December 20, 2013
By Steve Blumenthal
“People who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run.” Ben Graham and David Dodd in their 1940 book Security Analysis: Principles and Techniques
In November I wrote:
“What is evident today is dysfunctional government leadership, global central bankers in full throttle, debt accumulating beyond comprehension, and pension and entitlement promises that can’t possibly be met. We are living in a highly manipulated period of time. This is not normal and it is not healthy.”
If valuations were low (unlike today), the imbedded risk in equities would be far less; however, today’s Median PE is a relatively high 20.9. We are in the “people are likely to lose considerable money in the long run” category. In a picture it looks something like this:
I often wonder what Graham and Dodd would think of today’s technology. I don’t believe their approach to finding value would have waivered. What would they do today as we sit solidly in the highest PE category or quintile 5 (yellow line) on the chart above?
The reality is that when you buy something that is expensively priced, it is more difficult to make money. Are we looking at near 0% over the coming 20 quarters or 4.09% over the coming 40 quarters as the data suggests. I guess this isn’t really “considerable loss” but it might just be relative to future inflation and it might just be for the individual who sold in 2009 and is just getting the gumption to buy back in today.
Needless to say, I wish we were in the top quintile (blue line) with a historical 15.74% tail-wind at our back. I don’t think I’ll find that present under the tree this year or maybe not even next. But I believe it is coming.
The simple conclusion for the immediate future, QE or no QE, is that risk is elevated. So what is going to happen and when? Leaving the broader issues of deepening pension crisis, debt storms, tax pressures and developing global currency tensions (wars), I share some of my thoughts addressing what and when.
This piece is loaded with a number of charts so grab a coffee and dig in. Please let me know if you have any questions. Ok – Let’s look at the following:
- Present Valuations and Overvalued and Undervalued Market Price Targets
- Peak Profit Margins – Profits Do Mean Revert
- Tight Policy = Economic Contraction
- Bears and Bulls Within Economic Cycles
- Cyclical Bull Market Remains – Watch These Two Charts for Change in Trend
- Market Cycle Composite Chart – Interesting Look at the Four Year Presidential Cycle
- My Two Cents: Get Ready to Sell in 2014 (Then Buy the Dip)
- Strategic Investment Plan – Stick to Your Plan
Present Valuations and Overvalued and Undervalued Market Price Targets
There are many ways to measure Price/Earnings ratios. Some investors jump back and forth between forward estimated earnings and actual reported earnings. I favor picking one approach and sticking to it. I use the following chart from NDR as it looks at the actual (real) trailing 12-month median reported earnings and not the hoped for over-guessed, over-optimized, over-optimistic Wall Street forward estimates.
The idea here is to get a sense of where the market might be overvalued and undervalued and where it is fairly priced. This understanding can help identify both points of high risk and points of great value (alas Graham and Dodd).
The Standard and Poor’s 500 Stock Index typically performs better when the Standard and Poor’s 500 Stock Index Median P/E is below its historical median (the dotted green line in the next chart below), than when valuations are above its historical median (the overvalued line is just above the yellow highlighted circle in the next chart).
The yellow highlighted circle shows the current median PE as of November 2013 to be 20.9. The yellow box at the top left shows fair value on the S&P 500 Index to be at 1445, overvalued at 1892 and undervalued to be 997. Today the S&P 500 Index is trading at 1809.
Markets can certainly grow to be more overvalued or undervalued yet I believe that these targets represent good levels to consider when evaluating risk and potential return. At 20.9 Median PE, we are back to levels seen at the market peak in 2007/2008. Can 1892.98 on the S&P 500 Index be achieved? Maybe and it could go higher but we are walking on very thin ice.
Peak Profit Margins – Profits Do Mean Revert
History also shows that high profit margins cannot be sustained. We should be careful not to project the strong profits of yesterday forward to tomorrow. Many of the reasons are related to the dynamics of business cycles. Peak profit margins cannot be maintained and they revert back to or below trend.
