An eclectic approach to better trading and investing. Finding market inefficiency. Discussing and applying the best ideas and methods from several disciplines.
In most aspects of life, gaining information is helpful. Smart people learn how to learn, and use the skill in everyday life.
There is a cruel twist of fate:
When it comes to investing, a little knowledge can be a very dangerous thing!
If you read the headlines, you are assured of being at least one step behind. In the case of many headlines, it may even be a step backward.
Today is a great case in point. Essentially, there was no fresh news except for an Italian bond auction (of short-term paper) that went very well, sending overseas markets and US stock index futures higher in pre-opening trading. Everyone knew that the more important test would come tomorrow, when Italy auctioned off longer maturities, stretching out to ten years.
This was the only fresh information, and I reported as much in my diary.
What Happened?
We then saw the same correlated trade that has been the staple of the past year: Lower Euro, Higher dollar, lower commodities (oil and gold for sure), and lower stocks. Traders love simple heuristics, so it was "risk off."
Notice that there is no explanatory power involved in this statement. The Italian auction went well, and the initial reaction was positive for longer maturities. Any other stories about the ECB balance sheet were "old news" since that program has been sliced and diced for a few days.
Two Competing Headlines
Tomorrow morning's papers will have many competing headlines offering explanations for today's trading.
Here are two choices, ironicalliy from the same source:
The second headline is followed with this explanation: Investors get bearish on Wednesday despite an okay debt auction in Italy as eurozone fears never fail to haunt the market.
This is refreshing honesty from reporter Chao Deng, for whom I predict great things! She understands some key principles:
Not every move needs an explanation;
There are no delayed reactions;
There is a never-ending quest to explain every move;
Some moves are basically random and/or unexplainable.
This is consistent with her basic professionalism and her article in the Columbia Journalism Review. (I had a minor inspirational role in this, but it is 99% hers). Here is a brief quote:
When reading a typical stock-market story, one that says something like, “Futures Gain Ahead of Obama Jobs Plan,” did you ever think to yourself: “How do we really know the market move had anything to do with the president’s jobs plan? Says who?”
Says me.
I’m a markets reporter. It’s what I do.
Read the whole article. She explains the problem in interpreting the news.
The Sign of the Apocalypse in Financial News
To understand this, you need to get the context of today's trading.
Let us suppose that the Dow is down a buck thirty. There are only a few stocks fighting the market. The "B team" is on the job at CNBC. One of the pretty ladies has to point to each of the winners and say something. What should she say?
One of the winning stocks was Weyerhauser (WY), fighting the "risk off" tide. The CNBC anchor noted that Seeking Alpha featured an article explaining five reasons that Weyerhauser might move higher.
I was intrigued. As a long-time contributor to Seeking Alpha I was delighted to see that CNBC was showing some respect. I looked for the article and found something that was published the prior day. It was written by an anonymous author. I hope that CNBC continues to feature Seeking Alpha, but the process should be more disciplined.
I have no opinion on the merits of the article, but it is obvious that it had nothing to do with the stock strength today. My point is that even the biggest media sources will reach deep to find an explanation for an unusual stock move.
And finally -- if something good happens for the company at some point, there will be a technical analyst who will tell you that today's trading signaled something big!
Investment Implications
I have been advocating the approach favored by NFL offensive coaches -- Take what the market is giving you!
For new accounts I spent today buying great dividend stocks at low prices and selling calls with inflated premiums. There are many such examples, but don't start with a list of the highest yields. Look for good yields, good earnings growth and reasonable payout ratios. I recently mentioned Abbot Labs (ABT), Johnson and Johnson (JNJ), Intel (INTC), and Microsoft (MSFT) as candidates. There were some excellent new choices today, but I am still shopping for clients. This is a happy hunting ground for yield-oriented investors.
In the absence of fresh bad news from Europe, stocks managed some solid gains last week. Our trading model, Felix, reflected greater confidence than most traders and investors (including me).
As noted last week I plan to focus on year-end matters, as well as enjoying time with family and friends. This is a somewhat abbreviated version of the regular weekly update. I want to provide continuity on the indicator updates, as well as capture important events in real time.
There was plenty of news, but I will highlight only a few items.
Background on "Weighing the Week Ahead"
There are many good sources for a comprehensive weekly review. My mission is different. I single out what will be most important in the coming week. My theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week's Data
The economic data was mixed, but the most important were positive. Initial jobless claims continued the downward trend, covering the period that will be part of the monthly employment survey. GDP was revised lower, but the third quarter now seems like ancient history. Personal income and spending were weaker than the recent trend.
There was great coverage of these stories from my favorite sources, and I'll get back to highlighting that in two weeks.
Europe
Europe remains the big story, dominating everything else. This is the single most important thing to understand, for both traders and investors. It might start to be a case of the "dog not barking" for those who know their Sherlock Holmes. In the absence of fresh bad news, the market seems to have an upward tilt.
There was a developing story this week that is still given short shrift by many observers: the recognition that the European "solution" will be incremental in nature. Regular readers know that I have been a lonely advocate for this position for many months (as noted in this new summary of articles). I forecast that there will be no magic bullet and no single meeting with a comprehensive plan. I anticipate that we will observe a gradual process of compromise and negotiation. Eventually this will include many programs and participants. The result will be messy and will not please everyone. My time frame for general recognition that this is "working" is mid-2o12. I put "working" in quotes because the underlying problems will linger for years after the situation is no longer viewed as a crisis.
