Category: stocks

A Pause On the Road

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August 30, 2015

For the past few weeks, the volatility in the stock market has been front and center.  I finished last week’s blog with a note that the market would be conducting a vote of confidence in the coming weeks.  In the opening minutes last Monday morning, the Dow Jones index dropped a 1000 points, almost 6%.  No doubt many investors had spent the weekend worrying and put their sell orders in the night before.  By Friday’s close, however, the SP500 had gained almost 1% for the week.

A few weeks ago the Dow Jones index, composed of just 30 large company stocks, marked a death cross. The death cross is the crossing of the 50 day price average below the 200 day average.  See last week’s blog if you are unfamiliar with this.  This week the broader SP500 index, composed of the largest 500 U.S. companies, marked it’s own death cross.

Two weeks ago, I noted the attitude of one Wall St. Journal reporter to the dreaded death cross. In one word: blarney.  In two words: hocus-pocus.  So why do some investors and the press give this any attention?  Used as a trading system in the broader SP500 the death cross (sell) and it’s companion golden cross (buy) signal have produced a winning trade 4 out of 5 times.  Where do I sign up?, you might be thinking.  In an almost sixty year period of the SP500, however, the extra annual return is slight – about  8/100ths of a percent, or 8 basis points  – over no timing strategy, i.e. buy and hold.  To the average small investor, taxes and other fees more than offset this negligible advantage.

In contrast to any technical stock market price indicators, the fundamentals of the U.S. economy are mostly strong or expanding. Consumer Confidence rose above 100 this past month, surpassing the optimism of the benchmark set in 1985.  The second estimate of GDP growth released this past week was above some of the high estimates.  After inflation, real GDP growth continues at 2.65%.

Corporate profits are growing at 7.3%, home prices are up 5%.  Real, or inflation-adjusted, consumption spending and income is  growing at more than 3%, equaling the heights of pre-recession spending and income growth in early 2007.

Housing prices are increasing for a good reason.  Inventory of homes for sales is relatively low.  In the middle of the 2000s, prices rose even though inventory of homes for sale were going up, a sign of a speculative bubble.  Ah, things look so clear in the rear view mirror.

New jobless claims remain at historically low levels and job growth has been consistently solid.  There are more involuntary part-timers than we would like to see and the participation rate is low.  Gloom and doomers will tend to focus on the relatively few negative points in an otherwise optimistic economic panorama.  Gloom and doomers think that those who disregard  negative signs are Pollyannas.  Eventually, years later, the gloom and doomers are right.  “My timing was off but, see, I was right!” they exclaim. The lesson of the death cross and the golden cross are this: a person can be right most of the time.  The secret to successful investing is knowing when we are wrong and acting on it.

For the individual investor, signals like the death cross can be calls to check our assets and needs.  Older investors may depend on some stability in their portfolio’s equity value for income, selling some equities every quarter to generate some cash.   Financial advisors will often recommend that these investors keep two to five years of income in liquid, low volatility investments.  These include cash, savings accounts, and short to medium term corporate bonds and Treasuries.  Younger investors may see this price correction as an opportunity to put some cash to work.

The China Syndrome

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August 23, 2015

Some of you may have spent the summer vacation on a small island in the Pacific where there was no access to the news.  So a quickie catch up.  The new Mission Impossible movie Rogue Nation is edge of the seat great fun and its still on the big screen.  And, yeh, almost two weeks ago the central bank of China devalued the Yuan a bit over 3%. Yes, that was a bit unusual.  An unexpected 8% drop in July’s exports spooked economists in the Chinese government.

That brought some additional pressure on oil stocks but the larger market eked out a .7% gain at the close of the week on August 14th.  But – cue up the going down the dark stairs into the basement music – the 50 day average of the Dow Jones crossed below the 200 day average during that week.

Yep, the death cross of doom.  Of course, the Dow Jones is only 30 stocks, weighed down by the plunging fortunes of oil giants like Chevron and Exxon.  The 50 day average of the broader SP500 index was still above the 200 day average so there was cause for concern, but not panic.

For the first two days of this past week, the market was essentially flat.  USO, a commodity ETF that tracks West Texas Intermediate crude oil (WTI) rose more than 1% on Tuesday.  Then came the news that crude oil inventories were continuing their relentless advance upwards. On the good side, lower oil prices are leading to higher demand but sometimes investors focus on the bad news.  WTI oil dropped 4.4% on Wednesday.  Whispers of disappointing manufacturing production out of China added fuel to the fire. On Thursday, the broader market fell 2%, joining the continuing downturn in energy stocks and emerging markets.  A PMI (Purchasing Managers Index) survey of Chinese manufacturers confirmed a slight contraction in the Chinese economic machine. That spooked investors, leading to a 3% drop in the broader market on Friday.

By the time the smoke cleared at the end of the week’s battle, the broader index had lost 5.6% for the week.  Energy and emerging market indexes were down 8%.  Weekly volume in the popular SP500 ETF SPY was the highest this year, an indication that this concern may be more than a temporary blip.

The 50 day average of the SP500 is still above the 200 day average.  No feared death cross yet.

After four years without a 10% correction, the SP500 crossed below that mark this week, falling 10% from the recent high in late May.  Time to sell? Did you get out of the market last October when the broader market fell more than 6% in a month?  Remember that one? The market was going to fall by 50%, according to some market gurus.  Friday’s close is 5% above that October low.

