actual returns around the expected average is very greatly affected by time. The longer the time period over which investments are held, the closer the actual returns in a portfolio will come to the expected average. The following table shows the compounding effect on $1.00 invested at different compound rates compounded over different periods of time. It’s well worth careful study – particularly to see how powerful time is. That’s why time is the “Archimedes’ lever” of investment management.
Compound Interest over Time
|Compound Rate of Return
Source: Investment Policy, How to Win the Loser’s Game; Charles D. Ellis
When asked what he considered man’s greatest discovery, Albert Einstein replied without hesitation: “Compound interest!” But compound interest is ignored in most bull markets. For instance, the late-1990s, the bulls said compounding dividends doesn’t matter. Nobody wants to pay double taxes on ‘em, and that old bear growl about the markets being vulnerable when the yield on the S&P 500 drops below 3% hadn’t been valid for years (the same can be said from the 2009 lows). So who cares if the current yield is only roughly 2.0%? Well, we happen to think dividends are very important. Indeed, historically, a major percentage of the return on stocks has come from dividends.
How much? Of the ~10.4% compounded annual return generated by stocks in the S&P 500 since 1926, nearly “half” has come from dividends, according to Ibbotson Associates. Their studies show that, over the long term, stock prices have risen at an annual pace of less than 7% with most of the rest of the returns coming from compounding reinvested dividends. Now the more popular index with the public, and the financial media, is the Dow Jones Industrial Average (INDU/18085.45), which also shows a yield of roughly 2.0%. Year-to-date from December 31, 2015 close, up until last Friday’s Flop, the Dow has gained some 6%. Historically, the INDU has also averaged a little over 10% total return annually. Most of the time, however, the INDU showed a 4% to 5% dividend yield, with price appreciation making up the 5% or so of the difference of that 10% annual total return. Accordingly, if you only have a current 2.0% yield, that means you have to get an 8.0% annual price appreciation.
Now, if the Dow 30 have already scored a ~6% return for the year, combined with a dividend yield of ~2%, that implies we should expect a mere 2.0% appreciation into year’s end. We actually think the gains will be greater than that as this bull market transitions from an interest rate-driven to an earnings-driven bull market. But, “This time it’s different” say many pundits. Capital gains will more than make up for the compounded annual returns from dividends. Well, when dividends and the magic of compounding are ignored, those pundits have to be counting exclusively on a capital gain and the assumption that they can predict tomorrow. Now predicting tomorrow is virtually impossible unless you are ______. Well you can fill in the blank after you read the following story from Connie Bruck’s book, Masters of the Game: Steve Ross and the Creation of Time Warner, about the now deceased Steve Ross, the former head of Time Warner:
In February 1962, just a month before Kinney Services (the predecessor to Warner Bros.) went public, its Riverside funeral chapel division had contracted to purchase a location on Broadway, which it intended to convert to a new funeral chapel. Shortly afterwards, it was announced that Lincoln Center was to be constructed just across the street from the projected Riverside chapel. As Ross would later tell the story, he instantly realized that this would be an opportunity to make money. Before long, he received a call from Governor Nelson Rockefeller, who asked if he was thinking of building a funeral chapel across from Lincoln Center. When Ross assented, Rockefeller asked if Ross had received approval from the zoning commission. Ross said he had. Rockefeller then said, “Have you checked that?” Ross said, “Yes.” And then Rockefeller said, “No, I mean have you checked that tomorrow?!”
That story kind of reminds me of the FBI’s “data dump” the Friday before the Labor Day weekend, “Have you checked that tomorrow?” We actually have and think a mid/late-September swoon in the equity markets is for buying. The next few weeks will tell, so stayed tuned.