This type of policymaking is viewed disparagingly by the current market punditry. It is actually a classic and respected approach, dating back to Charles Lindblom's 1959 article, The Science of Muddling Through.
This week there were several new members in what I am going to call the "Lindblom Club."
Mark Mobius says that the Euro crisis could be over by June and that it is easier because the UK will not be involved. There were widely publicized articles quoting Mobius as predicting a disaster from derivatives. Joe Kernen does a nice job, going right to the heart of the story with his questions. The entire video is worth watching.
Doug Kass, also giving credit to Steve Liesman, writes as follows:
Despite the anxiety in the markets and the downside risk to the world's economic growth entwined in the European debt crisis, I remain of the view that a credible plan to stem the debt crisis in Europe has just begun and that European and global leaders and central bankers will all come to their senses and intervene in a massive way.
I expect more members in the Lindblom Club as the weeks go by. There may never be a magic moment, but the story will gradually shift.
The Indicator Snapshot
It is important to keep the weekly news in perspective. My weekly indicator snapshot includes important summary indicators:
An Economic/Recession Indicator. I am evaluating several candidates. None confirm the ECRI forecast of an inevitable and imminent recession. These are sources that have a similar track record, greater transparency, but less PR. I realize that I am (long) overdue for making the choice for a new indicator. It has been a careful research process, and I expect the explanation to require multiple articles. Meanwhile, if something really bad were taking place, I would make it clear in the weekly updates. From the strongest candidates, I see the recession odds over the next nine months as being less than 25%.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. We voted "Bullish" this week.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
There are few important reports this week. I am mostly interested in initial jobless claims and the Chicago purchasing managers index (as a hint about the ISM report). For anyone who is interested in real-time commentary on these reports you can check out my new "investment diary" at the Wall Street All-Stars site. Some readers informed me that there was some kind of hacker attack leading to a virus warning. The team there has cleaned up the problem, so please check it out again.
Trading Time Frame
Our trading accounts were fully invested last week, starting with a partial position on Monday afternoon. Before that Felix had high ratings, but also high uncertainty which relegated everything to the penalty box. As I predicted in last week's update, this led to new trading positions and we were fully invested by Wednesday. This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated.
Investor Time Frame
Long-term investors should continue to watch the SLFSI. Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," but it is still high. For investors desiring this risk management approach we raised cash when the trigger hit the range. We have also been cautious with new accounts. We still do not have an "all clear" signal, but I expect the SLFSI to decline next week.
Our Dynamic Asset Allocation model maintains a very conservative posture, featuring bonds and other defensive holdings.
To summarize, we have a very conservative approach in most of our programs, recognizing the uncertainty and volatility. For new accounts we are establishing partial positions, using volatility to buy favored names and selling calls for those in our Enhanced Yield program.
Take what the market is giving you.
[Interested readers can get information which you can use for your own investing and/or consider us for some help -- our approach to limiting risk, coaxing out more yield, and exploiting the current opportunities. This includes a description of how to do a year-end tuneup. Write to main at newarc dot com -- no charge, no obligation, and respect for your email privacy.]
Conclusion
Repeating my prediction from last week:
Trading volume will be lower
There will be less political activity and speech-making
The reduced volume sometimes exacerbates big moves, so I make no guesses about volatility.
A Final Investment Thought
When I talk with individual investors, most of them are struggling with headline risk. They also are bombarded with stories about how the market is overvalued, earnings estimates are wrong, and the world is in a permanent state of disarray, led by poor leadership everywhere.
As someone who lived through Nixon, Vietnam, a cold war where nuclear destruction was a daily possibility, interest rates in the high double-digits, and many other challenges, I am shaking my head in disbelief.
By my standards, the world is a better and safer place. Opportunities are greater in both work and entertainment. The potential for personal productivity is huge. The comical Washington scene is no worse than it has ever been. Hasn't anyone ever heard of Will Rogers?
"A fool and his money are soon elected."
....and too many others to count. This is nothing new.
What has changed is the way we observe and parse news, and the link between that and our investment decisions. If you want to read one thing during the holidays, check out this article by Chuck Carnevale, who shares my relentless focus on fundamentals. While the article provides a nice uplifting message, it also includes a shopping list of 100 cheap stocks -- a nice Christmas gift from Chuck.
Here are the first ten (alphabetical) stocks on the list, just to illustrate the valuable information in the table.
I own two of these names for different programs (ABT and AFL) and many others from the rest of the list.
I have explained this on several occasions and promised more detail. After listening to countless talking heads talk about the QE II rally, we need some clarity.
Background
There are two views of the world:
Gains in various markets are all the result of Fed policy and things will reverse as soon as Fed policy changes.
Stock market gains have resulted from improved fundamentals.
Viewpoint #1 gets most of the attention, especially when the market sells off a bit. The second viewpoint is almost a state secret. Too many people confuse actual market fundamentals with what they call "headwinds."
The Facts
If you really want to understand market fundamentals, you need to consider valuation, risk, and future potential. I discuss these concepts every week in my Weighing the Week Ahead series. Today I want to consider a longer time frame.
