Category Archives: Stock Market

Assessing the Current Rally

Since the February 11th bottom at 1810, the S&P 500 has rallied 14%. The market is now within 3% of an all-time high. Although the market could pullback in the short-term, the technicals of the rally lead me to believe that the February 11th bottom could hold.

As I mentioned previously, I do not believe that the selloffs we have seen over the last year were fundamentally justified. Although there has been extensive media coverage about a possible US recession, the economy continues to grow at around 2%. The economy probably would be growing faster if it were not for the plunge in capex spending in the energy sector. This negative effect should lessen in the coming quarters. Moreover, there are signs that the US manufacturing sector, which was hurt by the strong dollar and weak global economy, has bottomed.

ISMFedMar2016-2

The decline in corporate earnings has also been citied to justify the stock market’s troubles. However, even with the cut in earnings estimates the S&P 500 trades at 17.5 times forward earnings – a historically cheap valuation given the low interest rate environment. And if the US dollar continues to weaken and the oil price continues to increase, then earnings could surprise to the upside.

Instead, I attribute the market sell off to a bull market that lasted several years without a meaningful correction and overwhelming bullish sentiment. The decline in earnings coupled with the first Federal funds rate increase in nine years provided the catalyst for market turmoil.

Last year, market breadth provided a warning about an impending correction when it deteriorated as the S&P 500 remained near highs. The rebound at year-end was characterized by narrow breadth, which signaled a false rally and new lows were around the corner. Given how breadth has helped to forecast stock market moves, it is encouraging that the current rally has been broad-based.

NYSE Advance-Decline

NYSE New Highs

Although I am concerned that the financials have not performed better during this rally and the market is overbought, economic fundamentals and market breadth indicate that the lows have been seen for this correction and new highs could be forthcoming later this year.

Managing a Drawdown

I have been mostly on the right side in calling the stock market’s short term movements over my investing lifetime. Although accurately predicting the market’s short term gyrations is much more difficult than forecasting where the stock market will be in 5 years, I believe it is feasible with well-reasoned analysis which incorporates market sentiment, technical analysis, stock market history, macroeconomic fundamentals, valuation, and the simple view that markets are inherently cyclical.

After correctly predicting “a 5-15% multi-month correction to refresh the bull market” near the all-time high last year, I believed that the market’s ensuing selloff in the second half of 2015 was sufficient for washing out excessive optimism and reseting valuations. Thus, I did not see nor position my portfolio to withstand the market’s 10% drop year-to-date. In retrospect, I underestimated the impact that the Federal Reserve’s first rate hike in nine years would have on the market. It is now clear that the market needs more time to digest it and the relentless selling is to ensure that the pace of interest rate rises that the Fed is planning is slowed.

By being 90% invested in equities, with a heavy weighting in financials, my portfolio has suffered a meaningful 15% drawdown in 6 weeks. However, this is not my first experience dealing with losses. I have found that it is important to re-evaluate your original investment thesis, while giving close scrutiny to the arguments that are being put forth for justifying why your positions are going against you. If you determine that your initial analysis was faulty or did not incorporate important information, and you regret your current positioning, then it is necessary to cut losses and reposition your portfolio. On the other hand, if you believe your investment thesis is intact, then you need to be unemotional, hold your core positions and weather the storm.

I intend to follow the latter path. I see no evidence of a US economic recession – instead I think the current expansion accelerates – nor do I see any reason why a Chinese slowdown will impact the US in a meaningful way. Looking at my own stocks, rather than selling, I feel like buying more. For example, I take comfort in the fact that Citigroup ($C) is trading for 60% of liquidation value, while it is buying back stock and growing earnings.

I believe the stock market is closer to the bottom than the top. The 1998 Russian debt default and eurozone debt crisis of 2011 did not cause a US recession, but they did induce substantial stress in financial markets with 20% stock market corrections. It is possible that in a worst case scenario that the S&P 500 could also ultimately decline 20% from the highs, or fall to 1700. By having 10% of my portfolio in cash, using no margin and having invested capital which I have no immediate need for allows me to sleep well at night and ride out the correction, in case it deepens into a full-fledged bear market.

