Financial Markets Update of Nov 27 2017
- The market has been doing very well…
- Nasdaq: 28.00% YTD Technology Sector
- Dow Jones: 19.20% YTD Large Cap Industrial
- S&P 500: 16.20% YTD Large Cap Diversified
- Russell 2000: 11.90% YTD Small Cap Diversified
- Total Bonds (BND): 1.29% YTD Fixed Income Diversified
- Emerging Markets (VWO): 26.10% YTD Developing Countries
- Money Market (BSV): 0.03% YTD Safety
- Your Benchmark based on your Risk Profile and Personal Economics: A MIX
Happy Holidays! I hope we will get to speak during the holiday seasons!
Here’s a quick update for your and your friends.
Please note that the S&P 500 is the preferred market benchmark as it is more diversified than its counter-parties like the Nasdaq or the Dow Jones. It is not as diversified as your portfolio because the S&P 500 is comprised mostly of large cap stocks (i.e. large companies only). Your portfolio will include some fixed income securities that are less volatile and tend to give lower returns. Note that the performance of the Russell 2000, which is comprised of small cap stocks, is lagging behind the large cap sector. When Trump got elected in Nov. 2017, the small cap sector did very well initially because of the “America First” rhetoric. However, with the tax cut on the way, it looks like large companies, with large international presence, will benefit the most from his election.
- Is the market a bubble? Is the market too high?
My favorite answer to many forward-looking questions is: “Honestly, I don’t know! (because nobody really does know!) But I can give you my professional opinion.” I tend to think of these questions in probabilistic terms knowing that I won’t always get the right answer, but if I do enough research, in addition to my almost twenty years of experience, my opinion will have a higher probability of accuracy than that of a lay person.
Many market participants have argued that the stock market is overvalued for many reasons, but the main one being that valuations are too high. I tend to be in the camp of those who agree with this assessment with perhaps a 75 percent confidence that it is correct. As a market practitioner, this is not enough information to act upon on behalf of clients. When listening to the news, I always recommend that people pay attention to evaluations that are time bound and specific, and leave no wiggle room for backing off the prediction. Given the current situation (my ticket out :)) I think that the market will sell off (due to correction or a bear market) with a 10-30% drop during the next 6 to 12 months. Of course, this prediction will have to be updated based on any new data and/or events that happen between now and then. However, there is a high likelihood of a correction in the next 12 months.
Recent research has shown that momentum strategies (by both professionals and non-professional investors) can keep rallies going for some time (often years) until a crash happens. This knowledge has encouraged me to stay at least 50% invested in the market although I am ready to head to the exit (up to a minimum bar based on your profile) with any signs of troubles. Other investors probably have the same idea, but I have put automatic sell orders for you (called stop sells) which will sell some of your positions automatically if the market drops by about 5%. 2.
Why does the market keep going up although it is overvalued?
Research by Chabot, Ghysels, and Jagannathan from The Federal Reserve Bank of Chicago, UNC-Chapel Hill, and Northwestern University, respectively, has shown that most investment managers tend to add positions to their portfolios even when they know that the market is overvalued or there is a crash coming. They do that because that is how they can attract funds and increase their revenues by keeping up with the market performance or momentum. The crash tends to happen when money or liquidity is pulled out of the economy by the Federal Reserve by raising interest rates or there is a shock to the system that makes it difficult for people to refinance their loans. Ray Dalio, manager of the largest hedge fund in the world, Bridgewater Associates, has explained the cycle in a very interesting video on how the economy works (see references below).
In March 2000, I remember feeling bad for Julian Robertson (billionaire, mind you) who was considered until then one of the best asset managers of his time. He called it quit and returned some cash to investors because, as a value manager, he was lagging the stock market (specially the Nasdaq) and this is what he said:
“As you have heard me say on many occasions, the key to Tiger’s success over the years has been a steady commitment to buying the best stocks and shorting the worst,” he wrote. “In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much.”
Right after he closed his fund, he was proven right! Value stocks did well while the internet stocks collapsed.
Seth Klarman who is taking a similar approach to Julian Robertson just returned cash to some investors this past Sept. If history rhymes, the next correction in tech may not be far off. However, I still revert to over 100 years of market research by Chabot & al. which states that the better strategy is to stay with the momentum for at least with part of the portfolio.
This chart of Nasdaq from 1997 to 2003 is proof that we have seen these kinds of run up before; it did not end well! However, history does not repeat itself; it just rhymes!