My approach is very simple and based on hard data. It is easy to understand. It is contrarian since most traders and pundits want to use words and anecdotes rather than data. Here is the key table.
Let us consider each of the three key elements.
Valuation
I use the one year forward earnings from the "bottoms up" estimate from Thomson/Reuters. Many critics take the inconsistent position that forward earnings are too optimistic, but explain the typical 70% beat rate by saying that estimates are guided down. I have written about this at length and challenged the skeptics. I maintain that there is a point where forward estimates by bottoms-up analysts are quite useful -- the best we can do. That point is approximately one year ahead. I continue to invite any loyalist for another method -- particularly those espoused by Hussman or Shiller -- to show that they can predict earnings one year in advance with greater precision.
With this in mind, the "Jackson Hole" forward earnings yield was 8.31% and it has declined to 7.74% now. When compared to the ten-year yield (interest rates in the table) the risk premium was a huge 5.75% last Fall and is still 4.61%. On a long-term basis this is a juicy premium unless risk is huge.
Risk
When considering the yield premium, you need a way to evaluate risk. Most people do this by producing a laundry list of unquantified (and maybe unquantifiable) worries. I choose to focus on data. An excellent candidate is the St. Louis Fed Stress Index, which uses 18 different data series. The methodology employed isolates the specific contribution of each factor. These are not government measurements, but actual market data. It is a sophisticated way of letting the market speak to you. It was also a great method for spotting problems in 2007-08.
At the time of the Jackson Hole speech the SFLSI was at a worrisome .69 level. (1.0 is a one standard deviation change. I am doing reserach on the best warning level). Right now the SFLSI is in negative territory. Simply put, if you measure risk in objective terms, it is vastly different from last fall.
Potential
I view economic growth as the potential for future earnings. While the market is not a GDP futures contract, it does have a good long-term relationship with economic growth. Stocks famously have predicted ten out of the last three recessions. There is incessant skepticism, for political, mercernary, and publicity reasons. Let us compare then and now.
Last August
The ECRI growth index was at negative 10. Many widely-publicized pundits insisted that this never happened without a recession. Double dip was on everyone's lips. Nearly everyone ignored the ECRI's own interpretation.
Now
The ECRI growth index is in positive territory and has stayed there for many months. A realistic estimate is a continuation of modest growth, but only extremists expect a recession in the next year. The perma-bears of last autumn have fallen silent.
Briefly put, the potential is much better.
Conclusion
For those of us looking at data, it is so easy to understand the stock market rally. The big question is why the market has not moved even higher. I see many specific stocks that are more attractive than ever on a P/E basis, even if the prices are higher. (JPM, AAPL, and CAT are among current choices).
This article has emphasized the real reasons for the rally, but I still expect to write about some of the alternative explanations.
In an era where many data series have moved higher, it is easy to find strong correlations. While most people pretend to know about the difference between correlation and causation, very few market studies demonstrate the ability to distinguish.
A Final Thought
I have tried to interest various economists in discussing the QE II effects. Most are completely uninterested because they only see a few basis points of effect. When I explain that traders and financial television (not to mention the conspiracy sites) are completely focused on this, they just express amazement.
Yale Professor Robert Shiller is widely celebrated for his Cyclically Adjusted Price Earnings (CAPE) ratio. The method uses ten years worth of trailing earnings to account for the business cycle. This allows you to have a "normalized" growth rate. Prof. Shiller has created a database going back into the 19th century.
To my surprise, many of the skeptics in the trading community that would normally disparage such an effort as an irrelevant ivory tower enterprise have rushed to embrace these findings.
There has been a recent debate about the Shiller method. I was not going to comment-- what more is there to say? -- but a recent joint appearance of Professors Shiller and Jeremy Seigel created new and important information. No one else seems to have noticed, perhaps because you had to go through 45 minutes of painful political diatribe to get to the main act. Through the wonders of TIVO, I have done the work and you can enjoy the result.
I'll start with some background on my own interpretation, give a nod to the current debate, and then highlight the key conclusions from the exchange.
The Best Interpretation of CAPE
Since I know that most people do not follow the links and read background, I am going to quote my own article from a year ago. Regular readers understand this theme, and I hope they have joined me in profiting from it.
...right at the market bottom, I wrote an article reviewing the various approaches to valuation and explaining why they would be no help. You needed to step away from backward-looking methods.
A Small (but humorous) Digression
The earnings debate reminded me of an article from decades ago. One of my favorite sportswriters, Pete Axthelm, wrote for the New York Herald Tribune and Sports Illustrated. He brought sports to the masses through Newsweek and also wrote some highly-regarded books. Last year he was inducted into the US Basketball Writers Hall of Fame. He died, far too soon, at age 47 in 1991.
In the days before computers, one of Pete's columns reviewed a system for betting on NFL games. It was a betting wheel, with cardboard overlays and windows. You lined up one wheel for the point spread, another for the difference in team winning percentage, and a third for.....well, you get the idea. Then you looked at the "result" window and it said either "Bet" or "No Bet." Pete's review tried all of the games for that week and he kept getting "No Bet" as the answer. That was probably good advice, but it was frustrating for a man of action. He also was the handicapping expert on some of the networks. His conclusion was that the device must have been put out by Gambler's Anonymous!