The call for this week: Our timing models, and internal energy models, are not always right. When that happens, we admit it quickly for a de minimis loss of capital. However, our models are right a whole lot more than they are wrong. So our hope, although not really embraced because of our models, that the recent intraday low around 2158 (basis the S&P 500) would contain the decline, proved to be wrong. Subsequently, when that level gave way, a trapdoor opened, leaving the S&P 500 (SPX/2127.81) trading slightly above its 2100-2120 support level with a single-point “attractor” target price of 2108. Failing that, 2092 is the next “attractor.” Friday’s Fade caused the SPX to break below its 50-day moving average (DMA), but the Russell 2000 and the NASDAQ Composite did not follow (possible a downside non-confirmation). For what it’s worth, by our work, the two most oversold sectors are Consumer Discretionary and Consumer Staples on a short-term basis. Interestingly, both the SPDR S&P 500 (SPY/213.28) and the iShares Barclays 20 Year Treasury Bond ETF (TLT/135.52) were off more than 1% last Friday (SPY -1.90% and the TLT -1.63%). Historically, when that coincident combination has happened, the SPY is up 0.10% a week later and up 1.30% a month later 57% of the time according to our friends at Bespoke. Back on the Brexit Bombshell, with the Industrials off some 600 points that Friday morning, we advised doing nothing because what typically happens is that investors brood about their losses over the weekend. Then they show up on Monday in “sell mode,” which leads to “Turning Tuesday.” Said strategy worked like a charm on the Brexit vote, and we actually came out with a “buy list” that “Monday Melt” (6-27-16). We are not as sure the same chart pattern will play this time, but we are hopeful it will! I will concede the McClellan Oscillator is very oversold, so if early this week we get a downside whoosh to anywhere between the 2092-2108 “attractor” zone, we should get a recoil rebound. But, right now, we are not sure it will be sustainable. North Korea’s bomb, Hillary’s health, and Trump’s election odds just recalibrated the stock market’s odds, leaving the preopening S&P futures off 14 points as I look out over the Saint Lawrence Seaway at 5:00 a.m. and prepare to meet with portfolio managers.
P.S.: It was fifteen years ago on Monday (9-10-01) when I used Obi-Wan Kenobi’s quote from Star Wars, which read, “I felt a great disturbance in the Force, as if millions of voices suddenly cried out in terror, and were suddenly silenced. I fear something terrible has happened.” The quote was used because, since August of 2001, the stock market should have been going up and it wasn’t! I miss the 16 friends I lost the next day.
I do not think the same sequence is going to play here . . .
September 6, 2016
“Dry land is not just our destination, it is our destiny!”
. . . Deacon, from the movie “Water World”
As we dig out from Hurricane Hermine, where residents of Cedar Key experienced a nine-foot sea surge and consequently were looking for dry land, investors too have been seeking “dry land” for the past few months. To be sure, it has been a difficult environment with the S&P 500 (SPX/2179.98) trapped in a trading range between the August 2 low of ~2148 and the August 15 high of ~2191. In fact, looking at the closing prices of the S&P 500 (e-minis) shows an August range of just 1.54%. That’s the tightest range since August 1995 and the seventh smallest since 1928 (a tip of the hat to Ryan Detrick). That trend continued last week, yet from our water-soaked location we suggested the intraday low of last week (~2157) may represent the tradeable lows for this cycle, despite our model’s warning of vulnerability in mid/late-September. So what are longer-term investors to do? To answer that question, we harken back to our friends at the astute Riverfront Investment Group organization, a number of whom I worked with at Wheat First Securities in a life gone by. A few years ago I wrote:
For underinvested participants, we continue to like Riverfront Investment Group’s strategy for committing new capital to stocks. First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segment if a market pullback occurs – example: invest the remaining 10% of the cash on market pullbacks. And sixth, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.
