Yesterday, I discussed the “compression” of the market being akin to a “coiled spring” that when released could lead to a fairly decent move in one direction or another. To wit:
“As you can see in the ‘reddish triangle,’ prices have been continually compressed into an ever smaller trading range. This ‘compression’ is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.”
As shown, the bulls are “attempting a jailbreak” of the “compression” that has pressured markets over the last two months. While the breakout is certainly encouraging, there isn’t much room before it runs into a more formidable resistance of the 100-day moving average. Furthermore, with interest rates closing in on 3% again, which has previously been a stumbling point for stock prices, it is too soon to significantly increase equity risk in portfolios.
This is just one day.
As I stated previously, as a portfolio manager I am not too concerned with what happens during the middle of the trading week, but rather where the market closes on Friday. This reduces the potential for “head fakes” as we saw last week with the break of the of the 200-dma on Thursday which was quickly reversed on Friday. The weekly close was one of the two outcomes as noted in our previous Quick-Take:
“If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.”
This breakout will provide a reasonable short-term trading opportunity for portfolios as I still think the most probable paths for the market currently are the #3a or #3b pathways shown above.
If we get a confirmed break out of this “compression range” we have been in, we will likely add some equity risk exposure to portfolios from a “trading” perspective. That means each position will carry both a very tight “stop price” where it will be sold if we are wrong as well as a “profit taking” objective if we are right.
Longer-term investments are made when there is more clarity about future returns. Currently, clarity is lacking as there are numerous “taxes” currently weighing on the markets which will eventually have to be paid.
Rising oil and gasoline prices (Tax on consumers)
Fed bent on hiking rates and reducing their balance sheet. (Tax on the markets)
Potential trade wars (Tax on manufacturers)
Geopolitical tensions with North Korea, Russia, China and Iran(Tax on sentiment)
We continue to hold higher levels of cash, but have closed out most of our market hedges for now as we giving the markets a bit more room to operate.
With longer-term indicators at very high levels and turning lower, we remain cautious longer-term. However, in the short-term markets can “defy rationality” longer than anyone can imagine. But it is in that defiance that investors consistently make the mistake of thinking “this time is different.”
It’s not. Valuations matter and they matter a lot in the long-term. Valuations coupled with rising interest rates, inflationary pressures, and weak economic growth are a toxic brew to long-term returns. It is also why it is quite possible we have seen the peak of the market for this year.
I will update this “Quick Take” for the end of the week data in this coming weekend’s newsletter.(Subscribe at the website for email delivery on Saturday)
The Myth Of “Buy & Hold” – Why Starting Valuations Matter
If you repeat a myth often enough, it will eventually be believed to be the truth.
“Stop worrying about the market and just buy and hold stocks.”
Think about this for a moment. If it were true, then:
Why do major Wall Street firms have proprietary trading desks? (They aren’t buying and holding.)
Why are there professional hedge fund managers? (They aren’t buying and holding either)
Why is there volatility in the market? (If everyone just bought and held, prices would be stable.)
Why does Warren Buffett say “buy fear and sell greed?” (And why is he holding $115 billion in cash?)
Why are there financial channels like CNBC? (If everyone bought and held, there would be no viewers.)
Most importantly, why isn’t everyone wealthy from investing?
Because “buying and holding” stocks is a “myth.”
Wall Street is a business. A very big business which generates huge profits by creating products and selling it to their consumers – you. Just how big? Here are the sales and net income for some of the largest purveyors of investment products:
There is nothing wrong with this, of course. It is simply “the business.”
It is just important to understand exactly which side of the transaction everyone is on. When you sell your home, there is you, the buyer and Realtor. It is clearly understood that when the transaction is completed the Realtor is going to be paid a commission for their services.
In the financial world the relationship isn’t quite as clear. Wall Street needs its customers to “sell” product to, which makes it less profitable to tell “you” to “sell” when they need you to “buy the shares they are selling for the institutional clients.”
Don’t believe me? Here is a survey that was conducted on Wall Street firms previously.
“You” ranked “dead last” in importance.
Most importantly, as discussed previously, the math of “buy and hold” won’t get you to your financial goals either. (Yes, you will make money given a long enough time horizon, but you won’t reach your inflation-adjusted retirement goals.)
“But Lance, the market has historically returned 10% annually. Right?”