We can now see that this was one of the first examples of multi-variate data mining, a precursor to modern predictive methods in sports and the markets.
The Modern Equivalent
What brought this to mind was the many reminders about how over-valued stocks are if you look at trailing earnings. You can see the Shiller PE ratio in many places, but I favor this chart.
You can see that this approach will make sure that you get a chance to buy stocks every thirty years or so. The author of the article suggests that forward earnings are "notoriously unreliable." True enough. When Pete tried to pick next week's football games he was only about 50-50. Even a small edge made a lot of money, but you would have to call the forecasts "unreliable."
Meanwhile, the scores of last week's games are available in the newspaper. Unfortunately, the betting window is closed.
For those participating in the stock market, the earnings season will be important. For those who are convinced that stocks are overvalued because of write-downs in 2008, you can wait a long time for those earnings to roll out of the ten-year window.
The Current Debate
Here we are -- a year later -- and little has changed. Many highly-regarded sources (John Hussman, Henry Blodget, David Rosenberg, and Doug Short come to mind) write repeatedly about excessive market valuations. The Shiller method is the key piece of evidence.
The message, as interpreted by others, is that this is a dangerous time to own stocks. Shiller himself is on record predicting only a 1.3% annualized growth rate for the S&P 500 over the next ten years.
A well-staged discussion can provide fresh information. Challenged by Kudlow and Siegel, Shiller stated the following:
A young person with a long time horizon should have a 50% stock allocation. (This is a dramatic deviation from most interpretations of his findings).
The market bottom in 2009 was not really a great time to invest. It was only a little better than average.
If you want to make a big commitment, you should wait for times like 1981. (He did not mention that this would also require a double-digit interest rate).
You can verify all of this by watching the video, especially after the 4 minute mark.
Conclusion
The real test for the equity investor is not overall market valuation, but finding attractive stocks and sectors. For those of us who look forward, there is an abundance of choices. Many names are cheaper in earnings terms than they were two years ago. Meanwhile, the exaggerated use of Shiller's findings has contributed to a big whiff for the average investor.
Tadas Viskanta, ...(Y)ou have to have a system that gets you in and out of the market based upon your own signals and not pay attention to what other people are saying.
I could not agree more! The quotation is from today's screencast at Abnormal Returns, a brief video that I watch and enjoy every day. The cited text comes at the 2:10 mark or so, but you should really watch the whole thing. The links are also informative and fun.
[Regular readers of Abnormal Returns will notice that I have shamelessly ripped off their daily introduction to let Tadas have a turn at being the source of the "quote of the day."]
Inspiration
Like Tadas, I am not a big fan of round numbers or anniversaries, but his screencast inspired me to compare today's market with what we saw two years ago. I have done a few pieces like this in the past, but this was an occasion to be more systematic and to spend a few hours doing additional research.
The table below shows a summary of the method that I use to "have a system" and to ignore the noise. It combines value, future prospects, and risk.
There is room for improvement, but it helps me stay on the right side of the market.
I am going to discuss each of the categories in turn. The result, a doubling in stock prices, is what we seek to explain. Let me explain the other factors.
Value
There is something about discussing market valuation that generates passionate responses. Regular readers of "A Dash" know that I have provided solid evidence that the bottoms up projections by analysts are the best predictor of next year's earnings. I have a continuing invitation to those advocating alternative methods to provide any evidence. [Here is the article where I discussed the misinterpretation of the widely-cited McKinsey study.] So far I have no takers. This is something to keep in mind the next time you read someone assert, without evidence, that analysts are "too bullish."
Everyone who picks stocks looks ahead, starting with what they expect the earnings to be. The sum of this individual analysis of stocks is reflected in the valuation of the market. Who knows? If Ben Graham had lived in the era of sell-side analysts he might have improved his backward-looking method of forecasting earnings. My guess is that he would have employed the best available information, had it been available.
In the table above I have also provided data for those who (mistakenly) prefer to look at past earnings instead of looking ahead. I have also added interest rate comparisons.
The forward P/E for the market is now 13.5 compared to 10.8 in 2009. The trailing P/E comparison is even worse -- 15.8 instead of 10.3.
Many pundits thoughtlessly cite average P/E multiples without regard to interest rates. Since every major pension fund manager has a daily choice between stocks and bonds, the comparison is of obvious necessity.
The table shows two interest rate comparisons -- the rate for investment-grade corporate bonds and the ten-year treasury note. The former provides a comparison for those willing to take the risk of corporate failures and the latter an indicator of perceived risk in the system.
By this measure, stocks are 20% undervalued now and were only 12% undervalued in 2009. Another way of looking at this is that investors in corporate bonds have also done very well in the last two years.
The valuation disparity is quite different when compared to the ten-year note. The stock risk premium is still 100%. This is large by historical standards, but only half of what it was in 2009.
Future Prospects
The stock market is not a futures contract on GDP. Having said this, the prospects for the economy are the biggest single input for expected earnings. There is a real challenge in finding forward looking economic indicators. The Economic Cycle Research Institute has a good record and a widely followed forecast.
