December 6, 2013
By Steve Blumenthal
It was a rough call with an advisor friend. Corporate profits are on the rise and he is of the view that those profits will continue rising thus proclaiming, “we are in a unique new period”. I’m of the view that he’s wrong. Boy – do we all want to be right! I want to be right, but am I?
Debate with smart people plays an important role in our collective growth – we are here to learn. I quieted my mind and asked myself what I might not be seeing.
Shortly after this call I received an email from Ned Davis Research. The email discussed the mean reverting tendencies of corporate profits. Was the timing coincidental? Not sure. It is funny how that tends to happen more frequently than not. With Ned’s permission, I included the full report today.
In this week’s On My Radar, I share the following link to:
- Relook at the Secret Sauce Behind Profits – Ned Davis
- Trade Signals – Investors are the least bearish since 1987. Concerning!
Relook at the Secret Sauce Behind Profits – Ned Davis
One of the biggest concerns I see in the market today is that the Median PE on the S&P 500 Index is 20.9. That is a high number meaning stocks are richly priced. We investors want to buy at bargain prices (low PEs) and sell when company valuations become elevated (high PEs).
The next chart shows the 10-year median total returns based on if you bought at low PEs vs. high PEs. Ned looked at PE data going back to 1926 and shows the subsequent 10-year median total return depending if your starting point was a low PE (blue line) or a high PE (yellow line). History tells us it is best to buy when prices are low relative to a company’s earnings. Note today: we are in the lowest quintile today (yellow line below).
Ned does an outstanding job of explaining how and why corporate profits mean revert. The next chart shows the average annual return for the S&P 500 Index (1954 to Sept 30, 2013) is just 1.8% gain per annum when profits are as high as they are today. I shared this with my advisor friend.
Ned concludes, “I am not going to forecast profits, but I do think they have been boosted by a number of factors (“secret sauce”) that are either temporary or unsustainable. When doing valuation analysis on stocks, I would question how much near-cyclical highs in profits and profit margins are worth.” This might be a good piece to share with your clients who suddenly feel compelled to go all in on stocks.
Here is the link to the full piece. It is not too long and well worth the read.
Trade Signals – Caution!
Unfortunately, many investors feel comfortable investing at market highs and avoid the opportunities when the markets are more unattractively priced. For some reason, we put more weight on recent market events. Somehow projecting forward returns enables us to enter the markets with more confidence. Many would be far better served by doing the very opposite of what their emotional instincts are telling them. Mutual fund money flow data details this fact quite clearly. “Investing isn’t for the faint of heart”, my father used to say.
I have long favored hedging and/or selling at points of extreme optimism and buying at points of extreme pessimism. It is just so hard to be a large buyer in the face of extreme fear but that is where the best opportunities present themselves. And yes – it is equally hard to be a seller in the face of such extreme optimism. Faint of heart indeed.
Investor Sentiment is at Extreme Optimism today. You will see that I added a cyclical chart on Gold and a new chart showing professional investment advisors are the least bearish today than they have been since 1987 (not a typo).
Click here for a link to Wednesday’s Trade Signals.
Reflecting on the important call with my advisor friend was helpful. I’m grateful for his debate. Such debate sharpens us all. I conclude that prices are high relative to earnings and there is evidence that profit margins have peaked. QE could push the markets to even higher prices and I remain in the cyclical bull camp as you’ll read in Trade Signals. Oh, but this cyclical bull rally is aged and today’s over-confidence has me on high alert. Lighten up and get hedged. I believe another big correction is in front of us (best guess inside of 18 months).
I am heading to Phoenix on Sunday to speak at the IWM Global Indexing & ETF Conference. The conference brings together the indexing, ETF and broader investment management community for three days of lively discussion and thoughtful debate. The attendees are mostly endowments, public pension plan fiduciaries (it will be interesting to privately discuss the stresses they might be facing), corporate plans, union plans and non-profit plans.
I’m presenting on ETF best execution. The overall agenda is packed with some of the investment industry’s brightest minds. I always gain from listening and I am particularly looking forward to attending the managing volatility and risk via options and asset allocation strategies session.
I’m packing the sunscreen and maybe the golf shoes. Too much indoor time here in Philadelphia.
Wishing you an outstanding weekend!
With kind 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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