“Given how oversold the markets are we expect a relief rally. That rally could be quite explosive if news seems for a while to be getting better.

We suggest using any rally to position yourself for more weakness. Or, to put it more plainly, patience with market risk until things are a lot cheaper.” – The View From the Bluff, August 10^th 2011

That is from our last View From the Bluff two weeks ago on Wed. August 10^th. On Thursday August 11^th the “relief rally” began with an explosive move upward of over 4.6%. A week later a third of the market decline was erased. That kind of precise timing is luck folks, but we think the thinking behind it was sound.

However, as John Hussman pointed out Sunday before last:

The prone to failure part of the rally arrived with a vengeance last Thursday and the rally seemingly resumed yesterday.

So, what to expect going forward?

On a fundamental basis the US stock market is still overvalued. As discussed in our last “View from the Bluff” profit margins are already likely to begin retrenching. If the economy gets worse that will likely accelerate along with a slowing of sales.

Narrower segments of the US market are now near fair value, especially the highest quality parts of the market.

Overseas markets are another story. International and developing markets are looking reasonable on the whole. Not cheap, but around fair value. Some individual markets (such as Japan and parts of Europe) are actually looking cheap.

Longer term technical indicators are now all pointing toward a longer term bear market. For the S&P500 to get back to its 200 day moving averages (simple and exponential) by the end of the month would require gains of over 10% and 8% respectively.

Europe is in a real pickle, though you are probably tired of us talking about it for going on 4 years now. Still, European banks have been, and continue to be, in worse shape than American banks, as stunning as that possibility may seem. China is looking shaky with a Real Estate and credit crisis of their very own a real possibility. They may not import many of our goods, but our sins, economic and otherwise, seem to be consumed with eagerness.

Finally the economy is slowing, both in the US and globally, and almost all the indicators we look at are flashing that a recession is becoming very likely. However, not yet (though we are keeping an open mind.)

Given the weight of evidence every opportunity to reduce risk or move into non correlating strategies in the US markets should be taken before the “not yet” becomes an “already happened.” My best guess is we don’t go substantially below where we have been before the end of the year, which gives you time to liquidate, hedge or redeploy at higher points should the market rally. Obviously I wish markets worked out neatly enough for you to have complete confidence in waiting for higher prices to do so but they do not.

We will likely have a number of strong rallies going forward. The market is still oversold, investor sentiment is overly bearish and insiders are increasing their buying, so we would expect some consolidation here or even further advances. Use them to reduce risk. If you want stock exposure, concentrating on the highest quality parts of the US and International will likely do best should the market decline further (and the evidence is that risk is extremely elevated) but do well enough should the market and economy bounce back. That however is looking less and less likely.

Big up days will provide good opportunities to reduce exposure by either selling or hedging (and big up days are a bad sign on average, a topic we will address this week on the blog.) The damage of a longer term bear usually happens over 12-18 months, not one. Andrew Smithers (Author of Valuing Wall Street and calculator of the Q Ratio) expects a further rally due to stock buybacks and other factors but strongly believes investors should use it to position for an eventual decline:

“Investors should not, in general, buy stocks at this level, as the stock market is likely to become cheap at some time during the next 10 years and there is therefore a high risk that anyone buying today will lose money before they start to get a positive return,” Smithers said. “In these circumstances, they are likely to be better off by holding cash until the market has fallen.”

Smithers uses Equity Q, a variant of a ratio made famous by Nobel Laureate James Tobin, as an indicator of whether the market is overvaluing or undervaluing company assets. He uses estimates of market value published by the Federal Reserve.

Investors are “foolish” to use price ratios based on current earnings as a yardstick of whether the market is attractive, Smithers argues.[…]

“There are widespread claims that the U.S. stock market is attractive,” Smithers wrote on Aug. 15. “While foolish, these views are common. The risk that I see for those who have to take a short-term view is that their relative performance will suffer in a rally and that this will drive them to buy if the market does rally which, given the bad medium-term outlook, would amplify their poor performance.”

“Corporate buying has moved with the stock market in recent years,” Smithers wrote. “Companies are likely to use their cash resources to buy shares.” [….]

“It is common to find that investors, often supported by ill-judged comments by investment bankers and financial journalists, try to value shares on the basis of current profits,” he wrote. “This is, of course, very foolish as it means that they undervalue companies when profits are low and overvalue them when profits are high — as they are today.”