Correct. But again, it’s the math which is the problem.
Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends.
Average and Annual or two very different things. Investors may have AVERAGE 10% annually over the last 118 years, but there were many periods of low and negative returns along the way.
You won’t live 118 years unless you are a vampire.
The Entire Premise Is Flawed
If you really want to save and invest for retirement you need to understand how markets really work.
Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:
Lack of capital to invest.
Psychological and behavioral factors. (i.e. buy high/sell low)
Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.
While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.
Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:
Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
Mental Accounting – Separating performance of investments mentally to justify success and failure.
Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
Regret – Not performing a necessary action due to the regret of a previous failure.
Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”
As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, anxiety increases until individuals seek to “avert further loss” by selling.
This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.
However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.
Over any 30-year period the beginning valuation levels, the price you pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.
As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.
For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.
At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market than ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.
Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)
The point to be made here is simple and was precisely summed up by Warren Buffett:
“Price is what you pay. Value is what you get.”
This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.
So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.
The red line is 10% compounded annually. You won’t get that, but it is there so you can compare it to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisors promise of 10% annual returns for retirement, you aren’t going to make it.
I want you to take note of the following.
When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress.
Why 22 years?
Take a look at the chart below.
Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.
The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future.
Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.
But isn’t that what Baron Rothschild meant when quipped:
“Thetime to buy is when there’s blood in the streets.”
Quick Take: Market Breaks Important Support
I have often discussed that as a portfolio manager I am not too concerned with what happens during the middle of the trading week. The reason is daily price volatility can lead to many false indications about the direction of the market. These false indications are why so many investors suggest that technical analysis is nothing more than “voo doo.”
For me, price analysis is more about understanding the “trend” of the market and the path of least resistance for prices in the short and intermediate-term. This analysis allows for portfolio positioning to manage risk.
Over the last several weeks, I have been mapping out the ongoing correction in the market and have noted the important support that has been provided by the running 200-day moving average. The chart below is updated through this morning.
The break of the 200-dma today is not a good sign. Consolidation processes are much akin to the “coiling of a spring.” As prices become compressed, when those prices break out there is a “release of energy” from that compression which tends to lead to rather sharp moves in the direction of the breakout.
Importantly, the break of support today is NOT a signal to run out and sell everything. It is, however, a worrisome warning that should not be entirely dismissed.
As stated, nothing matters for me until we see where the market closes on Friday.
Here is what we are wanting to see:
If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.
If the market closes BELOW the 200-dma on Friday, the break of support will be confirmed, suggesting a downside failure of the consolidation pattern over the last couple of months. This break is bearish for the market and suggests higher levels of caution. Such will lead to two other options:
With the market oversold on a short-term basis, any rally that fails at the 200-dma will further confirm the downside break of the consolidation. This would suggest lower prices over the next month or so.
If the market recovers by early next week, above the 200-dma, positioning will remain on hold.
I am often asked why I don’t just take ONE position and make a call.
Because we can not predict the future. We can only react to it.
After having raised cash over the last couple of months on rallies, there isn’t much we need to do at the moment.
However, the weakness in the market, combined with longer-term sell signals as discussed on Tuesday, is suggesting the market has likely put in its top for the year.
We remain cautious and suggest the time to “buy” has not arrived yet.
Bull Markets Actually Do Die Of “Old Age”
David Ranson recently endeavored in a long research report to simply declare that “bull markets do not die of old age.”
“The life expectancy of bull markets can be inferred from history. Fourteen bull markets in U.S. stocks have come and gone since 1927, and their mean lifetime is 55 months. But this calculation can be taken further. From the age of one year to the age of eight years, there’s no overall tendency for life expectancy to decline as a market advance gets older. The present stock market advance, which began 105 months ago, is no more likely to end within the next twelve months than it was when it was only twelve months old. Bull markets do not die of old age.”
Think about this for a moment.
This is the equivalent of suggesting that since the average male dies at 88-years of age if he lives to be 100, he has no more chance of dying in the next 12-months than he did when he was 40-years old.
While a 100-year old male will likely expire within a relatively short time frame, it will not just “being old” that leads to death. It is the onset of some outside influence such as pneumonia, infection, organ failure, etc. that leads to the eventual death as the body is simply to weak to defend itself. While we attribute the death to “old age,” it was not just “old age” that killed the host.