Think about it this way…If profit margins are high, then earnings are high. If earnings are elevated and the market price relative to those earnings is elevated, then the downside risk when profits decline is elevated. Fearing the loss in profit and the pressure on corporate earnings, the price declines.
As the next chart shows, profit margins are higher than they were in 2007, March 2000, and 1955. In a perverse way, it is better to be buying when profit margins are weaker (see box in the upper left of the next chart). The system is primed and loaded for a significant correction. Let’s see what happens when the QE steroids are removed.
If you would like to dive deeper into why profits mean revert, I posted an excellent piece a few weeks ago on our website. Here is the link to that full piece. It is not too long and well worth the read.
Tight Policy = Economic Contraction
Another headwind facing equities is today’s tight policy. There is a tendency to hit us hard in year two of a presidential election cycle saving all the goodies for us around election time. I know that sounds a bit funny but it is true as we’ll see in the next few sections.
We don’t hear much about sequestration anymore, I guess that’s a good thing. The bottom line is that federal fiscal policy will be a drag on growth. This coupled with the Fed’s shift to taper means that policy is more restrictive than at any time since the financial crisis.
On the next chart, note the very poor gain in the economy when policy is tight. The yellow circle at the bottom right shows where we are today = policy tight. The lightly shaded gray area in the upper left of the chart shows the historical contraction associated with periods of tight monetary, fiscal and exchange rate policy.
Bears and Bulls within Economic Cycles
Of course, you know that there are business cycles. They are healthy and important. McDonalds opens on a hot corner and it is not too long before Burger King, Five Guys, or up-and-comers like the Shake Shack set their store front on the opposing three corners. Competition grows and margins get squeezed. Some survive, some fail, margins get squeezed and margins expand.
The best managed companies grow and the weak fall away. This is a very healthy and important part of the collective system. The next chart paints a visual picture and while not precise, it does give some guidance as to where we might be in the current cycle. Note the “YOU ARE HERE… OR HERE arrows.
As much as they have tried over hundreds of years, there is absolutely nothing that a single government or entity has been able or will be able to do to repeal the business cycle. Not socialism, communism, an open democracy nor a powerful central bank. Business cycles are important and they are healthy.
Cyclical Bull Market Remains – Watch These Two Charts for Change in Trend
In my best attempt to answer the when question, I believe that keeping an eye on the next two charts (especially the 13/34-week Exponential Moving Average (EMA) chart explained below). For now, the cyclical trend remains bullish (higher) though this particular cyclical bull is quite old. I think the when materializes within the next 18 months.
Chart 1 shows the 13-week EMA and the 34-week EMA. Trend change occurs when the lines cross. It has done an excellent job at identifying the bull and bear market cyclical trends.
We will monitor the cyclical trend and I’ll post this chart for you each Wednesday on our website in Trade Signals.
Chart 2 is a chart I have followed for years. NDR created the Big Mo Multi-Cap Tape Composite Model to give a disciplined composite reading on the technical health of the broad equity market. The model, plotted in the lower clip of the chart, aggregates the signals of over 100 component indicators and generates a reading between 0% and 100%, reflecting the percentage of the component indicators which are currently giving bullish signals for the S&P 500 Index.
The chart’s top clip plots the S&P 500’s weekly closes. As you can see, the current cyclical trend as measured by Big Mo remains in the bullish zone.
Market Cycle Composite Chart
Another concern of mine is the timing of the one year, four year and ten year market cycles that show 2014 to be a bumpy year. The following chart is a summary of the one year, four year and ten year market cycles and suggests an early 2014 rally followed by a meaningful decline and a year-end recover. Thus I think it important to be prepared (hedge) for a significant correction and have a buy the dip mentality.
The chart shows the early year bullish tendency and the challenges post-May. The trend is more important than level.
Looking more closely at the Presidential four year cycle; tighter fiscal policy tends to be habitual during the second year of the presidential cycle as does tighter monetary policy. With Fed taper now in play, this current cycle looks to be on course. The top section of the next chart shows an early-year rally, a mid-year correction followed by a year-end rally.