Some long term traders use a 50 week average as a guideline.  As long as it is rising, why worry?  Until this week, the 50 week average had been substantially rising since September 2009.  Why do I use the word “substantially?”  There were a few weeks in late 2011 and early 2012 when the average dipped a few cents.  This week’s decline was like those little dips – a mere 5  cents in SPY, the popular ETF that tracks the SP500.

The world’s economy has come to depend on the growth of two stalwarts – the U.S. and China. For the past eight years, the Eurozone has fumbled and floundered through a cobweb of of political and economic problems. When the U.S. economy cratered in 2008 – 2009, the economic burden shifted to China, whose expansionist growth truly saved the world from a Great Depression.  Although the U.S. economy is showing strong growth, can it offset the economic weakness in China?  The stock market is holding an election, a vote of confidence on that very question.

Debt Equity Ratio

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June 28, 2015

Ding, ding, ding!  I was surprised to see that this is my 500th blog article!

As I noted last week, the stock market has traded in a fairly tight range for the past six months.  Some market seers see this as a topping pattern before either a crash or a serious correction.

Money not spent on current consumption can be invested in past spending – debt – or tomorrow’s spending – equity.  Stocks rise when more people shift money toward tomorrow’s spending in the hopes of better corporate profits.

Last week I estimated the equity market at about $25 trillion.  The latest Federal Reserve Flow of Funds report puts the value of corporate equities at $22.5 trillion at the end of March.  A time series graph of the Fed’s valuation of non-financial corporate equity might give an investor some pause as it is 50% above the worst case scenario base trend line.

Using a middle of the road trend line, we see a market valuation that is 20% above trend.

On the chart above, I have outlined the long term bear market from 1968 – 1982.  That 14 year period of negativity might be a poor starting point for a trend line for the following thirty years.  Let’s take government debt out of the picture for a minute and look at the ratio of household and non-financial business debt to corporate equity valuations.  As the graph below shows, climbing stock prices (the divisor in the ratio) lower the ratio of debt to equity and signal a growing confidence in the future- or does it signal an overheated market?

 Let’s add in government credit market debt, which will shift the ratio of debt to equity up.

We can see the stock market peaks in 1968 and 2000 when the market entered a long term decline called a secular bear market.  Notice that the ratio at the start of the financial crisis in 2008 is about the same as today but that neither was at a peak or trough level.  Now let’s add in the credit market debt of the financial sector.

This again raises the percentage of debt to equity and subtly changes the pattern of the ratio.  We see the go-go years of the 1960s as a decade of confidence, perhaps too much confidence fed by an upsurge in defense spending.  Rising inflation, debt and the slog of war began to erode that confidence and lead into the secular bear market that started in 1968.

In the late 1990s we can see the ratio approach the same levels as in the late 1960s.   It is in this chart that we see a revealing characteristic that marked the period before the financial crisis.  Although stock market prices were rising, housing market debt was rising as well so that the ratio of debt to equity stopped falling after the recession of 2001 and the start of the Iraq war.  That halt in the debt-equity ratio signaled an uncertainty in future profits, tugging new investment dollars toward the past.

This trend of accumulated debt attracting new investment dollars is clearer if we reverse the ratio, showing the equity/debt ratio.  In the 1990s, equities climbed and the equity/debt ratio climbed as well.  In the mid-2000s, equities again rallied but the equity/debt ratio stayed relatively flat, indicating that investors were putting dollars into debt instruments as well as the stock market.  Since the financial crisis, equities have climbed far above the market levels of 2007 but the debt/equity ratio has recovered at a much slower rate.  Despite historically low interest rates, high government debt and finance debt continues to attract investors’ money.

Current stock market valuations are moving the ratio toward the future but investment in the spending of the past continues – until the 30+ year bull market in bonds reverses and investors abandon a falling bond market for the equity market.

Wage Growth Rings

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June 14, 2015

The broader stock market has been on a continuous upswing since November 2012 when the weekly close of the SP500 index briefly broke below the 48 week average.  The past six months is one of those periods when investors seem undecided.  Even though the market is above its 24 week average, a positive sign, it closed at the same level that it was just before Christmas.  Earlier this week came the news that Greece might avoid default on its June payment to the ECB and the market surged upwards. At the end of the week, news that talks had broken down caused a small wave of selling on Friday morning. Investor reaction to what, in perspective, is a relatively small event, indicates an underlying nervousness in the market.

As the SP500 began a broad upswing in late 2012, the bond market began a downswing.  A broad aggregate of bonds, AGG, fell about 5% over the following ten months before rising up again to those late 2012 levels this January.  In the past five months, this bond index has declined almost 4% as investors anticipate higher rates. A writer at Bloomberg notes a worrisome trend of concentrated ownership of corporate bonds.

Retail sales in May showed strong gains across many sectors in the economy. As the chart shows, growth below 2.5% is weak, indicating some pressures in household budgets that could be a precursor to recession.  Current year-over-year growth in retail sales excluding food and gas is up almost 5% – a healthy sign of a growing economy.