We like the cut of Andrew’s jib. Wait to take lots of risk until markets have fallen sometime in the next 10 years! That is patience.

Smart, but likely not realistic for most people, and of course there are ways to exercise that patience besides holding cash. Luckily, I doubt investors will have to wait 10 years. It has never taken 10 years for a market this overvalued to reach a more attractive point in the past, so we should act on the basis that such a long wait is unlikely. Our own research says even three years from now would be almost without precedent and conditions in the economy and markets suggest we may see it within the next year. The principle however is sound.

Shorter term we have a fork in the road at hand. Will we get our respite to reposition or will the downdraft continue? John Hussman describes the environment we are in from a decision making process quite well:

“Ideally, present conditions will be associated with what we’ve observed historically – a few weeks of moderate advance to clear the deeply oversold condition of the market, most likely followed by a fresh shift to a defensive stance. Given that the expected return/risk profile has just peeked above zero, we would prefer not to immediately experience the market’s version of “Whack-A-Mole,” but are prepared for that possibility as well. A break below the area around 1050 on the S&P 500 would put us in a situation much like 2008, where nearly every expectation of short-term stabilization was promptly dashed. For now, we don’t see the sort of uniform breakdown that we observed then. A break to fresh lows by numerous indices, an explosion of new lows in individual issues, and steep weakness in utilities or corporate bonds would quickly change that assessment, and we will respond accordingly.”

Could this be a false alarm? Sure, but like last year when the market advanced strongly from September through January the risk reward is on your side. Even in the worst case, if you missed those gains in their entirety they were eventually completely wiped out. All you would have missed was the rollercoaster. Any large and long rally from here will eventually suffer the same fate if history is any guide (See last issue for why) and it is unlikely you will miss all of any such rally anyway.

However, if the preponderance of evidence proves correct you derive three salient benefits:

• The first is you avoid the stress of a declining market, which is far worse than the stress of missing a rising market or suffering small, but easily recoverable, losses.
• Secondly you avoid large losses. We’ll assume that benefit needs no justification.
• Third, by preserving capital, even if you suffer some losses, you have the chance to redeploy it later when the markets are significantly cheaper and rates of return are far higher. In other words, nothing can make your financial future more secure than being able to take advantage of a market after a substantial decline. If prepared for they can be welcomed, not feared.

 

There Always Seem to be Bulls in our China Shop

For the fourth time since 2000 a significant selloff has been greeted with the typical “this has been a healthy correction” and talk of “overblown fears” and “irrational overreactions.” Now, we have no doubt that the markets swift descent shows a great lack of rationality. Certainly the collected companies that comprise the S&P 500 are not worth 20% less than they were back in April. Yet, we must marvel at the double standard the investment industry applies to such things, since it is just as true that the S&P 500 wasn’t worth 25% more in April than it was at the beginning of September 2010 either.

However that move was claimed to have been based on “strong fundamentals” “ample liquidity” and other factors that changes the actual worth of a company by little in the first case and generally not a whit in most of the others. Pointing out that the value of stocks as a whole arises from earnings (and only earnings that eventually can be returned to shareholders, not squandered by companies such asHewlett Packard) and dividends over many years and decades and not what happens in any one cycle, year, quarter or month makes most commentary on CNBC or the bleating of various investment houses a bit beside the point. Pointing out that the trend growth in earnings and dividends is somewhere between 1% and 2% above inflation a year makes justifying a move of 20% or more in any direction based on “fundamentals” seem a bit silly. In fact, trend growth in the price of the S&P 500 index has been only about 1.7% a year above inflation (the rest of the fabled 10% a year we always hear about has been dividends and inflation.) All of the fundamental numbers have been remarkably stable in the long run. In a rational world stocks wouldn’t move around much more than that per year.

The chart below illustrates both concepts well:

 

As an advisor this belief that we need to always “sell sunshine” permeates the advice we get about the advice we need to give to you. Our e-mail in boxes are filled with coaching suggestions on how to convince our clients to not only stay invested, but buy stocks. Investment houses tell us the same (see also here.) However, we rarely get advice from business coaches or large firms on how to explain to clients that markets are overvalued, that reducing risk even during a bull market can be a good idea in some circumstances or that there is ever really a time to sell. Of course, what are all the asset managers on Wall Street going to say when they get on CNBC? “Investors shouldn’t invest in my XXX cap fund because XXX cap stocks are overvalued and long term returns will be poor.” Maybe some have and I just missed them. That is why independent voices should be given more credence:

“4. Ignore the asset-gatherers and the brokerage firm strategists, their job is to calm markets and soothe investors. Let’s say Morgan Stanley runs $1 trillion in stock market wealth for investors. And then let’s say they felt there was serious trouble ahead. Do you really think they would ever make the sell call? Can Morgan Stanley really say “Sell 20% of your equities”? No. Because that would be $200 billion in supply hitting the stock market at once – they would crash it all by themselves! Too Big To Keep It Real has always been the problem with the wirehouse advice model.”