Of course, while there has been a strong historical correlation, there is nothing that can guarantee that this time will be the same. I favor the odds, but the Global Central banks are powerful and markets and humans are complex. Keep a close eye on the 13/34-week EMA cyclical trend chart.
Another point of concern is that liquidity is low. The ratio of all the cash available in money market mutual funds to the value of the stock market is down to just 12.9% versus 46.9% at the lows in 2009. We are now in the low liquidity zone where the stock market has historically lost money. Much of the money has already bought stocks.
Note the high amount of cash at the market low in 2009 and the low amount of cash at the market high in 2007. Sir John Templeton ringing in my ears, “buy when everyone else is selling”. That would have been at low PEs and high cash in 2009. Not the case today I’m afraid.
Finally, it is important to remember that markets preform well in periods of declining interest rates, declining taxes and declining regulation. Unfortunately, this is not the case today; we are in a period of rising regulation, rising tax rates and rising interest rates. Beefed up by the steady steroid injection, the stock market has become the biggest show in town.
My Two Cents: Get Ready to Sell in 2014 (or hedge) and be Prepared and Enabled to Buy the Dip
I realize how strong my bearish tilt is today. I also remember how bullish I was in late 2008. The bearish “this time is not different” call we made in 1999, the bullish buy signal in 2002 and the warnings of crisis tied to sub-prime junk and multiple tranches of Collateralized Debt Obligations in 2007. It turned out to be far worse than the -40% correction I was expecting. The total financial system almost imploded.
Here is some optimism: You can inexpensively hedge your long-term focused equity positions. Buy out of the money puts or use a collared option strategy. Here is one source to learn more yet there are many.
If I’m right about a significant market correction, then the small amount of money spent to hedge will be worth the cost. If I’m wrong and the market rockets higher, the cost to protect is a small expense.
Yes, equity participation is important. What if you didn’t have exposure to equities in 2013? Plus or minus 10% in 2014 is a safe bet but what if it is -50%? That too is possible. Given the expensive nature of the market along with the unprecedented actions of the global central banks, risk is off the charts. I believe we are in a period that favors a focus on downside risk protection. This requires some education on the more sophisticated ways to hedge and that time spent will separate you from the majority of advisors in our business.
Some more good news is to view the next big sell-off as an outstanding buying opportunity. Most secular bear periods contain three recessions. Equities drop nearly 40% on average in recession. Be prepared and enabled to buy the dip. I believe part of one’s strategic game plan is to make sure there is available cash to be in a favored position to take advantage of the coming opportunity.
The hard part in this investment game is that it takes great courage to sell when everyone is buying and to buy in the face of crisis. I believe we are within 18 months of a significant correction. The massive bubble is in the bond market and developed governments trashing their debt. Government bonds are not safe. A fall out will affect the stock market.
Thus, at such elevated valuations, elevated profit margins, elevated optimism and limited investor liquidity, we are at another important cyclical tipping point. Again, the good news is the tools exist to hedge and better manage your downside risk.
I so clearly remember the conference at the Union League in downtown Philadelphia in the mid-1980s. The great Sir John Templeton told me the secret to his investment success. I so desired to be great. I hung on his every word. Many years later and I can say I am happy I listened.
He said the secret of his investment success is that “he buys when everyone else is selling and he sells when everyone else is buying”. He added that it sounds easy but will be very difficult for you to do. I mention him frequently because I think about his sage advice often.
Ours is an imperfect business. It is impossible to get the timing just right all the time. After 30 years in the business, I’ve grown wiser. I know the very best in the game and none can do it consistently, but they do it far better than most. If you have the stomach to trade then listen to Sir John. It takes time, it takes self- awareness and it takes discipline. It is not easy.
If you are a betting person, then short the yen, load up on out of the money equity put options and short government bonds. I say sell the rallies and buy the dips. Follow investor sentiment and buy and sell (or hedge) the extreme readings.