 

The Return of the ’97/’98 Playbook

My long-term bullish outlook on US stocks is predicated on a US economy that continues to strengthen in the face of a global slowdown. This has happened before. FT Alphaville compares the current period to 1997/1998:

Recall what things were like in those heady bygone days:

  • Oil prices had plunged by nearly 60 per cent from the start of 1997 through the end of 1998
  • Spreads on high-yield bonds had widened by about 4 percentage points in 1998, while spreads on the junkiest junk debt had widened around 6 percentage points
  • Currency crises and deep downturns were afflicting poorer countries from Latin America to Russia to Asia
  • The US dollar had rocketed up more than 20 per cent from the start of 1997 through the end of August, 1998
  • Core inflation had slowed from an annual rate of 2.0 per cent in June, 1997 to just 1.0 per cent by June, 1998 — the slowest rate ever recorded until 2010
  • America’s unemployment rate had dropped by a percentage point to levels not experienced since March, 1970

Now compare to what we have now:

  • Oil prices are down about 65 per cent since mid-2014
  • Spreads on high-yield bonds are up around 3 percentage points since the start of 2014, while the spreads on debts rated CCC or lower have widened by nearly 9 percentage points
  • Many large emerging markets, including Brazil, Russia, Turkey, and China, are either shrinking or slowing down sharply
  • The dollar is up nearly 20 per cent since the summer of 2014
  • Core inflation slowed from an annual rate of 1.7 per cent in July, 2014, to 1.3 per cent ever since the start of 2015
  • America’s unemployment rate has dropped by a whopping 1.6 percentage points since the start of 2014

As it pertains to stocks, there are a couple of important differences: currently, US economic growth is slower and interest rates are much lower. In my view, both variables cancel each other out in their effects on equity valuations. In 1998 US stocks shook off a 20% correction to go on a parabolic (and unsustainable) run based on earnings growth and multiple expansion. I believe history will repeat itself, although stocks may experience more modest gains and the current bull market will last longer.

With regards to numerous recent predictions about a US recession, it seems that they have mostly been based on the recent weakness in manufacturing activity. But it is important to keep in mind that the US economy is primarily driven by services, while manufacturing’s share is less than 10%.

US Employment by Sector
Source: The Economist

And as reported by the ISM, manufacturing is contracting while services is expanding healthily. If the 1998 playbook is followed, then the manufacturing sector will soon return to growth.

Manufacturing and Services Decoupling

Therefore, if US economic growth continues to chug along and it turns out that investors’ fear about a recession were misplaced, then as in 1998, the maximum possible drawdown that one should expect is limited to around 20% and the bull market will shortly resume.

Bull Market to Resume in 2016

And now we are behaving hysterically at the prospect of just one? It’s a bit of a joke, really… We might have a wobbly few weeks when they do move, but I’m sure the Fed will stroke us like you wouldn’t believe and the markets will settle down, and most probably go to a new high.
-Jeremy Grantham on the Fed’s eventual first rate hike. (8/6/15) http://on.ft.com/1InJDDg

In May, I wrote that I was looking for a “5-15% multi-month correction to refresh the current bull market”. My cautiousness was based on a bull market that had not experienced at least a 10% correction in 3 years, a corporate earnings recession, excessively bullish sentiment, and deteriorating breadth..

Since then the market finally declined by a meaningful 14%. Also, the current decline in year-over-year S&P 500 earnings (by 14%), which can entirely be traced to both a strong US dollar and a collapse in energy prices, is likely to be the worst that we will see. According to the calculations of Thomas Lee, a Fundstrat Global Advisors LLC stock forecaster, the dollar’s rise this year has subtracted $10 per S&P 500 share. U.S. corporate profits would have grown by 8% without the impact of the strong dollar. Similarly, ex-energy S&P-500 earnings have grown 5% indicating that most US corporations are still prospering.