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Wage Growth

“Since 2009, when the great monetary experiment began, global bond markets have increased in value by about $17 trillion. Global equity markets have increased by about $40 trillion. The average worker has seen wages increase by about $722 billion, which means about 2% of the benefit of QE (quantitative easing) went to workers. The rest went to asset prices.” (Source)

A cross section of a tree shows a historical pattern of rainfall, temperature and volcanic activity.  Wage and salary income across a population can provide a similar historical picture of the economic climate of a people.  The recovery from the recent recession has been marked by slow growth in wage and salary income relative to the growth rates of previous recoveries.

Economists find it difficult to reach a consensus to explain the muted growth.  A WSJ blog summarized a number of explanations.  I have noted several of these in past blogs.  They include:

Slack in the job market.  However, the labor dept reports that the number of job openings is at a 15 year high. (BLS Report)

Some economists point to the large number of involuntary part timers, those who want a full time job but can’t find one, as an indication of slack in the labor market.

The number of people quitting their jobs for another job is improving but is still weak by historical standards.

Sluggish productivity growth. Multi-factorial productivity growth estimates by the labor dept show that productivity gains in the past 15 years are chiefly from capital investment, not labor productivity.  Capital productivity during the recovery has been slow but labor productivity has been terrible, according to multi-factorial productivity assessments by the BLS.  As the century turned, we applauded the transition toward a more service oriented economy.  Less pollution from manufacturing industries, we told ourselves.  “The service sector is less cyclic,” economists reminded us.  It is much more difficult to wrest productivity gains from many service sector jobs. The cutting of a lawn, the making of a latte – there is a minimum threshold of time to do these things.

The sticky wages theory: namely, that companies withhold raises during the recovery because they couldn’t cut wages during the recession.

Let’s compare income growth to retail sales growth, using the data for retail sales less  food and gas whose prices are more volatile.  Periods when both growth rates decline set the stage for recessions.  Periods when both rates increase mark recoveries.

Simultaneous declines in 2011 and 2012 prompted stock market corrections.  The upswing of the past two years has contributed to the rising stock market.

Easter Egg

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April 5, 2015

On this Easter Sunday, Christians celebrate the Resurrection of Jesus, Jews observe Passover, basketball fans await the final contest of the Final Four and baseball fans look forward to the start of the new season.  After Friday’s disappointing report of job gains in March, investors might be wondering what will happen Monday when markets in the U.S. reopen following Good Friday.  In overseas markets, yields on the 10 year Treasury bond fell on the employment news.  Job gains that were about half of expectations helped allay fears of a June rate increase.  We may see a positive response from both the bond and equity markets on Monday as the time table for rate increases might start in September.  On the other hand, the weekend might allow more rational judgment to prevail. One month’s disappointment does not a trend make.  Year over year gains in employment are especially strong.

April is usually a good month in the stock   market.  Since breaking the 2000 mark in August, the index has neither gained or lost much ground.  Gains in the technology companies that are included in the SP500 (Apple, for example) have been offset by losses in the oil sector of the SP500 (Exxon, Chevron, for example).  Long term Treasuries (TLT) have risen 10% in the past six months, despite the prospect of rising interest rates in 2015.

ICI reports that domestic long term equity mutual funds had an outflow of about $8 billion in March. Investors have not abandoned equity funds by any means but have changed focus. During this past month, $14 billion flowed into world equity funds.   Bond funds continue to post strong inflows – $10 billion in March.

The boomer generation amassed a lot of pension promises through their working years.  Pension funds must balance both equity and bond risk in their investment portfolios  and yet try to meet their assumed growth rates of 7% – 8%.  Caught on the horns of this dilemma, pension funds straddle both the equity and bond markets.  During the past ten years, many have become underfunded because they have not been able to match their projected growth rates.   This delicate balance of risk and reward sets the stage for a catastrophic decline in response to even a relatively small monetary shock because pension funds can not afford to wait out another three or four year decline.  Too many boomers will start cashing in those promises accumulated during the past decades.

The relatively low number of new jobs created in March was probably due to the severe winter in the eastern part of the country.  The BLS revised downward their previous estimates of employment gains in January and February.  Even with the downward revisions and this past month’s relatively anemic 126,000 gains, the average for the quarter is still about 200,000 per month, a particularly strong figure when one considers the impact that plummeting oil prices have had. In the first 3 months of this year, companies in oil and gas exploration have shed 3/4 of the jobs added during all of last year.  The strong dollar makes U.S. exports more expensive and hurts manufacturing.  The employment diffusion index in manufacturing industries dropped below 50, a sign that there is some contraction in the 83 industries included in this index.  However, March’s Manufacturing Purchasing Managers Index showed some slight expansion still and employment in manufacturing is still strong.  Across all private industries, the diffusion index remains strong at 61.4.

Fed chair Janet Yellen has repeatedly said that interest rate decisions will be based on data.  If the data of subsequent months show a resumption of strong growth, an interest rate increase at the FOMC meeting in late July could still be in the cards.  The CWPI composite built on the PMI anticipated a declining trend in growth this winter and spring before resuming an upward climb.  When the non-manufacturing  PMI is released this coming Monday, I’ll update that and show the results in next week’s blog.  Based on the numbers already released, I do anticipate a further decline in March then an evening out in April.  The particularly strong dollar  has cast some doubt on growth predictions, particularly in manufacturing. Both oil and the dollar have made sharp moves in the previous months and it is the rate of change which can be disruptive in an economy.

