Investors in Capital Advisors’ Managed Equity strategy may have noticed three stock sales in the past two days – Range Resources and a reduction in Google yesterday, and UnitedHealth today.  This note will explain what we’re up to.

Capital Advisors tracks the behavior of three variables in the asset markets to form an objective view of the market climate at any given time.  The three variables we track measure valuation, trend and risk in the stock market.  The tools we use to measure these variables are:

 

• Valuation:  “Normalized” Price-to-Earnings Ratio (P/E)
• Trend:            Moving Average
• Risk:              Credit Spreads

 

Together, these three variables indicate when stocks seem statistically most likely to perform better, and vice versa.  When we say “statistically most likely,” we are referring to historical correlations between beginning conditions and subsequent outcomes for each of these variables.  Consider valuation, for example.  The table below shows the historical correlation between the beginning valuation of the U.S. stock market (as measured by a Normalized P/E Ratio), with subsequent 3-year returns from stocks.  The study period covers 1,524 overlapping 3-year holding periods between 1881 and 2010:

                                                                      Distribution of 3-Year Returns

                                                                                  S&P 500 Index

                                                        1,524 Overlapping (monthly) Observations

                                                                                      1881 – 2010

 

Note:  “Beginning Valuation” represents the normalized P/E ratio of the S&P 500 Index, as measured by Robert J. Shiller at www.econ.yale.edu/~shiller/data.htm.  Study conducted by Capital Advisors, Inc.

The message we take from this data is that the distribution of probable outcomes in the stock market is not static.  More importantly, the likelihood of a favorable, or unfavorable experience over any given 3-year period seems fairly predictable based on a purely objective metric we can observe every day – the current valuation of the S&P 500 Index. 

The current valuation level for stocks is not particularly favorable.  The current normalized P/E for the S&P 500 Index is 20.5 (source:  Robert J. Shiller).

The second variable we track is the trend of the stock market.  We define the trend as being either positive or negative with a quantitative measure called a “moving average.”  When the price of a market index like the S&P 500 is higher than a trailing average of the index over the past several months, the market is said to be in an up-trend, and vice versa when the price of the index falls below its moving average. 

 

 

Here is the historical correlation between the pre-condition of a positive/negative moving average reading with subsequent monthly returns in five broad asset classes:  

Source: Robert Shiller – www.econ.yale.edu/~shiller/data.htm (1872-1925): Standard & Poor’s; Ibbotson; Bloomberg LP (1926-2010) ; www.mscibarra.com; www.REIT.com; Deutsche Bank AG; Capital Advisors, Inc.

 

This data supports the adage that “the trend is your friend.”  Various asset markets have delivered higher average monthly returns with a lower frequency of negative monthly returns in periods following a positive moving average reading versus a negative reading.  For what it’s worth, Capital Advisors has conducted similar studies involving stock market benchmarks for 27 different countries and 10 major industry sectors.  The results were similar.

As of today each of these five markets is trading below its moving average.  This may suggest lackluster returns from these markets in the near-term. 

The third variable we track is risk.  We define risk as the spread between the yield on sub-investment-grade corporate bonds – i.e. “junk bonds” – and 10-year U.S. Treasuries.  When the spread between these two bond markets is wide it may suggest that investors expect increasing defaults among high-risk corporate bonds; and vice versa when spread between junk bonds and treasuries is narrow.  Here is the historical data for the risk indicator:

                                   Correlation of Yield Spreads with Subsequent Monthly Returns

                                                                      S&P 500 Index - 1989-2011

 

Source:  Standard & Poor’s; Credit Suisse; Bloomberg; Study conducted by Capital Advisors, Inc.

 

The best way to characterize the risk indicator today is “flashing yellow.”  The recent spread between junk bonds and 10-year Treasuries is 6.34% - not quite in the widest quartile of its historical range (6.6% and higher), but very close.  The trend in this indicator is also important, so the fact that spreads have been widening rapidly in recent weeks adds a negative bias to the absolute level of the spread.

The stock market climate, as defined by the three indicators listed above, is not particularly favorable today.  This does not mean stocks cannot perform well in the near-term.  Notice, for example, that the average monthly return has been positive in over half of all monthly observations when either the trend or risk indicators were negative.  Likewise, two-thirds of all 3-year holding periods produced a positive return, even when the beginning valuation was in the most expensive quartile of its range, like now.  We are not suggesting investors should sell out of stocks.

We are suggesting that now is not the time to invest aggressively in the stock market.  Which leads to the main purpose of this note…why the recent stock sales?   Following the sale of UnitedHealth today, approximately 13% of our Managed Equity strategy will be allocated to cash.  Of the 87% of the strategy still committed to stocks, approximately 55% consists of “blue chip” companies with strong balance sheets, global businesses, and growing dividends.  Examples include AT&T, Abbott Labs, General Electric, Intel, Johnson & Johnson, PepsiCo, Procter & Gamble and Wal-Mart, among others.

The Managed Equity strategy also includes leading companies poised to benefit from the growth of mobile devices connected to the global internet.  Examples here include Apple (single largest holding), Applied Materials, Broadcom, Google and Qualcomm.  These stocks comprise approximately 16% of the portfolio today.

The remainder of the portfolio consists of special situations we find attractive for one reason or another.  One example is the auto sector, as represented by Ford and General Motors.  These companies have proven they can turn a modest profit at depression-level auto sales of around 10 million units per annum in the U.S. market.  We expect Ford and GM can earn very attractive profits at a run-rate of 12-13 million units, which would historically be considered a recessionary level.  These companies should be very profitable when auto sales return to normalized levels of 15-17 million units per annum, perhaps within in the next two years.

Notice we have not mentioned Europe once.  This is not because we are unconcerned.  In fact, some kind of market shock emanating from the euro zone is the single largest risk factor we worry about today.  Moreover, we don’t believe risk in the euro zone can subside until a more substantial policy response is implemented in the region.  The most likely end-game seems like some form of a euro-wide bond – either a so-called “Eurobond,” or cross guarantees of existing sovereign debt that behaves the same way. 

Whether measured objectively through indicators for valuation, trend and risk; or subjectively by pondering all that might go wrong in the euro zone, we come to the same conclusion about the current market climate – proceed with caution.

 

Security Recommendations: The investments presented are examples of the securities held, bought and/or sold in the Capital Advisors Core Growth Composite during the last 12 months.  These investments may not be representative of the current or future investments of that composite. You should not assume that investments in the securities identified in this Research Note were or will be profitable. We will furnish, upon your request, a list of all securities purchased, sold or held in the composite during the 12 months preceding the date of this presentation.  It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities identified in this Research Note. Other Disclosures: Commentary is published by: Capital Advisors, Inc. This commentary does not purport to be a statement of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources believed to be reliable. The securities mentioned do not represent all securities bought, sold, or recommended to clients of Capital Advisors, Inc. Due to differences in timing, objectives, or portfolio size, issues discussed in this note may not apply to all clients. Opinions expressed herein are subject to change without notice. Capital Advisors, Inc., or one or more of its officers or employees, may have a position in the securities discussed herein, and may purchase or sell such securities from time to time. Specific information regarding topics covered in this report is available upon request. Additional information, including management fees and expenses, is provided on Capital Advisors’ Form ADV Part II. The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the amount invested. Bond Investments are affected by interest rate changes and the creditworthiness of the issues held in the portfolio. A rise in interest rates will cause a decrease in the value of fixed income positions. Past performance results are not indicative of future results.  Copyright © 2011, by Capital Advisors, Inc. All rights reserved.

 

 

 

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