In 2009 their Weekly Leading Index was a meager 105.5 and the growth index a negative 23.7. Today the WLI is at 105.5 and the Growth Index a postive 6.5. While the ECRI does not look ahead more than six months or so, the economic prospects look good. This is confirmed by other professional economic surveys.
The economic future looks much better than it did in 2009.
Risk
I evaluate risk using the St. Louis Fed Stress Index. This method is objective and market-based. If a doomsday pundit is telling you to worry, and the concern is not reflected in any of the 18 factors in the SLFSI, I recommend choosing the data over the anecdotes.
In 2009 the SLFSI was at 3.88. This is measured in standard deviations, so it was a true black swan. The chance of this happening is about 0.5%. An intersting comparison is the maximum stress from the prior 90 days, which I show in the change in the level. The prior high was at a 3/1000 percent extreme.
The current readings are quite normal -- very close to the middle of the distribution with a mild decline from the high in the last three months.
The future also looks less risky than it did in 2009.
Investment Conclusion
The overall conclusion from this analysis is pretty clear. This is a better time to invest than it was two years ago. The valuation is a little lower, but the risk is much, much lower. Risk-adjusted return is our goal.
I realize that most readers will disagree with this conclusion, but that is only because they already know what happened to an investment in 2009, and they are skeptical about the future.
Many would also have been skeptical in 2009. This is the challenge of looking ahead. Investors need an objective, data-based method for cutting through the noise.
You might want to consider my Value+Economy+Risk approach. I write about this method nearly every week in my "Weighing the Week Ahead" series. I also have a risk-adjusted program for clients, where I pay special attention to what might go wrong. You can do the same at home by following the indicators I have outlined..
One More Thought
One more factor that I cite is the need for a list of widely publicized worries. Most investors are big losers because they react to market "headwinds" by selling. The gradual meeting of worries has been the story of the last two years. We continue to have a long list of worries, highlighted every day. When this is no longer true, it will be a warning of a market top.
As compelling evidence the Abnormal Returns article provides a link to an entertaining article on Clusterstock, reviewing the bearish punditry of the last two years. As you read through the past predictions, you might well notice that most of those cited are offering the same advice now as they did then. A little research will show that they are often hailed as "early" predictors of the financial crisis, which means they were bearish as early as 2005 or so....
What better evidence can there be for the quote of the day?
What if I told you that you could spend 30 minutes and get a much better perspective on the market? For most investors this would help them at a time many see to be a crossroads.
Here is a chance to learn from one of the best.
Ray Dalio is the manager of Bridgewater, the largest hedge fund. Dalio started the fund in the 70's. Despite his success he keeps a low profile. Many average investors have probably never heard of him. Bridgewater now has almost $90 billion under management after a gain of nearly 45% last year.
Normally we would not hear much about Dalio's thinking. There was a recent article about the "culture" of the firm. Apparently it inspired Dalio to make a response via a rare public appearance. Having agreed to the interview, he also discussed various other topics.
In over 20 years of CNBC watching, this may be the most unusual interview I have seen. It takes almost thirty minutes, but I guarantee that anyone watching with an open mind will learn something. In fact, I recommend watching it twice.
Here were some points that I found to be interesting, enlightening, and refreshing.
The Squawk team showed some respect, allowing Dalio to speak for several minutes at a time without interruption. If records were kept, he might have the top three uninterrupted sequences in CNBC history -- all in one interview. "Do you want me to explain this?" he would say.
Dalio would not be pushed into the "popular" position. He was outspoken in praise for the Fed's actions. He explains what would have happened otherwise.
Dalio sees a gradual loss in status for the dollar -- moving from THE reserve currency to one of the reserve currencies. He also views gold as a currency. He thinks that major market players are under-invested in assets denominated in emerging market currencies and in gold.
He sees current government policy as gradual deleveraging when the country can print money. He cites the UK and the US as examples. Entities that cannot print money must restructure in a painful process (Greece, California). He thinks that taking the pain slowly, 3% over ten years, is sound public policy.
He likes US equities for this year and probably next year, calling it the "sweet spot" of the cycle.
He sees stocks as attractively valued. (No one asked him to refute the assorted methods asserting otherwise).
And here were my favorite themes, all familiar to regular readers of "A Dash."
He specifically avoided judgmental or political comments. He emphasized that he made money by predicting what policy would be and how to profit.
When asked about something where he was not an expert, he said so! This is a rare occurence on financial TV. Most guests think that once they are on camera, they are experts on anything. Dalio specifically avoided predictions on municipal bonds. If only others would follow this refreshing example.
Investment Conclusion
I suppose that part of my enthusiasm for Dalio's interview is that many of his themes are my own themes. Most investors would do well to consider the vastly different mind set of this successful manager. He is not complaining about the Fed, market manipulation, distorted stats, or any of the eyeball-attracting Internet themes. He is just quietly making money for his investors -- lots of it.
He is not searching for disasters or the next black swan. He is focused on the main investment themes. He is looking forward, not at what happened in 2008.
My personal takeaways are to be open-minded about gold and emerging market stocks. I include both in the ETF program, but perhaps I need to be more aggressive.
Since I started regular posting in December of 2005, I am going to declare this to be my five-year blogiversary. The posts were a little sporadic in that first month, but I was trying hard to explain my purpose. Here is a quotation from an early article:
It isn't difficult to convince investors that stock prices are volatile. Something less known, though, is that corporate profits fluctuate even more. Using a ratio of these two volatile measures is sure to give you misleading signals now and again.