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Unemployment

New claims for unemployment were the lowest since the spring of 2000, just as the bubble of the dot-com boom began to deflate.  As a percent of those working, this is the third time since WW2 that new claims have reached these very low levels.  The last two times did not turn out well for the economy or the stock market.

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Oil

Going back through some old notes.  Here’s an October 2009 article where Deutsche Bank estimates the price of oil at $175 in 2016.  2009 was just about the time that newer techniques in horizontal drilling were being developed.  The fracking boom was just about to get underway.  Whether you are an investor or a second baseman, the future is tough to figure out so stay balanced, stay prepared and keep your knees bent.

Stock and Housing Valuations

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March 1, 2015

There are several popular methods to evaluate stocks.  The P/E ratio is probably the most quoted metric.  This is a stock price divided by its current earnings.  A conservative variation of this popular methodology is Professor Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio.  The basis for this metric is the observation that all data reverts to its mean.  Professor Shiller’s method adjusts the past ten years of reported earnings for inflation, then averages those earnings and divides the current price by that average to get a CAPE ratio.

Any well-regarded valuation method has its detractors. This Economist blog points out objections to the Shiller CAPE ratio. In a 2014 blog I tackled an objection to Shiller’s methodology: a ten year average can include a severe downturn in earnings that does not reflect current conditions. I massaged away the 2008 to 2010 downturn to show that Shiller’s CAPE ratio was little changed by the downturn.

Some object that the CAPE ratio uses reported earnings, which includes depreciation (lowers earnings) and interest (increases or decreases earnings).  Operating earnings exclude these items and more accurately reflect the profits generated by ongoing operations.   Operating earnings may be a valid basis for evaluating a single company and Warren Buffet uses this method, among others, to get a sense of sustainable earnings.

Some prefer to use forward operating earnings, which are estimates of profits for the next twelve months.  These estimates come in two varieties: top down and bottom up.  Top down estimates are calculated by estimating a growth percentage of profits for the coming year and applying that percentage to the sum of current profits.  Bottom up estimates are painstakenly compiled by taking the forward earnings guidance given by each company.  Top down estimates tend to be optimistic and are usually revised downward with the passage of time.

I prefer Shiller’s method as a more realistic approach for a long term investment in a stock index like the SP500.  Successful businesses should be able to generate enough profit in their operating margins to account for depreciation, which is included in reported earnings.

Another valuation method is the flip side of the Price Earnings or P/E ratio – an E/P ratio, or earnings yield.  As of a week ago, the current earnings yield was 5.02%.  This is then compared to the 10 year Treasury rate, 2.13%, as of Feb. 20, 2015.  The difference between the earnings yield of stocks and a risk-free investment like U.S. Treasuries – currently about 3% – is called the risk premium for owning stocks.  Often, this risk premium is quoted in basis points, which are 100ths of a percent.  So 3% = 300 basis points.  In 2007, the risk premium was over 4%.  The average from 2002 – 2006 was about 2% as stocks climbed out of a prolonged slump following the dot com bust and 9-11.  So, using this method, we could say that stock valuations are somewhere in the middle, neither frothy or pessimistic.

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Housing

Sales of New Homes remained brisk at just under 1/2 million.  The supply of new homes on the market indicates historically strong demand.

The latest Case-Shiller home price index increased 4.3% year-over-year, below the 4.7% growth curve of the past forty years.  From 1975-2000, home prices increased 5.5% annually.  During the boom years of the 2000s housing prices surged above that growth curve only to fall swiftly in the crash of 2008.  The bust in the housing market has more than taken out the excess, bringing the forty year growth curve to 4.7%.

The home price index does not take into account the larger homes being built over the past two decades.  The median square footage of new homes has grown from 1555 SF in 1975 to 2457 SF in 2013. (Census Bureau data)

A greater percentage of today’s homes include air conditioning, extra bathrooms and other amenities that the homes of forty years ago did not have, skewing the long term effective growth curve even lower.  While some metropolitan areas on both coasts may be overvalued, national averages suggest that housing prices are fairly valued.

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Economic Summary

Twice a year the chair of the Federal Reserve testifies before the Senate Banking Committee.  Chair Janet Yellen’s testimony this past week was a concise distillation of economic trends.  Investors bombarded with an avalanche of articles and blogs may sometimes find it difficult to synthesize all the information they absorb.  Ms. Yellen’s initial summary cuts through the clutter:

The unemployment rate now stands at 5.7 percent, down from just over 6 percent last summer and from 10 percent at its peak in late 2009. The average pace of monthly job gains picked up from about 240,000 per month during the first half of last year to 280,000 per month during the second half, and employment rose 260,000 in January. In addition, long-term unemployment has declined substantially, fewer workers are reporting that they can find only part-time work when they would prefer full-time employment, and the pace of quits–often regarded as a barometer of worker confidence in labor market opportunities–has recovered nearly to its pre-recession level. However, the labor force participation rate is lower than most estimates of its trend, and wage growth remains sluggish, suggesting that some cyclical weakness persists. In short, considerable progress has been achieved in the recovery of the labor market, though room for further improvement remains.

