September 5, 2014
By Steve Blumenthal
Higher we go! While valuation and sentiment data scream caution, trend data and Fed policy tells us to continue the ride. Today, let’s take a look at the latest valuation charts and an updated look at Don’t Fight the Fed or the Tape.
As you’ll see, the mean fair value of the S&P 500 Index is 1604.99 based on PE data over the last 50 years. The market closed at 2003 on August 31. Markets can go from overvalued to extremely overvalued. The idea is to get a sense of just where we are today and what future returns might look like.
Also included is a piece I wrote for Forbes this week titled, “Why Bonds Are A Buy And Everybody Had It Wrong”
In December of last year, more than 70% of Wall Street economists polled said that the interest rate on the 10-year Treasury note will end the year at 3.2% to 3.5%. Not one said the yield would be lower than 2.90% and not one said it would be higher than 4.10%. Goldman Sachs’ estimate is for a 3.25% yield by year end.
Then, the yield was 2.99%. It is at 2.40% today. Of course, there’s just over a quarter of a year to go, but the call to date is a gigantic miss.
I hope you find it both interesting and helpful.
I share the following in this week’s On My Radar:
- Don’t Fight The Fed or The Tape – When the Fed and trend are positive, stay with the trend
- A Look at Current Valuations
- Forbes – “Why Bonds Are A Buy And Everybody Had It Wrong”
- Trade Signals – Cyclical Bullish Trend for Stocks Remains – 09-3-2014
Don’t Fight the Fed or the Tape
In the following chart, note the returns highlighted in yellow. The model beats the S&P 500 by a 2.5 to 1 margin while being invested and exposed to risk only 44.7% of the time.
Both the Fed and trend evidence remain positive. Let’s keep a close eye on this chart as we move into 2015 for the most likely change in Fed policy is March or June 2015.
A Look at Current Valuations
Highlighted below in orange shows the market 19.9% away from fair value, 4.8% away from overvalued and 44.6% away from undervalued.
A 1 standard deviation move above fair value marks a reasonable overvalued level but note that the market moved north of 2 standard deviations in 1999 and again in 2003.
I believe valuation indicators are a good way to measure investment sentiment and investment risk. It can also help us get a sense of what probable forward 10-year returns might look like. Today, with high valuations we should expect low forward returns but that doesn’t mean the market won’t move higher over the short term.
You can click here for a piece I wrote for Forbes about using valuation tools as a way to measure the degree of market risk.
Much of recent earnings have been fueled by the ultra low interest rates. Corporations can borrow and buy back stock. With fewer shares outstanding and earnings flat, the earnings per share go up. Also, lower financing rates find their way into higher profit margins and better earnings. Low borrowing rates make mergers and acquisitions more attractive and achievable. Such buying demand drives share prices higher. It is important to remember that profits are highly mean reverting. It is for this reason that here too risk is high.
I believe we are at or just past the peak of the current business cycle and a default wave in the high yield market is ahead (2015 to 2020). Martin Fridson, CFA, in my opinion one of the smartest minds in high yield research, estimates that nearly $1.6 trillion of high yield (“junk”) bonds globally will default between 2016 and 2020.
He believes default rates will surge between 2014 and 2016 and persist through 2020. That will make funding more difficult and slow down corporate share buy backs and merger and acquisition activity.
My take away is that it is important to follow the trend evidence and important to not fight the Fed. I think so much hinges on the timing of the coming Fed exit. This is all happening at a time when valuations are high, margin debt is high and investor sentiment is too optimistic. We should be on alert for a sharp correction.
Trade Signals – Trend Positive, Weekly Sentiment at Extreme Optimism Remains – 09-3-2014
Included in this past Wednesday’s Trade Signals post:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains (as measured by Big Mo and 13/34-Week EMA S&P 500 Index chart)
- Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Extreme Optimism (Bearish for the Market)
- Daily Investor Sentiment Composite: Neutral Reading (Bullish for the Market)
- The Zweig Bond Model: Cyclical Bullish Trend for Bonds (supporting bond investment exposure)
Click here for the link to the full piece
Conclusion
It is about a two and a half hour drive from suburban Philadelphia to Penn State. Tonight I am getting together with nearly 200 aging soccer alumni. We are getting together to celebrate our old coach, Walter Bahr. Walter coached us to the Final Four my freshman year in 1979. Oh, that was fun but we came up short in a heartbreaking 4-3 loss in the semi-final game. What Coach Bahr taught us over those four amazing college years was far more about life than about soccer. Little did we know that at the time. He, of course, will smile and deflect all credit. 200 strong, sitting next to him at the stadium tonight, know otherwise.
PSU is ranked 16th in the nation and sits 2 and 0…a good start. I’m rushing out the door as game time is 7:00 pm, having dinner with Brie and her friends just prior to the game and football has a home game this weekend. An exciting few days ahead. Happy and grateful. I hope the same for you.
I’ll be in Chicago mid-month for the Invesco Powershares ETF Asset Manager Summit on September 15-16 and then a short cab ride up the road to the Morningstar ETF Conference on September 17-19. I speak at the Morningstar conference on Friday. Some meetings in New York follow at month end.
Call an old coach and say hi. The ripple effect of kindness will travel much farther than we may ever know.
Have a great weekend!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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