This was a point that my friend David Rosenberg made in 2015 before the first rate hike:
“Equity bull markets never die simply of old age. They die of excessive Fed monetary restraint.”
First, averages and medians are great for general analysis but obfuscate the variables of individual cycles. To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in a financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.
But each of those economic expansions did indeed come to an end. The table below shows each expansion with the subsequent decline in markets.
Think about it this way.
At 104 months of economic expansion in 1960, no one assumed the expansion would end at 105 months.
At 118 months no one assumed the end of the “dot.com mania” was coming in the next month.
In December of 2007, no one believed the worst recession since the “Great Depression” had already begun.
The problem for investors, and the suggestion that “bull markets don’t die of old-age,” is that economic data is always negatively revised in arrears. The chart below shows the recession pronouncements by the National Bureau Of Economic Research (NBER) and when they actually began.
The point here is simple, by the time the economic data is revised to reveal a recession, it will be far too late to do anything about it from an investment perspective. However, the financial market has tended to “sniff” out trouble
The Infections That Kill Old Bull Markets
Infection #1: Interest Rates
As noted by David Rosenberg, with the Fed continuing to hike rates in the U.S., tightening monetary conditions, the previous 3-year time horizon is now substantially shorter. More importantly, the “average” time frame between an initial rate hike and recession was based on economic growth rates which were substantially higher than they are currently.
Furthermore, as interest rates rise, so does the cost of capital. In a heavily leveraged economy, the change in interest expense has been a good predictor of economic weakness. As recently noted by Donald Swain, CFA:
“What if marginal interest expense pressures are the true recession signal (cause of economic weakness) and the yield curve is just a correlated input to that process? If so, for the first time, the Fed is hiking into what is already the most hostile refit period in 35-years.”
The point is that in the short-term the economy and the markets (due to momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately act as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:
Higher borrowing costs which lead to lower profit margins for corporations.
Stocks are cheap based on low-interest rates. When rates rise, markets become overvalued very quickly.
The economic recovery to date has been based on suppressing interest rates to spur growth.
Variable rate interest payments for consumers
Corporate share buyback plans, a major driver of asset prices, and dividend issuances have been done through the use of cheap debt.
Corporate capital expenditures are dependent on borrowing costs.
Infection #2: Spiking Input Costs
When rate hikes are combined with a surge in oil prices, which is a double whammy to consumers, there has been a negative outcome as noted by Peter Cook, CFA last week.
“A better record of predicting recessions is achieved when Fed has hiked rates by 2.00%-2.50%, AND oil prices have at least doubled. The price of money and energy are major financial inputs to financial planning, so when they simultaneously rise sharply, consumers and businesses are forced to retrench. Based on the Fed’s well-communicated strategy, it plans to raise rates another 0.75% during 2018 on top of the previous 1.50% over the past few years. If crude oil stays above $50-60, both conditions for a recession would be met in the second half of 2018.
Yet neither the Fed, or any high-profile economist, is predicting the beginning of a recession during 2019, let alone 2018. Answering the inflation/deflation question correctly is the most important issue of the day for investment portfolios. If recession/deflation arrives before growth/inflation, a major adjustment in expectations, and capital market prices, is coming within the next year.”
This shouldn’t be surprising.
In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.
“With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.
For investors, that poses huge risks in the market.
While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”
Infection #3 – Valuations
Lastly, it isn’t an economic recession that is truly problematic for investors.
If asset prices rose equally with increases in earnings, in other words the price-to-earnings ratio remained flat, then theoretically “bull markets” would last forever.
Unfortunately, since asset prices are a reflection of investor psychology, or “greed,” it is not surprising that economic recessions reveal the mispricing between the premium investors pay for a stream of earnings versus what they are really worth. As I noted just recently:
“Bull markets are born on pessimism, grow on skepticism, and die on euphoria.” -Sir John Templeton
Take a look at the chart below which is Robert Shiller’s monthly data back to 1871. The “yellow” triangles show periods of extreme undervaluation while the “red” triangles denote periods of excess valuation.
Not surprisingly, 1901, 1929, 1965, 1999, and 2007 were periods of extreme “euphoria” where “this time is different” was a commonly uttered phrase.