In fact, the past two years are among only four years out of the last thirty that the US dollar index registered double-digit declines. It would seem highly unlikely that the US dollar will continue to rise without taking a pause. Similarly, if the year ended today the price of light sweet crude oil would have suffered its third worst annual decline after 2008 and 2014 in thirty years. Again, it is highly unlikely for a major asset class to experience a massive move in the same direction for three consecutive years. On the other hand, if the US dollar and oil prices are stable in 2016 then earnings should resume its upward trajectory given the US economy’s decent growth.

US Dollar Index Oil (WTIC)
2014 -13.1% -45.6%
2015 (ytd) -12.0% -33.4%

If forward earnings estimates stop being cut, then the current PE multiple of 16 looks reasonable and in-line with the long-term average. But if the forward PE multiple is juxtaposed with historically low levels of interest rates, then there is a good chance that multiples can rise.

As seen in the following Investors Intelligence poll, the recent correction has erased the high levels of bullishness that existed during the past few years and has created excessive pessimism, which should also support equity prices.

Investors Intelligence Survey

Market breadth remains my only concern, though it was encouraging to see during Friday’s sell-off that breadth did not make a lower low.

Market Breadth

My own expectation for 2016 is that the US dollar will be stable (+/- under 5%), oil will range between $30 to $60 per barrel, interest rates will be somewhat higher, US economic growth will pick up to 3%+, and the rest of the world will continue to be weak. Under such a scenario, I estimate S&P 500 companies to earn $110-120/share next year leading analysts to pencil in $130/share for 2017. If forward multiples rise to 17 or 18 to reflect receding worries of a US recession and a rapid tightening of monetary policy, then I believe that the S&P 500 can reach between 2200 to to 2350 next year.

According to Sam Stovall, a U.S. equity strategist at S&P Capital IQ:

“For 2016 I don’t see another flat year, nor would history say that flat years typically follow flat years. In fact, there have been 10 times since World War II in which the S&P 500 rose or fell by 3 percent or less. In the subsequent year the S&P 500 rose in price 80 percent of the time and posted an average annual increase of nearly 13 percent and was flat only once. We think that the S&P 500 will close 2016 at 2,250, representing a mid-to-high-single digit price appreciation.”

Given the market’s flat performance in 2015, the upper end of of my range, which corresponds to a high single-digit to double-digit percentage gain looks more likely. As I tweeted, my bullish outlook allowed me to get 100% invested near the bottom of the market’s decline last quarter. Although, I trimmed my position during the ensuing rally back towards the highs in expectation of turbulence as we approached the Fed’s first rate hike in nine years, the sell-off last week allowed me to rebuild a 90% long position.

RisksandReturns
Reducing net long exposure to 90% from 100% with $SPX at 1990.
9/16/15, 1:31 PM
RisksandReturns
Reducing net long exposure to 75% from 90% with $SPX at 2075
10/23/15, 10:16 AM
RisksandReturns
I bought near lows, believing this is not a bear mkt. But with $SPX just 2% below ATH I also think more time is needed before breaking out
10/23/15, 10:20 AM
RisksandReturns
Back to 90% net long at 2010 on $SPX. I believe bull market is ready to resume.
12/21/15, 4:09 PM

The closure of extraordinarily easy monetary policy has brought on the long awaited stock market correction. But, as opined by Jeremy Grantham in the quote at the beginning of this post, make no mistake about the Fed’s intentions: it remains the market’s friend. And once the market realizes it, the bull market will resume – it is only a matter of time!

I’m 100% Long for the 1st Time in Years

The 5-15% multi-month correction that I was waiting for since May has finally arrived. Last Friday I tweeted that I increased my net long exposure to stocks from 25% to 75%. And I tweeted again on Monday morning that I was using my remaining cash balance to buy stocks during the early morning flash crash.