At the same time that the labor market situation has improved, domestic spending and production have been increasing at a solid rate. Real gross domestic product (GDP) is now estimated to have increased at a 3-3/4 percent annual rate during the second half of last year. While GDP growth is not anticipated to be sustained at that pace, it is expected to be strong enough to result in a further gradual decline in the unemployment rate. Consumer spending has been lifted by the improvement in the labor market as well as by the increase in household purchasing power resulting from the sharp drop in oil prices. However, housing construction continues to lag; activity remains well below levels we judge could be supported in the longer run by population growth and the likely rate of household formation.

The Gathering

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February 14, 2015

In January of this year, the SP500 finally rose above the inflation adjusted high set in 2000.  Here is a chart from multpl.com that I have overlaid with a few boxes.  Long term market trends are dubbed “secular” to contrast them with the shorter cyclical swings in valuation.  A secular bear market is a prolonged market downturn in which the inflation adjusted price of the SP500 never gets above a certain historical peak.

These long term periods are easier to define in hindsight.  They have begun with some peak and ended at some trough.  Years after the trough when the market has made a new inflation adjusted high price, market watchers get out their crayons and set the end of the bear market just after that trough.  Based on that historical rule, we would then say that the secular bear market that began in 2000 ended in 2009 at a market low six months after the onset of the financial crisis.

If history is any guide, an investor could expect further price increases for another 2 years (as in the late 1920s), or another 10 years (as in the late 1950s to late 1960s), or another 8 years (as in the 1990s).  In other words, history may not be much of a guide.

If the market tanked in 2017, two years after setting a new high, some sages would nod soberly and say it was just like the 1920s and was to be expected.  If the market continued rising another eight years before falling, ah yes, just like the 1990s.  The signs were all there if you knew where to look.

Secular bear markets share characteristics other than long term price swings.  During past prolonged downturns there have been five recessions within each period.  We have had two recessions since 2000.  Price to earnings, or PE, ratios went really low – about 6 – at the lowest trough of past downturns.  This is also the approximate low in the Shiller CAPE ratio.  Since 2000, the PE ratio has fallen to 10; the CAPE ratio to 13.  The current PE ratio based on the trailing twelve months earnings is almost 20, about 25% above the average. The number of years from peak to trough has been 19.  2000-2009 would be only 9 years, the shortest secular bear period on record.  The number of years from peak to peak has been about 26 years, much longer than the current 15 year period.

 This has led some to predict a further final crushing decline in the market to end the secular bear.  If the doomsayers are correct and we are only two-thirds through a secular bear market, we would expect market prices to plateau this year.  Then will come some shock – China’s real estate market implodes, or its regional banks collapse.  The so called PIGS – Portugal, Ireland, Greece, and Spain – could exit the euro.  There could be a major armed conflict with Russia or Iran that causes investors to abandon equities in droves.  The stronger dollar can put strains on countries whose currencies are pegged to the dollar. Such strains can cause a financial crisis similar to the one in Mexico in 1995 and the Asian and Russian crises of 1997 – 1998.  In the summer of 1998, the SP500 fell 15% in one month as fears grew that regional monetary imbalances would infect the economies of the entire world.

Secular bear markets come in types.  The two that started in 1929 and 2000 arose from what I call discovery shocks.  Investors lose conviction in their own hopes of future gains and leave the market.   The bear market that began in the late 1960s was a series of conflict shocks that spurred erratic changes in inflation.   As the country borrowed money to fund the Vietnam war, inflation rose above 3%, peaking at 6% in the spring of 1970.  The 1970s was marked by domestic and international conflict: the Watergate scandal and the oil supply wars with OPEC drove inflation to a high of 12% in late 1974.  As oil prices quadrupled through the 1970s, inflation spiked at almost 15% in the spring of 1980.  Through most of the decade, inflation stayed above 5% – a low that was almost double the historical average.

The SP500 made new records again this week although FactSet notes that the blended earnings growth for the fourth quarter of 2014 was only 3.1%.  The forward P/E of the SP500 is 17.1%, substantially above both the five and ten year averages (see paragraph below for illustration of changes in forward P/E). FactSet reports that nine out of ten sectors have forward P/E ratios that are above their ten year averages.  Only the telecom sector is selling slightly below its ten year average.  The forward P/E of the SP500 is based on projected earnings over the next year and volatile oil prices have made such earnings estimations difficult.  First quarter earnings by energy companies have been revised downwards by 50%, resulting in a 7.4% decrease in earnings estimates for the SP500.

Small changes in earnings estimates are multiplied 10 to 30 times to reach an evaluation of fair market price.  If 2015 earnings for SP500 companies are estimated at $100, an index price of 2000 is a forward P/E of 20.  If estimates are revised upwards to $110, then an index price of 2000 reflects a forward P/E of 18.  If the forward P/E of the SP500 is above the five and ten year averages as it is today, it means that investors and traders are betting that estimates of forward earnings will be revised upwards, resulting in a lower forward P/E ratio.

Long-term Treasuries (TLT) rose up 11.5% in the five weeks from late December to the end of January – too much, too fast.  After falling back in the last two weeks from their peaks, they are priced at the same level as in July 2012.  In 2014, traders who bet against long term bonds in anticipation of rising interest rates got slaughtered as long term Treasuries rose 25%.  Investors who moved out of long term and into shorter term bonds were disappointed as well.

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Retail Sales

Investors regard the monthly employment report and the retail sales report as the most important barometer of a consumer driven economy.  As an example of the correlation, consider a graph of inflation adjusted retail sales and the SP500 index.