What the majority of mainstream analysis fails to address is the “full-cycle” of markets. While it may appear that “bull markets do not die of old age,” in reality, it is “old age that leaves the bull defenseless against infections.”
It is the impact of an exogenous event on an over-leveraged, extended and over-valued market that eventually leads to its death. Ignoring the “infections,” and opting for “hope,” has always led to emotionally driven mistakes which account for 50% of investor’s under-performance over a 20-year cycle.
With expectations rising the Fed will further tighten monetary policy, the vulnerabilities of an “aged bull market” will be an issue for investors in the future.
“In investing, the man who wins is the man who loses the least.”– Dick Russell
Analysts’ Estimates Go Parabolic – Is The Market Next?
At the end of February, I discussed the impact of the tax cut and reform legislation as it related to corporate profits.
“In October of 2017, the estimates for REPORTED earnings for Q4, 2017 and Q1, 2018 were $116.50 and $119.76. As of February 15th, the numbers are $106.84 and $112.61 or a difference of -$9.66 and -7.15 respectively.
First, while asset prices have surged to record highs, reported earnings estimates through Q3-2018 have already been ratcheted back to a level only slightly above where 2017 was expected to end in 2016. As shown by the red horizontal bars – estimates through Q3 are at the same level they were in January 2017. (Of course, “hope springs eternal that Q4 of this year will see one of the sharpest ramps in earnings in S&P history.)”
That was so yesterday.
Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.
The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. “Optimism” is, well, “exceedingly optimistic” for the end of 2019.
The surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices. Buy now before you miss out!
“While earnings season has only just gotten started (only 10% of the S&P 500 companies have reported so far), a whopping 84.6% have beaten their earnings estimates, and 78.8% have beaten their revenue estimates. Those are impressive stats. And this earnings season looks like it could be even better than the lofty expectations going into it. This sets the market up for all-time highs just ahead.”
Sure, that could well be the case as a momentum-driven market is a very tough thing to kill. Despite the recent “hiccup” over the last month or so, the market remains above it’s 200-day moving average and there are few signs of investor panic currently.
However, there are two major concerns with the current trajectory of earnings estimates.
The first is that Wall Street has historically over-estimated earnings by about 33% on average.
Yes, 84% of companies have beaten estimates so far, which is literally ALWAYS the case, because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently.
At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.
Furthermore, the overestimation provides a significant amount of headroom for Wall Street to be disappointed in future, particularly once you factor in the impacts of higher interest rates and slower economic growth.
But economic growth is set to explode. Right?
Most likely not.
As I discussed last week, the short-term boost to economic growth in the U.S., driven by a wave of natural disasters, is now beginning to fade. However, the same is seen on a global scale as well. To wit:
“The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”
Furthermore, the economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. Furthermore, with corporations more highly levered than at any other point n history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.
With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. History suggests this will likely be the case. At every point in history where the Fed has embarked upon a rate hiking campaign since 1980, the “crisis point” has come at steadily lower levels.
But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.
There are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.
More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history. Currently, despite surging earnings expectations, market participants are already revaluing equity and high-yield investments.
In our opinion, the biggest mistake that Wall Street is potentially making in their estimates is the differential between “statutory” and “effective” rates. As we addressed previously:
“From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.
In reality, a company that earned $5.00 pretax only paid $1.41 in taxes in 2017 on average, leaving an after-tax profit of $3.59, and not $3.25. Under the new tax law that after-tax profit would come in at the $3.95 as stated in the article and the gain would be 10%, or half, of the gain Wall Street expects.”
There is virtually no “bullish” argument that will currently withstand real scrutiny.
Yields are rising which deflates equity risk premium analysis,
Valuations are not cheap,
The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
Further increases in interest rates will only act as a further brake on economic growth.
However, because optimistic analysis supports our underlying psychological “greed”, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this “willful blindness” that eventually leads to a dislocation in the markets.
Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.
This time will likely be no different.
Will tax reform accrue to the bottom lines of corporations? Most assuredly.
However, the bump in earnings growth will only last for one year. Then corporations will be back to year-over-year comparisons and will once again rely on cost-cutting, wage suppression, and stock buybacks to boost earnings to meet Wall Street’s expectations.
Are stocks ready to go parabolic?
Anything is possible, but the risk of disappointment is extremely high.
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