The misleading signal often comes near the end of recession, when earnings plummet. During the 1991 economic recession, for example, the composite earnings of the companies in the S&P 500 fell by 27 percent to about $16 a share. Their stock prices actually rose during that period, as investors looked ahead to better days. The P/E multiple quickly soared to 26 from 15, as earnings fell and prices rose. Since a P/E of 26 is high compared to long-term averages, investors focused on this ratio would have likely missed the beginning of a nearly decade-long rally.
The P/E multiple is much lower now, even though we are at the end of a recession, so the advice should carry extra weight. Regular readers know that I have taken a consistent and disciplined approach to fundamental market valuation, so I suspect that few will be surprised at this quotation.
My own take in 2005 was a bit different. I questioned his failure to incorporate changes in interest rates as part of his valuation model. Here was my position:
Unfortunately, his method ignores interest rates. In a couple of the low PE examples he gives, like 1974 and 1982, stocks should have a low PE since interest rates were in double digits. Just ask yourself: Would take an 8% return from stocks if bonds had a rate of 12%? What if the bonds were 4%?
Experts may disagree about how to incorporate interest rates into analysis, but there should be no debate about whether to do so.
The Hussman approach to fundamentals still does not recognize the importance of interest rates as an alternative asset class.
Five Years Later
During the ensuing five years I have written many articles about stock valuation, often emphasizing the differing time frames. My position, recorded weekly, has changed with the circumstances. Quite frankly, I expected John Hussman to be a big winner at the end of the recession. His "peak earnings" concept was going to come into its own. To my surprise, instead of cashing in on his theory he did something that I abhor. He arbitrarily discarded some of his data, the time period that did not fit his multi-year market opinion.
Let's be completely clear about this. Anyone who reaches far back into the past has many time periods of data that are dissimilar in many ways. If you take some recent period that you do not like and throw it out, meanwhile not giving the same examination to the rest of history, it is cherry-picking.
We can all make post-facto decisions to throw out data that we do not like, but that is not part of the researcher's creed. I now see an article where he has used multiple variables to find something that he calls a "Who's Who of Awful Times to Invest." Big problem! He has changed the variables from his original 2007 article, which you can check out here.
It is easy to look at past data and a large number of variables and back-fit a result, especially if you keep changing the independent variables. If you have a big staff it is even easier. The real test is whether the methods that were specified in advance -- that would be the methods written about in 2007 -- actually worked. It is perfectly acceptable to change methods if circumstances warrant, but you should not pretend that it is simply an "update" of a past approach.
An Alternative Viewpoint
The Hussman viewpoint is one of the most popular reads for individual investors and for investment advisors. By email I received an update from Georg Vrba, P.E. Georg has written some fine articles drawing upon a number of variables to improve on the buy-and-hold approach. Here is an example. Georg kindly mentioned my article demonstrating why an increase in the forward P/E multiple is merely a return to normal.
I hope that Georg will publish his results soon. To summarize, his methods confirm the first nine Hussman examples but disagree violently with the current case. How interesing!
A Warning
I know that my readers include many Hussman fans. I also enjoy reading his analysis. This is really about methods and changes over time. I am stating in advance that I am too busy with year end analysis and forecasts to do a detailed debate in the comments. I will read and note arguments. Next year I'll take another look, but I am not going to engage in instant rebuttal.
Market relationships differ depending upon the time frame. Right now, higher bond yields are bullish for stocks. This article explains why.
The most important question for equity investors relates to rising interest rates and the implications for stocks. Nearly everyone (including us) agrees that long-term rates are moving higher. That has been the recent move and it implies significant capital losses for those holding long bonds. Here is a nice analysis of the risk by John Lounsbury.
Several pundits have weighed in on the effect of an interest rate increase. Let us take a closer look.
Background
On a theoretical basis, lower interest rates are bullish for stocks. Companies can borrow more cheaply. The choice for those doing asset allocation tilts toward equities. The data support the traditional stock/bond relationship --- usually.
But these are not typical times. Higher interest rates may be consistent with higher stock multiples. Abnormal Returns covers the topic and also highlights other sites on bond yields. I want to go beyond the generalized arguments and look to some strong supporting data.
Exceptional Periods
There are circumstances where the relationship is reversed, when higher bond yields are actually correlated with higher stock prices. Several commentators have suggested that this might be such a time, but I always like to look at the data.
We have seen this before....
We had a similar situation in 2004. A top analyst from a major firm, drawing upon the help of his entire team, developed a regression model relating bond and stock prices. The research team facilitated their analysis by throwing out data that did not fit their thesis. As usual, it was a mistake to begin the research with a pre-destined conclusion in mind.
This research was actually one of the things that inspired me to start blogging. I figured that if the proprietary research by big firms has such major flaws, there had to be room for people who had strong and discplined methods. You can check out my old article (one of my favorites) by looking for the initial reader challenge here (no one solved the problem then, and you won't now) or the full exposure of the big firm's blunder here.