Retail sales in January declined slightly from December.  Investors were somewhat heartened by the 2.4% annual gain, at least 1% above inflation, but remember that last January was particularly poor and was an easy benchmark to beat.  On the other hand, lower gasoline prices lowered this year’s total,  offsetting the comparison with a weak benchmark.

Sales at food and drinking establishments rose more than 11% y-o-y in January.

Large y-o-y gains in food and drink usually occur in the winter months.  January 2000, 2001, 2004, 2006, December 2006, January 2012, and these past two months all peaked at more than 8% y-o-y gains.  Eating and drinking out are largely discretionary for most of us.  A change in the pace of growth in this behavior signals  changes in consumer attitudes that are more real than a consumer confidence survey.  Changes in this discretionary budget item is a survey of wallets. In the past year, the growth of food and drink sales has accelerated, indicating a more confident, less fearful consumer.

While the various consumer sentiment surveys indicate what we tell interviewers, the wallet survey indicates what we really think.  In early 2009, the U. of Michigan Consumer Sentiment Survey showed a rebound of confidence.  What the survey indicated was more a rebound of hope, not confidence.  Consumer spending on eating and drinking out was still declining.

2011 is an indication of the opposite – plunging sentiment according to a survey but growing spending at food and drink establishments, indicating that the volatile drop in sentiment might be short lived.  The plunge in confidence was a response to the budget battles between the Republican House and the President.

Low inflation, relatively low gasoline prices, strong employment and retail sales gains all point to steady moderate growth.  Judging by the PE (19.7) and forward PE (17.1) ratios, the market may have already priced in that growth.

Then and Now

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January 25, 2015

Valuation

Blogger Urban Carmel has written a thorough article on current market valuation, focusing on Tobin’s Q as a metric.  This is the market price of equities divided by the replacement cost of the companies themselves.  During the past 65 years, the median ratio is .7, meaning that the market price of all equities is about 70% of the replacement cost.  At the end of December, the Tobin’s Q ratio was more than 1.1.

Are stocks overvalued?  Valuing the replacement cost of a company might have been more accurate when the assets were primarily land, factories and other durable equipment.  Today’s valuations consist of networks, processes, branding, and other less easily measured assets.  The valuation discussion is not new.  In 1996, before the U.S. shed much of its manufacturing capacity, economists and heads of investing firms argued about valuation, including Tobin’s Q.  You can punch the way back button here and read a NY Times article that could have been written today if a few facts were changed.

Currently, households have 20% of their financial assets in stocks, the same percentage as in 1996.  In December 1996, then Federal Reserve chairman made a comment about “irrational exuberance”  in market valuations.  Prices would continue to rise, then soar, before falling from their peaks in mid-2000.  At that peak, households held 30% of their financial assets in stocks.  At an earlier peak, 1968, households had the same high percentage of their assets in stocks.

On an inflation adjusted basis, the SP500 has only recently closed above the all time high set in 2000 (Chart here).  The Wilshire 5000 is a market capitalization index like the SP500 but is broader, including 3700 publicly traded companies in its composite. On an inflation adjusted basis this wider index is 40% above the peaks of 2000 and 2007.

Long term periods of optimistic market sentiment are called secular bull markets. Negative periods are called secular bear markets. (See this Fidelity newsletter on the characteristics of secular bull and bear markets).   These long-term periods are easier to identify in hindsight.  Some say that we are nearing the end of a long-term bear market, and that there willl be a big market drop to close out this bearish period.  There have been so few long term market moves in 150 years of market data, that it is possible to tease out any pattern one wants to find.  The aggregate of investor behavior is not a symphony, a piece of music with defined structure and passages.

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REIT

As Treasury yields decline, mortgage rates continue to fall.  The Mortgage Bankers Association reported  that their refinance application index had increased by 50% from the previous week.  The refinancing process involves the payoff of the previous higher interest mortgage.  Mortgage REITs make their money on the spread, or the difference, between the interest rate they pay for money and the interest on loaning that money on mortgages.  When a lot of homeowners prepay their higher interest mortgages, that lowers the profits of mortgage REITs like American Capital Agency (AGNC) and Annaly Capital Management (NLY).  Both of these companies have dividend yields above 10% and are trading below estimated book value.

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Housing

Back in ye olden days, around 1950, the world was a bit different.  The Bureau of Labor Statistics published a snapshot of incomes, housing, and other census data, including the data tidbit that people consumed fewer calories in 1950 than today, 3260 then vs. over 3700 today.

Housing and utilities averaged 27% of income in 1950 vs. 40% today.  Food costs were 33% then, 15% today.  The median house price of $9500 was about 3 times the median household income (MHI) of $3200.  For most of the 1990s, the prices of existing homes were slightly higher, about 3.4 times MHI.

The prices of existing homes rose 6% in 2014 – healthy but not bubbly.  However, the ratio of median price to median income is now at 3.8.  Historically low interest rates have enabled buyers to leverage their income to get more house for their bucks, but the lack of income growth will continue to rein in the housing market.

The ratio of median new home prices to MHI has now surpassed the peak of the housing bubble.