RisksandReturns
Increased my equity exposure from 25% to 60% on this 5% pullback in the S&P 500
8/21/15, 10:15 AM
RisksandReturns
Further increased equity exposure to 75% on S&P 500 dip below 2000
8/21/15, 1:43 PM
RisksandReturns
Just went 90% net long as S&P 500 futures broke below 1900. Sell offs based merely on EM problems has always been a good buying opportunity.
8/24/15, 8:13 AM
RisksandReturns
Just went 100% long on test of Oct ’14 low. Could not get filled on individual stocks so bought $SPY
8/24/15, 9:44 AM

I almost always keep at least a 10% cash balance, but the indiscriminate panic selling seemed to be devoid of any fundamental reason making me convinced that markets will experience at least a short term rebound. The most popular reason ascribed to the August selloff, the crash in the Shanghai Composite and the slowing Chinese economy, do not warrant a 12% correction in my view.

Rather, the best explanation for the correction is that the market was simply due for it after not having experienced a 10% pullback for one of the longest stretches in history.

Months Without a 10% Correction
Source: Ryan Detrick

Moreover, with the Fed having supported financial markets with extraordinary monetary stimulus during the past 7 years, it would seem likely that markets would stumble as the Fed backs away.

Fed QE Impact on Market-2

Although, the Fed wisely decided to taper its QE3 program to avoid the market dislocations that ensued after QE1 and QE2 were halted, the fear of a rising Fed funds rate has spooked markets once again. If the current panic does not subside before the Fed’s September meeting, a rate hike is likely to be postponed.

During market turbulence it is important to not get caught up in the media noise and lose sight of the economic fundamentals which ultimately determine equity prices. As shown below, after the winter induced Q1 slowdown. the US economy is back on track for 2-3% growth. And looking ahead, the economy is on the verge of accelerating to 3%+ growth as I wrote about here.

2015 Q1 GNP-2

By almost every sentiment and technical measure, the market is due for a rebound at which time I will get back to a 10% cash cushion. I do not know if we have seen a bottom, but after a 12% correction I believe we are closer to the bottom than to the top and new highs are only a matter of time. Therefore, I want to be heavily long US stocks.

 

A Market Correction is up to the Fed

Since I turned cautious on stocks in early May, the market has been treading water with minimal volatility. If the year ended today, the S&P 500’s intra-year decline of 4% would be the 2nd smallest in 35 years.

S7P 500 Intra-Year Declines

This would be highly unusual for a year in which corporate earnings estimates have been slashed and economic growth has disappointed. Moreover, we have seen significant deterioration in the market’s breadth with the utilities and transports both having already corrected 15%.

I believe one reason that the major averages are holding up is that expectations of Fed rate hikes have been pushed back.

Economists Fed Rate Hike Forecasts

Coming into 2015, economists were projecting the first Fed funds rate increase to take place in June — now they believe it will occur in September. Market participants, on the other hand, are betting on December as seen in Fed funds futures pricing. By pushing out expectations of rate increases, the Fed has in effect eased.

However, I believe there is a reasonable chance the Fed could move in September. Fed chair Janet Yellen has repeatedly said that the Fed will not wait for inflation to hit its target. All that is needed is confidence that inflation is moving towards its target. If job growth continues at its recent pace, then it will be hard for the Fed to justify emergency level rates with unemployment approaching 5%.

Therefore, the July and August inflation and jobs data will be worth paying attention to. 200,000+ monthly job growth with rising inflation will cause the Fed to move in September. Since this is not currently priced into the markets, a major stock market correction could ensue. However, weak economic numbers could lead to a Fed on hold and a continuation of the recent choppiness or a slight move higher.

Nevertheless, the 4% year to date correction in the S&P 500 seems too mild to me, and I will wait patiently for more of a pullback.

 

Time to be Cautious of US Stocks

I have been quite bullish on the US economy and US stocks over the past couple of years. I viewed every correction as an opportunity to increase my long position. In fact, the near 10% correction in October got me 90% invested – one of my highest exposures to US stocks ever.