So now you have a strategy, the next step is what sectors should you consider? Studying chart 1 (see page 3) reveals the PEG ratio (price to estimated growth) is expensive for the alleged “safe sectors.” As can be seen, the cheapest sector is Consumer Discretionary (0.96), followed by Information Technology (1.52), Healthcare (1.57), and Industrials (1.80), all of which have a lower PEG ratio than the S&P 500 Index (1.83). Recently, Andrew Adams and I have been featuring the Financials (which at 1.92 have a marginally higher PEG ratio than the index) because there has been a massive upside breakout in ALL of the financial indices (chart 2). It is worth mentioning that last week the MSCI adjusted its Global Industry Classification Standards (GICS) by taking real estate investment trusts (REITs) out of the Financial sector and creating a new 11th sector for the S&P macro sectors (the mortgage REITs stay in the Financial sector). This has implications for select exchange traded funds (ETFs) like the Financial Select Sector SPDR Fund (XLF/$24.57) because without the REITs the dividend yield on the XLF should decline from roughly 2.0% to less than 1.4%. To see how big a contributor to performance the REITs have been, just examine chart 3 on page 4.
You now have an investment strategy on how to commit capital to the equity markets and which sectors offer the lowest valuations, so let’s turn to overall valuations. I read a report last Friday that this year’s “bottom up” earnings are estimated to be around $117 for the S&P 500. I don’t know where that estimate came from, but it certainly was not from Standard & Poor’s. S&P’s “bottom up” estimate for this year (as of 8/29/16) was $110.76 versus last year’s $100.45. If S&P’s estimate for 2016 is close to the mark, it implies stocks are pretty expensive with a P/E ratio of 19.7x earnings. However, S&P’s 2017 estimate is $132.91, leaving the SPX trading at 16.4x next year’s estimate with an earnings yield of 6.1% (earnings ÷ price, or $132.91 ÷ 2180 = 6.1%). When compared to other investment alternatives those valuation metrics are not all that expensive. Moreover, as often expressed in these reports, we believe the secular bull market is transitioning from an interest rate to an earnings-driven bull market. This should become more evident over the next 12 months.
Turning to the asset classes, and using trailing 12-month earnings, shows most asset classes are expensive. For example, these are the P/E multiples for the five major asset classes: U.S. Large Cap 22.43x; U.S. Mid Cap 24.69x; U.S. Small Cap 22.61x; Non-U.S. Developed 19.35x; and Emerging Markets 15.81x. Hereto, however, the P/E multiples are more parsimonious using 2017 estimates.
Finally, speaking to the question of momentum versus value, it is worth considering there is a chance that after a few years of underperformance, “value” may start to outperform. Using iShares MSCI MTUM ETF (MTUM/$77.82) as a momentum proxy, and iShares MSCI VLUE ETF (VLUE/$65.40) as a value proxy, Bespoke creates a ratio chart (chart 4). When the ratio line is rising momentum is outperforming and when it is falling value is outperforming. As can be seen, the chart is potentially at an inflection point. Using the top weighted 10 components in the VLUE, which have favorable ratings from our fundamental analysts and screen positive on my proprietary algorithm, produces this list: Apple (AAPL/$107.73/Outperform); Cisco (CSCO/$31.83/Outperform); and Wal-Mart (WMT/$72.50/Strong Buy). As for a list of names that could benefit from the Hurricane Hermine tragedy, which also carry favorable ratings from our fundamental analysts: Beacon Roofing Supply (BECN/$46.55/Strong Buy) and PGT, Inc. (PGTI/$11.98/Strong Buy).
The call for this week: While everyone is focused on Hermine, almost unnoticed is that the Icelandic Meteorological Office, following two large earthquakes, is on alert for an eruption from Katla (Iceland’s largest volcano). Recall it was the Eyjafjallajökull eruption in 2010 that crippled Europe for a month and impacted the economy (Eyjafjallajokull). Meanwhile, bullish sentiment tags a three-year low among Wall Street strategists (not us), the negative nabobs continue to chant, “The D-J Transport refuse to confirm the D-J Industrial’s upside,” and the media is replete with how September is historically the worst month of the year for stocks (chart 5 on page 5). And that comment caused one old Wall Street wag to drag out Mark Twain’s stock market axiom, “OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks. The other are July, January, September, April, November, May, March, June, December, August, and February.” We think a September interest rate ratchet is probably off the table and that the first point of potentially more serious vulnerability for the equity markets doesn’t arrive until mid/late-September. This morning the preopening futures are relatively flat on no real news overnight.
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