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Retirement Income

Wade Pfau is a CFA who has written many a paper on retirement strategies and occasionally blogs about retirement income.  Here is an excellent paper on the change in psychology, risk assessment and strategies of people before and after retirement.  Wade and his co-author summarize the critical issues, the two dominant withdrawal approaches, the development of the safe withdrawal rate, and the caveats of any long term planning.  The authors review the strategies of several authors, discuss variable spending rules, income buckets and income layering,  annuities, and bond ladders.  You’ll want to curl up in an armchair for this one.

Dance Partners

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January 18, 2015

When investors are grumpy, good news is not good enough or it is too good.  Confidence among small businesses climbed to levels not seen since late 2006 and the positive sentiment was broadly based, including new hiring and plans for expansion.

On the other hand…December’s 9/10% decline in retail sales was a surprise after a strong November.  However, a closer look at the retail figures shows some real positives.  The year-over-year gain was 2.6%, above the 1.7% core inflation rate, indicative of modestly  growing demand.

Excluding retail gas sales, retail sales gained 4.8% over last year.

Now, let’s put gas sales in some historical perspective.  In January 2007, the price of a gallon of gasoline was $2.10, about the same as it is now.  On average, we are driving more fuel efficient vehicles than in 2007, yet total retail gas sales are 25% higher now.

Every six weeks, the Federal Reserve releases their Beige Book survey of economic conditions around the country.  They also reported moderate growth in employment and sales.  They noted that flat wage growth and low inflation reduces any urgency in raising rates.  Friday’s release of the CPI confirmed the low inflation rate.  Including gas and food, the yearly increase was only .7%.  Core inflation, which excludes gas and food prices, rose 1.7%.  Consumer sentiment is nearing the levels of the early to mid-1980s, the beginning of a period of strong growth.

For now, stocks and oil prices are dance partners.  In a week of negative sentiment, traders were watching the 1975 level on the SP500.  This was mid-December’s bottom, a short-term key level of support.  After Thursday’s close near 1990, stocks rallied on the strong consumer sentiment and a report from the International Energy Agency that lower prices are causing some oil production cuts. Fourth quarter earnings season has just begun but if volatility in oil prices remains strong, this may drive market sentiment at least as much as earnings reports.

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Job Openings (JOLTS)

November’s job openings showed a slight increase, getting ever closer to the 5 million mark and nearing an all time high set in the beginning of 2001 as the dot-com boom was ending.  This summer open positions surpassed the mark set in June 2007 at the end of the housing boom.

The  economy grows stronger on many fronts – labor, retail, housing and industrial production – and is near multi-year high marks without the help of a widespread boom in any one sector of the economy.  The surge in oil  shale production is confined to a few states.

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Portfolio Allocation

As the market remains somewhat volatile, it’s time to revisit a familiar theme – allocation.  Let’s look at a selection of portfolios with moderate allocation. How much difference has there been between a portfolio with 60% stocks and 40% bonds (60/40), and one with 40% stocks, 60% bonds (40/60)?

Earlier in the year, I mentioned a site  that can backtest a pretend portfolio.  In the free version, the re-balancing rules are fairly simple but it does allow us to make some comparisons of long term trends.

All of the following tests include the years 2000 – 2014, a period which covers two downturns.  The first, from 2000 to 2003, was a protracted decline after the dot com bubble.  The second, from late 2007 to 2009, was severe.

The test includes an annual re-balancing to get to the target percentages, and assumes a modest investment of $100 each year into a $10,000+ portfolio.  Because of the two downturns, it’s no surprise that the portfolio weighted toward bonds did better than the portfolio weighted toward stocks.

The difference between the 60/40 and 40/60 was about 7/10% in annual return.  If we were to use intermediate term bonds as a proxy for the bond component of the portfolio, the difference would be even less.  In the middle range of allocation models, the differences in returns over a long period of time are probably smaller than what we worry about.

The importance of moderate allocation is illustrated by the following two examples.  Let’s consider the period from 1995 – 2014, which includes three market rises and two downturns.  Note the ratio: three up to two down.  If we compare a portfolio of all stocks to a balanced portfolio of 50% stocks and 50% long term bonds, we see that it is only in the past five years that the all stock portfolio finally meets the return of the balanced portfolio.

Long term bonds are especially sensitive to changes in interest rates so let’s look at a balanced portfolio of stocks and intermediate term bonds.

In this case, it is only in the past two years that the total return of the all stock portfolio has outperformed the balanced portfolio.  One of the those years included an unusual 30% gain in one year.  In short, it is hard to argue against a balanced portfolio over a long period of time.

Lastly, the example below shows a slight advantage to re-balancing a portfolio.  However, the additional .2% gain each year should not cause us to lose sleep if we forgot to do this for a few months.

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Oil Prices

Oil suppliers are pumping down their inventories as global demand for oil weakens.  More product, less demand = lower prices. In a standard economic model, customers want more of a good at a lower price.  Suppliers are less willing to supply a good at a lower price.  Eventually, suppliers and customers reach an equilibrium at a certain price.

What happens in a price war does not follow this simplified textbook model.  Suppliers with deep reserves try to drive out other suppliers by flooding, or at least over supplying, the market, thus driving the price down.  More units are bought but at lower prices, so the value of gross sales may be lower even though the units sold is higher than before.  The profit on each unit sold, or marginal profit, gets lower and may get negative for a time till the more vulnerable suppliers leave the market.