If you want to see the entire logic -- and you should -- check out the full article. It required more hours of research than any other piece I have ever done. Meanwhile, here is the key finding:
The relationship between stocks and bonds is curvilinear. In the "normal" range of interest rates, stocks and bonds trade as expected. When interest rates fall to a an extremely low level, the relationship breaks down. Why? The very low interest rates reflect deflation concerns and extreme skepticism about earnings from stocks.
Here is the relationship:
The historical data show the relationship between stocks and bonds. The chart highlights two distinct anamolous periods. Please note that I am not just throwing out data. Analysts (and readers) are free to draw whatever conclusions seem appropriate. The chart facilitates your analysis rather than forcing you into a conclusion. If you read the entire article you will see five different views of the same data. It shows the difficulty of the task.
My Conclusion
The evidence shows a long-term relationship between the forward earnings yield and bond yields. This is what we would expect.
When bond yields get very low, the relationship breaks down. This also makes sense. Yields have been very low twice in the last decade, both times when there were extreme deflation fears. Under those circumstances there is intense skepticism about future earnings forecasts, so the multiple is low.
Investment Conclusion
We are currently at the unusual tipping point in the relationship. The emerging consensus about improving economic prospects is having two effects: higher long-term bond yields and more confidence in earnings.
The implication is that stocks will get a higher multiple in 2011 as confidence improves. This is not merely speculation, but a conclusion based upon the data cited.
If the market were to embrace this traditional relationship, the forward earnings multiple would be in the 20's. This suggests an S&P 500 value that is 50% higher (or more) than current levels.
I am not making this as a prediction, since the climate of fear has cast a negative spell upon earnings. Who knows how long this will last? I have often suggested that low market multiples are the best single gauge of investor sentiment. I do predict that the path of least resistance is higher, and it could be much higher.
The summary:
Higher bond yields imply more economic confidence and a higher stock multiple.
You heard it here first, including when I highlighted the topic in the gloomy days of August.
Investors have very different needs and concerns. Broadly speaking, I classify people between those more interested in preserving wealth and those trying to build wealth. There are other considerations, but that is a good place to start.
Many investors of both stripes now wish they had bought the market in the Spring of 2009. As stocks rallied, there were three distinct choices:
You could decide that you had "missed the bottom." This meant that you would sit on the sidelines, perhaps forever, because you could not get over your initial mistake.
You could accept the fact that you were not a big-time risk taker. You wanted to see evidence that there would not be a great depression. At some point you decided to climb aboard.
You are still trying to decide.
Those taking Path 2 did great on a total return basis, making 32% plus dividends, but it required buying at a point of near-maximum risk. It iss OK to be cautious, especially if you are preserving wealth. The Path 3 investor has an opportunity that equals that of 2009 on a risk-adjusted basis.
Let us look at the data.
Getting a Second Chance
Usually we do not get a "do-over" in life. Because of the pervasive negative sentiment about politics and the fear trade, the opportunity to buy traditional investments at good prices is still there.
T0 understand this, you must ignore absolute prices and forget about the fact that you did not buy the market in 2009. That is all history. Where are we now?
5/8/2009
12/8/2010
S&P 500
929.23
1228.00
Forward 4q eps
60.47
91.98
Forward P/E
15.37
13.35
Inverse of Forward P/E
6.5%
7.5%
L-T eps growth rate
7.0%
7.0%
10-year Treasury yld
3.2%
3.2%
Difference
3.3%
4.3%
Stock prices have rallied, but earnings estimates have done even better. When you compare the market to the bond alternative, the yield differential is striking. Regular readers know that I have produced unrefuted evidence that one-year forward earnings estimates are excellent.
Briefly put, if you have waited for a favorable risk/return to buy stocks, the time has come.
Investment Conclusion
Buying stocks today has more upside than at the bottom in the Spring of 2009. Since many of the major issues are off of the table, there is even less risk. Since many issues remain, stocks are still cheap.
The table shows the S&P 500 averages. Successful investment advisors who have beaten these averages over a long time period may do even better.
There is an extra kicker. The political dynamic has changed for the better. As I noted in my weekly review, the tax and unemployment benefit compromises have dramatically improved the prospects for economic growth. This will immediately help corporate earnings and eventually help the deficit projections. Some market sectors will benefit more than others.
There are many elements of conventional Street wisdom that are completely wrong. One of my missions at "A Dash" is to challenge what many find to be obvious.
As we embark on a new earnings season, a consideration of how we think about earnings may be especially helpful.
As background, here are two elements of Wall Street Truthiness about earnings:
Companies and analysts are widly optimistic about forward earnings.
Companies lowball earnings expectations so that they can deliver an earnings "beat."
The astute readers of "A Dash" will immediately see that these widely-held beliefs seem to be inconsistent. Many of those in the financial punditry happily advance both arguments -- but not in the same post.
There is an obvious explanation. At some point there is a "crossover," a point where the forward estimate is accurate. If both statements are true, we know that estimates are accurate at some point, so when does the crossover occur?
Background: My Viewpoint
My contention is that most people are making a big mistake by dismissing forward earnings. If people form a negative opinion about a source of information, they just tune it out. My approach is to embrace many sources, but be careful to define the happy zone for each.