That sell off got me particularly excited because it was just before the most seasonally bullish period: the first 6 months of the pre-election year of the presidential cycle. As the following chart by Ryan Detrick shows, since 1950 the market has gained every time during the November to April period of the 3rd year.

Presidential Cycle Returns-2

With April ending last week, true to form, the market gained once again during the past 6 months, although by only 3.3%. Last week I decided to do some significantly selling so that I am now only 25% net long. However, I plan to remain long all the stocks listed in the trades section.

My cautiousness stems from not only from the seasonally unfavorable May to October period, but also due to sentiment and valuation. One important sentiment indicator, insider transactions ratio, shows that executives are selling much more of their own shares than buying.

Insider Transactions Ratio

In addition, Investors Intelligence survey of financial advisors and newsletter writers shows bears are near historic lows.

Investor Intelligence Bears

And the Hulbert Stock Newsletter Sentiment Index also confirms that bullishness is prevalent in the investment community today.

HSNSI 4:24:15

Valuation also presents a near term obstacle for stocks as the collapse in oil prices and the surge in the US dollar has caused S&P 500 earnings to decline while the market remains near record highs. As a result, the market is trading at 18x forward earnings estimates compared to the long term average of 16x. And there is a good chance that estimates of record earnings in Q3 and Q4 could be slashed.

An important support for stocks during this bull market has been the ‘Fed put’. That is, whenever stocks sold off or the economy weakened the Fed was ready to stimulate the economy with QE or pushing out market expectations of rate hikes. While that put still exists, I would argue that there is also now a ‘Fed call’ in play. If the economy or stock market were to heat up, the Fed stands ready to increase rates thereby capping the upside returns to stocks.

I want to be clear that I remain bullish on the US economy and stocks (in the long term). And without an imminent recession or sky high equity valuations, a bear market looks unlikely. However, sentiment measures and high valuations underscore the need for a 5-15% multi-month correction to refresh the bull market.

A Rough 10 Years

The New York Times has created an nice graphic which shows that for the 10-year period ending in January, the S&P 500 had its worst inflation- and dividend-adjusted performance in 82 years.

The New York Times > Business > Image > The Current Market Is the Worst YetAnd if the stock market doesn’t surge over the next 12 months, the negative 5.1% annual return is likely to get worse this time next year because the S&P 500’s 20% appreciation in 1999 will no longer be counted.

Valuing Stocks Relative to Bonds

A popular method for determining whether equities are cheap is to compare the stock market’s dividend yield with the yield on long-term government bonds. Using the amount of dividends paid by companies in the S&P 500 index during the past 12 months, the dividend yield is currently 3.22%. Meanwhile a ten-year treasury yields 3.75%. The following is a historical look at how dividend yields and long-term treasury yields compare.

11751_a11751_b

Currently, the spread is as tight as it has been since the early ’60s. Does this mean stocks are cheap relative to treasuries? Or is it likely that going forward stocks will yield more than treasuries as was the case for most of the period before 1958.

Treasuries have zero default risk, but plenty of inflation risk since the amount of the coupon is fixed. Stocks, on the other hand, have little inflation risk (because companies can increase profits in inflationary conditions), but carry default risk.

During periods of high monetary inflation, where the value of money is losing value at a rapid pace, the market will assume that inflation will continue to be very high in the future and demand a higher yield from bonds than from stocks to compensate them from future loss of purchasing power. At the other end of the spectrum are periods of deflation when the money supply contracts. Deflations cause corporate profits and dividends to decline in nominal terms, though they may increase in real terms. Therefore, expectations of deflations usually result in stocks having higher yields than treasuries.

Independent of inflation or deflation, the economy could be growing or contracting. Over long periods of time the economy usually expands. Ignoring any effects from changes in the money supply, investors will be willing to accept lower dividend yields than treasury yields because dividends are likely to increase over time. On the other hand depressions, which are economic contractions that last for many years, can increase the risk of bankruptcy causing investors to demand greater yields from stocks than from treasuries.