The governments of Venezuela, Russia and Nigeria depend on oil revenues for much of their income.  Should oil prices stay below $50 for half a year or more, these countries will be pressed to curtail social benefit programs and infrastructure projects.  The interest rates on their bonds will increase as investors price in a greater risk of default.

Sudden changes produce fractures.  Fractures produce frictions. Frictions dissipate in a cascade of minor adjustments or suddenly in a violent upheaval.

New Year, No Fear

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January 4th, 2015

As the calendar flips from December to January, some favorite activities are predictions for the coming year and reviews of the past year.  Here are a few predictions I’ve heard in the past few weeks:

“We think oil will continue to drift downwards as global demand slackens.”

“We think long term Treasuries will continue to show strong gains in the coming year.”

“Output remains strong, and the labor market continues to strengthen.  We expect further gains in the stock market this year.”

“We expect gold to find a bottom in the $900 to $1000 range and we will be initiating a long position at that time.”

Predictions are foolish, of course.  They are too certain.  An expectation is a bit more sober, a pronouncement of a probability.  Did anyone hear these expectations at the beginning of 2014?

“Oil prices will decline by 40% this year.”

“We expect long term Treasuries to gain 25% in 2014.”

“We expect the euro to fall to a 4-1/2 year low against the dollar.”

I don’t remember any of those predictions at the beginning of 2014.  So here’s my expectation – er, prediction: in 2015, I will be surprised by some of the events that will unfold.

If that doesn’t satisfy your prediction craving, here are several – let’s call them guesstimates – of SP500 earnings and price predictions in 2015.

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Blue Light Specials

As I mentioned a few weeks ago, there are a few stock sectors that are “on sale,” selling below their 200 week, or 4 year average.  Falling gas prices in the last half of 2014 have had a negative impact on energy stocks (XLE, VDE).  Selling below their 200 week averages in December, both ETFs are hovering at their 200 week average.  The 50 week average is above the 200 week average, indicating that this is, so far, a relatively short term trend.

Emerging markets have been in the doldrums for a year and a half.  The 50 week average is just about to cross above the 200 week, signalling that the downturn may have exhausted itself.

The mining sector (XME) is down – way down.  The 50 week average is below the 200 week average and current prices of this ETF are below the 50 week average.  The mining sector can be quite cyclical but could be quite profitable in the next six months.

In the summer of 2011, the oil commodity ETF USO lost a third of its value.  In the melt down of 2008, it lost 75% of its value, falling from $115 down to near $30.  This week USO broke below $20, losing half of its value since July.  Since September 2009, shortly after the official end of the recession, the 50 week average has been trading in a range of $34 to $38, and is currently at the low point of that five year range.  While this may not be appropriate for a casual investor, it might be worth a look for those with some play money.

Other sectors – industrials, materials, finance, health, technology, consumer staples, consumer discretionary, retail and utilities – are above both their 50 and 200 week averages.

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Happiness Is An Open Wallet

The Conference Board’s Consumer Confidence gauge rose still further above 90 in December.  At some time in the distant past, in a year called 1985, all the people were happier than they are today.  That long ago time became the benchmark 100 for this index.  The index number is less important than the trend of confidence – whether it is rising, falling or staying the same.

The Case Shiller 20 City Home Price Index for October showed a 4.5% yearly gain.  The double digit gains of last year and the first six months of 2014 were unsustainable.  However, I would be concerned if this continues to fall toward zero, indicating a serious softening of demand, or a lack of affordability or both.

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The non-SP500 World

The SP500 index, composed of the 500 largest companies in the U.S., was up 11.4% for 2014. An index of mid, small and micro-cap companies was up a more modest 7.1% (Standard Poors) for the year.  An index of REITs was up 25.6% in 2014 after stalling during much of 2011, 2012 and 2013. I was surprised to learn that during the past twenty years, REITs outperformed the SP500.

Conventional wisdom holds that rising interest rates are bad for REIT stocks.  A study of REIT performance shows that the impact is less than most investors think. In addition, the income growth generated by REITs has outpaced inflation in all but one out the past 15 years. VNQ and RWR are two ETFs in this market space.  VNQ has a 10 year return of about 9%, RWR a bit less.

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Social Security

The Social Security program depends on current taxes to pay current beneficiaries.  In per person inflation adjusted dollars, the federal government collects twice the amount of money it did forty years ago.  Per person revenues have almost caught up to the levels of 2006.

The problem is that there are a lot of people starting to retire.  Politicians of both parties have spent the excess social security taxes collected in the past decades.  Last week I asked what you would do if the stock market lost 30% of its value.

This week’s sobering question for those in or near retirement:  what would you do if social security payments were reduced, or means tested?  With the stroke of a pen, Congress could reduce the maximum monthly benefit from $2533 to say $2100.  This would affect a relatively small percentage of voters, those with higher incomes, a favorite target for benefit cuts.  Perhaps you are taking care of an ailing child or parent and need the income.  You might submit a 4 page form listing your pensions, IRAs, the assessed value of your home and any mortgage you had against the house, your mutual funds, stocks and bonds.  Using a complex formula to factor in your age, special circumstances, the cost of living index in your area and the total of your assets, the Social Security Administration would calculate your monthly benefit.  Can’t happen here in the land of the free, home of the brave?