If you are an individual investor, then broadly diversify your portfolios to include a broad selection of different risks. Avoid the temptation to COMPARE EVERYTHING YOU HAVE TO THE S&P 500 INDEX. I speak with hundreds of investment advisors and their broadly diversified global portfolios are up 10 to 17%. Rebalance quarterly or annually and stick to the strategic plan. You’ll need that diversification soon enough.
If you want concentrated bets, then buy an advanced index fund and compare that to the S&P 500 Index. Ask yourself how you reacted to the crisis in 2008. Did you sell near the market low? What about 1999? Tech stocks or value stocks? Did you raise cash in early 2000. The record for new money flows into stock funds happened in March 2000. That was the top. Are you tempted to buy in today? Chasing yesterday’s gainers is a loser’s game. I recommend emotional investor therapy and a strong advisor coach. The data is clear that investors buy and sell at the wrong time.
The very best investment advisors we work with construct broadly diversified portfolios and stick to a broader total portfolio strategic investment plan. I recommend a new form of 60/40 today. I like 30/30/40 (equities/fixed income/tactical). This reduces equity and fixed income exposure from 33/33/34 as I had recommended last year. Rebalance and add to the unconstrained tactical strategies in that third bucket.
Bonds are in one of the biggest bubbles of all time. Shorten maturities or tactically trade that exposure. If appropriate for your client, find alternative sources of fixed income and significantly reduce bond exposure. Finally, remember that in the not too distant future, there may be an opportunity to once again overweight equities. Something like 50/20/30 might replace 30/30/40.
The first chart I presented today shows the equity markets return when you buy at the lowest quintile PE. That is 14% annualized for the forward expected 4% today. As opportunity presents, shift the strategic allocation and always rebalance quarterly or annually.
We’ve had a good year here at CMG. Our CMG Opportunistic All Asset Strategy, CMG Tactical Rotation Strategy and our CMG Global Equity Strategy have all done well. The CMG Managed High Yield Bond Program has performed, much as I expected, and certainly better than the aggregate bond indices. Our targeted tactical trading strategies, Scotia Partners Growth S&P Plus Program and CMG System Research Treasury Bond Program, have underperformed but I continue to hold a favorable view towards both of the strategies. Both have had just one losing year since 2004; though that certainly does not guarantee you anything. Size properly within your portfolios and rebalance.
I’m often asked about gold and it sure was a difficult year for that asset. Such is the nature of the game – not all risk streams perform at the same time. With the ongoing and developing global currency wars, an inflation play in the portfolio continues to make sense. If you are not allocated to commodities and gold in your portfolios, then consider adding some. Both are down significantly in 2013. It may be a bit early on commodities, gold and gold miners, but I do see it as a “buy when everyone else is selling” moment.
If you have strategic allocations to both, then rebalance and stay the course. Both have had a strong run since 2000 and played an important diversifying role. Rebalance and stick to the strategic plan. A strategic investment plan should have a five year time horizon and I see no reason why gold shouldn’t be a small weighting in one’s overall investment plan.
Anyway, thank you for reading today’s Blumenthal Viewpoint. I hope you find a few good ideas that can help you as you work with your clients. I’m grateful for our relationship and wish you the very best in the coming year.
Happy Holidays to you, your family and everyone you hold close to your heart
I’m taking my not-so-little-anymore sons to one of our favorite places on the planet, Snowbird, Utah on December 27 for a few days of skiing. I am so excited as are they. There is a lot of running around ahead for me this weekend as I’m a bit behind on my shopping list. The kids are getting older, but there is still that seasonal magic in the air. Gifts, yes. They are getting bigger and their ideas are being emailed to me daily.
I lost some important people in my life this year and that leaves me with a bit of an empty hole inside that will have a tough time getting filled. I think about them often. I’m sure you have experienced the same. I know of no present they gave to me better than the love in their heart. That might just be the biggest gift we can give this year and every year.
Wishing you a very Happy Holiday and a spectacular 2014.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Suburban Philadelphia
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.net
610-989-9090 Phone
610-989-9092 Fax
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