By the way, Josh Brown’s entire post on how to survive a crash is worth reading if you have the time.

The markets irrationality is not to be bemoaned really. For the patient investor the markets short term irrationality is what gives it the potential to deliver abnormal returns.

Of course, just because we agree that the market is not worth 20% less than it was in April in no way means we believe the US market is cheap (which is the illogical conclusion many analysts jump to, which show the biases of Wall Street and the industry overall quite clearly.) Every measure we look at shows it was at least 40% overvalued then. If we thought that the current dive was due to some well considered epiphany from investors we would call it logical but not yet logical enough. Alas, we think it is just panic and while value is the gravity that wears away the pernicious effects of irrational exuberance and the salutary benefits of  extreme pessimism we think it has little directly to do with shorter term movements. Or, we should say, not consciously.

 

To know the truth, all you need is simple addition and subtraction

 

Is the US market cheap now? We addressed that last letter but let us look at it another way by breaking down the markets returns into its components. The long term return of the stock market is around 6% above inflation (This is known as the Real Return, the rest of the 10% we always hear about has been inflation.) If long term growth in earnings has been about 1.5% above inflation (and it has been give or take about a half percent depending on the time period) then to reach a similar return of 6% over the long term we need to receive dividends of about 4.5% (which unsurprisingly is about what the average long term dividend yield has been. Funny how that works.) Right now the S&P 500 yields about 2.2%. What would we need to happen for the dividend yield to be 4.4% today? We would need for the market to fall about 50%!

Over the long term, the math above about what return you can expect from the market is relentless. The message is clear though, cheaper prices means higher returns.

In fairness, we think the need for a 50% decline to get to fair value is a bit much. We think fair value is above that since 6% above inflation is really more than we have a right to expect from stocks in the first place. We like 5.7% ourselves but if one assumes a lower required return than that the market is at the less expensive end of the range we describe below. In addition, dividend payouts are lower than in the past which arguably distorts things a bit (which is really debatable, but we are going to be optimistic.) Making those adjustments comes up with a range for the US from an extremely optimistic 22% further to fall to reach fair value to our more pessimistic 50%. Most likely the real number is around 35-45% lower from yesterday’s close, which just happens to be the range of fair value if we look at other fundamental measures of value, though the Q ratio shows something closer to 50%. When value calculated using a broad range of very different measures and methods of calculation roughly agree we feel comfortable in saying we are roughly correct, which is certainly better than a being precisely wrong.

Doug Short provides a great resource for tracking various measures of value we look at in addition to our own “components of returns” approach. The numbers are from the end of July, so take off about 10%. We also hasten to add that each of these valuation methods have been shown to actually correlate with subsequent long term returns, unlike most claims about value which claim that current markets are cheap (Click here for a larger version)

 

The most optimistic assessment is using the arithmetic trend for the S&P 500, which would be around 900 or about 22% further down from yesterday. The most pessimistic is the Q Ratio at a bit above 50% after the recent decline, which  interestingly enough reads as being as far away as the difference between real dividend growth and the trend in equity prices seen in the earlier chart. We doubt that is a coincidence.

If this were an exact science we would let you know, but certainly the market is not cheap.

Further Reading

We have been of the opinion since 2000 that we have been in a long term (or secular) bear-market. Obviously that has proven true. How far away are we from the end? JJ Abodeeley and I discuss just that in Are We There Yet?

JJ also does a great job of dealing with a pet peeve of ours, the use of forward operating earnings estimates to claim that markets are cheap in The Misuse of Forward P/E. Of course, we have spent more than 15 years listening to people claim stocks were cheap no matter the environment to predictably disastrous ends so why should we expect anything different? He also takes a swipe at the foolishness of claiming the market is cheap because of bond yields, which always warms our hearts.

 

 

(c) Thompson Creek Wealth Advisors

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