In the case of stock analysts, I have some fairly strong opinions. When I began in the business in 1987, making the transition from the academic world, I enjoyed reading widely. Since my company had access to research from many sell-side firms, I would often read twenty analyst reports on a single company. Most of the reports sounded the same, like something that might have been written by one of my old students. As I learned more about how analysts were recruited, I realized that my perception was accurate!
The reason for reading many reports on the same company was to discover who had a different idea - -something unique that others had missed. It was a valuable exercise.
In my most successful investment program one of the factors is an excessive reaction by analysts. I have studied thousands of reports, always with a skeptical eye. I like to be on the opposite side of the upgrade/downgrade cycle.
For these reasons I find it amusing that some readers -- people who have never actually read a report, relying soley on someone telling them about an "upgrade," insist that my use of analyst data is "naive." I mention this only to show the grip that preconceptions have on our thinking.
My position is that we should look at each source for possible useful information. The army of stock analysts is very good at doing one thing:
Analysts' forward earnings estimates are very good for a one-year time frame.
The Common Mistakes
A few weeks ago I wrote a piece arguing that forward earnings estimates were better at forecasting future earnings than were the popular backward looking methods. I was quite surprised by the reaction. You would think that I was writing about religion or politics!
I am always delighted to have comments, but none of the commenters engaged me on the proposition raised. Not a single one showed that Shiller or Hussman or anyone else who specializes in a 20-20 view of the past was better at forecasting future earnings. They all skipped ahead to a discussion of stock valuation.
To emphasize, in the forward earnings series I am taking this one step at a time.
Earnings are important. Eventually, stock prices reflect the fundamentals. If you do not understand this, you should reach some of the work from Chuck Carnevale, whom I have cited on several occasions.
If you have a better estimate of next year's earnings, you will have an investment edge.
The consensus forward estimates are the best method of looking one year ahead. I do not know of any better source. Suggestions are most welcome, but use evidence.
These three points are the current agenda. In a future article I'll discuss more about ways of using the information, but there is only so much you can do in a single piece. This article, and the related research, took about 25 hours. It would be easier (and generate more page views) to post a breezy opinion piece every day. My approach is more valuable for investors who will take the time to read, and to keep an open mind.
So please -- be fair! If you want to be a perma-bear who is waiting for the Shiller method to signal another era of single-digit P/E ratios, that is your privlege. You are not an investor. You are a spectator. Unless interest rates go to 16%, you'll never see it. You are not trying to forecast earnings, and you basically have no winning investment options.
Why People are Going Wrong
One of the reasons so many people are mistaken about forward earnings is the widely-cited study from the McKinsey Quarterly. Scores of blogs have shown the key chart from this. Since it confirms everyone's pre-existing viewpoint, no one bothered to consider the dilemma I posed at the start of this article.
I want to be completely clear that McKinsey is focused on unrealistic long-term expectations for companies that include their clients. The article talks about 3-5 year growth forecasts. They do not address forecasts in the one-year time frame. The authors responded to a preliminary inquiry in my research for this article, but they did not respond to questions about the "crossover" or the one-year time frame. Most of the people citing the article are taking the McKinsey conclusion and incorrectly applying it to a one-year time frame.
Here is the McKinsey chart:
McKinsey does not explain the scale on the vertical axis, so we do not know the meaning of EPS. Their main point seems to be the general downward path of estimates. They do not attempt to explain the fact that 2/3 of the companies beat estimates. We have no way of checking this research, since unlike academic researchers, they are not sharing the data.
I can do better. I myself have some of the Thomson Reuters data and a friend has documented other years. Here is my own chart for the time period that I can verify.
While my data do not go back as far in history as McKinsey's, I think the information is more accurate in showing the final earnings result (months after the calendar year ends) and showing recent years.
There has also been a change in behavior in the post SOX era. Companies and their accountants have become more accurate.
Since the squiggles are difficult to interpret, let me focus on forecasts for the twelve-month time horizon. This table shows the calendar year forecast made at the start of each year, comapred to the actual result (known about sixteen months later).
These are impressive results. With the exception of the year of the Lehman failure and the concomittant economic collapse, the estimates have been too pessimistic.
Conclusion
The criticism of investment analysts typically gets a round of cheers from the investment world. It lets us all feel smug and superior.
It is more profitable to ask if there is anything analysts actually contribute. This article shows that the consensus is quite useful in forecasting earnings for the upcoming twelve months. Since most people do not believe this, the knowledge gives you a significant investment advantage.
Acknowledgements
I very much appreciate the advice and cooperation of Tom Brakke, the leading expert on analysts and earnings estimates. The conclusions here, and any mistakes, are mine, but I appreciate Tom's advice and help. He has many excellent ideas on how to use forward earnings. I hope he chooses to join in.
I also appreciate the continuing discussion of forward earnings by Brian Gilmartin of Trinity Asset Management. He always has a finger on the pulse of estimate changes.
I have requested more data from Thomson Reuters. To my surprise, they have not responded. One would think that they would want to cooperate in demonstrating the value of their research. So far, no luck.
Meanwhile, my own future articles in this series will discuss issues in interpreting earnings estimates.
UPDATE: Chart corrected 10/15/10, 1:30 CDT to reflect a few missing data points. Thanks to reader "Angel" for spotting this. (JM: My data source is excellent, but the record switched from weekly to monthly reporting, as you can see from the lines. This was the only year affected.)
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