Combining the effects from monetary inflation and economic growth on treasury and stock yields give the following table:

Microsoft Word1

I have inserted question marks for deflationary economic growth which characterized most of the 19th century when corporate profits steadily increased in real terms, but not necessarily in nominal terms; during such times there should be no significant difference between treasury and stock yields. Also, there should not be much of a difference in yields during highly inflationary depressions because it is not clear whether businesses can increase profits in nominal terms.

The table does a good job of explaining why dividend yields exceeded treasury yields during the time frame from 1871 to 1957 if one considers that this was a mostly disinflationary period punctuated by a couple of deflationary depressions. Consider that during this entire period of 87 years, inflation, as measured by the CPI, increased by 128% and corporate earnings rose by an average of 5.2% annually.

But since 1957, a period of just 50 years, the CPI has increased by 634% and corporate profits grew by an average of 7.9% annually. Thus, it should be of no surprise that since 1957 investors have demanded greater yields from treasuries than from stocks when the rate of inflation has been so high and there was not a single depression. Dividend payouts steadily increased throughout the period except for only a few short-term reductions.

So to form an opinion on whether stocks should yield more than treasuries one needs to know if the economy has entered a period of inflation or deflation and if a depression will be avoided. It is my belief that the US has entered a depression, where real earnings will decline and not recover for several years. If the Fed prints enough money and creates substantial inflation, earnings could bottom in nominal terms in 2010 at the earliest at which point I expect treasuries to yield more than stocks.

Until then I expect the depression to be disinflationary, rather than a deflationary because the government is preventing any significant bank failures which is a necessary condition for deflation. Although asset and consumer prices are declining, this is not deflation; instead it is a reflection of a drop in the velocity of money as individuals and businesses hoard cash. So if indeed this is a disinflationary depression, I expect the difference in yields between treasuries and stocks to diminish over the next year.

Japan offers a recent example of a disinflationary depression and as can be seen in the chart below the yield on Japanese stocks exceeded the yield on long-term government bonds during a significant part of the past two decades.

Google Image Result for http___www.utopia-global-portfolios.net_images_figure_1.gifI am expecting similar results in US markets and would not be an aggressive buyer of equities until they yield more than treasuries.

I’m Now Neutral on Equities

The recent stock market rout has left equities no longer trading at the expensive valuations that I had been concerned about. They aren’t cheap either, so I don’t plan to do any buying at current levels. But I have closed virtually all of my short positions leaving my portfolio with lots of cash. My reasoning for believing that stocks have become more fairly priced is based on my outlook for earnings and the multiple the market will assign to those earnings.

S&P 500 four-quarter rolling operating earnings peaked at $90 during the 2nd quarter of last year. After the second quarter of this year earnings have declined to $70. Given that the only driver of earnings growth, energy and materials companies, will now suffer declining earnings, I expect at some point over the next year S&P 500 earnings will bottom within the $50-$60 range and will remain there for several more quarters.

Typically PE ratios are in the single digits during both deflationary periods because of worries of plummeting earnings and highly inflationary periods when investors demand a greater earnings yield to compensate for a rising cost of living. While inflation has been uncomfortably high recently, I believe we are entering a disinflationary period where the market will assign a multiple close to the historical average which is 15.

So if we get earnings of $50-$60 and multiply it by 15, I get a fair value for the S&P 500 of around 750 to 900. I felt very comfortable taking a big short position when the S&P 500 was trading at over 1300 earlier this year. But last week it dipped below 900 and I had no reason to remain short. If the market rallies to around 1100 I will re-establish a big short position. If the market continues to drop and falls to below 600, I will probably go aggressively long. But within 600 and 1100 I’m not going to make any big bets.

Currently, I’m almost entirely in cash. I own Altius Minerals (TSX:ALS), a handful of tiny positions in micro-cap resource stocks, a short position in MBIA (NYSE: MBI) calls, and a short position in 30 year Treasury bonds. Because I don’t see any significant mispricings in the equities, commodities, credit, and currency markets, I’m going to wait patiently for opportunities to present themselves which they always do with high frequency.