- A few reasons it makes sense to be cautious with the market
3.1 High Valuations based on P/E (price to earnings) or E/P (earning yield)
You have probably heard of the term P/E (pronounced Pee Ee) ratio, which is the price of a stock divided by its yearly net earnings. This ratio is used in order to be able to compare big and small companies. Another way to think of the P/E ratio is the cost per $1 of net earnings. If you are investing, you want to pay as little as possible for each dollar of earnings of the company you are investing in. The earning yield is nothing more than looking at the problem from the opposite direction, meaning, how much does the company earn for each $1 invested.
Right now, the price to earnings ratio of the S&P 500 is at 25.21. It means that you are paying $25 for each $1 of earnings. The historical ratio average is $15.68 and the median is $14.68. As both earnings and prices greatly fluctuate over time due to expansions and recessions, Prof Robert Shiller of Yale University (2013 Nobel Prize recipient) developed and popularized a smoothing method of the earnings by using the average earnings of the past 10 years. The cyclically adjusted CAPE P/E of the SP500 is at 31, which means that investors are paying about double the average price they historically paid for each dollar of earnings. The only way to get back to historical norms in such a situation is for earnings to double or prices to be cut in half. It is more likely that a mixture of both will happen.
3.2 Debt levels are at record Highs again
Margin debt is at a record high (see chart below), meaning that more and more people are borrowing money to buy stocks. In these situations when a correction happens, many can receive margin calls and be forced to sell their investments, which can exacerbate the selloff. Credit card debt has also reached record levels due to the high confidence in the economy (see chart below from the Fed). These two factors make the economy less resistant to shocks which can easily exacerbate any small imbalance. There seems to be no bubble in the housing sector, but several years of engineered low interest rates by the Fed have made people forget about the trials of debt and allowed consumers to load up on loans. I am not sure whether consumers and businesses have reached their limit on debt, but in a Wall Street Journal article dated on 11/27/2017 (see link below), it discusses the fact that loan growth (not the amount of outstanding loans) has slowed in recent months.
Margin Debt Adjusted in Real dollars
3.3 Earnings may not be what they truly are… back to earning shenanigans!
“Only when the tide goes out do you discover who has been swimming naked” is a favorite saying by respected investor Warren Buffett (I hope he keeps on kicking – age 87). Numerous reports by the Financial Times, Wall Street Journal, and MarketWatch have raised the alarm over earnings not being what they truly are. These shenanigans tend to happen toward the end of every business cycle as companies get punished (steep drops in stock prices and/or no bonuses) for missing their lofty earnings targets. Obviously, to avoid such negative situations, managers, accountants, CFOs, and CEOs start being a little bit laxer in reporting losses and get more aggressive in reporting income. This situation reminds me of the MCI WorldCom and Enron scandals of the early 2000s or the mess at mortgage companies during the 2008 recession. It is just a matter of time before investors realize that the tide will eventually run out.
- A Few reasons this market “may” keep going up
Here are a few reasons the market will keep going up for a little longer:
4.1 Tax Cuts will favor corporate earnings and stock investments
If the tax cut passes as written, it will favor corporate earnings and increase the amount of cash available to corporations. In the equation discussed above, the Earnings (E) will increase making the P/E lower and more reasonable. The tax cut could cause corporations to go through a period of consolidation during which they bid up the price of rivals to acquire them and gain greater market share. Also, the reduction on mortgage deductions (limit at $500,000 of mortgage) will make stock investments more appealing than real estate investments. People may choose (or be forced) to buy cheaper houses especially along the major coastal cities of the U.S. with the low mortgage interest deduction and the elimination of state tax deductions (a double whammy for democratic leaning states!). Ironically, the elimination of the mortgage deduction could precipitate a drop in real estate prices which could make people feel less rich and curtail their spending. This in turn can bring about a slowdown in the growth of the economy. Since the tax bill is not final, it is hard to know what its impact will be in the economy. The real reasons we do not get tax overhaul that often is because it is messy and there are always unintended consequences. However, it seems like Trump has chosen a very good time to push through tax cuts for corporations and states with low income taxes (Republican leaning states).
4.2 Emerging Market Growth can pull the U.S. economy
Growths in emerging market economies (China, Eastern Europe, Southeast Asia, Latin America) have just started in earnest in the past 18 months (see references below). It is always the case that emerging markets’ growth accelerates towards the tail end of the business cycles. However, emerging markets in aggregate have gotten big enough to be able to pull the U.S. through a couple more years of growth. Although most of the growth in emerging markets is funded by cheap debt (perhaps true for all growth cycles), we may be nearing the end of cheap money as Central Banks around the world are starting to increase rates to mute speculation which will lead to inflation, the arch enemy of any economy.
4.3 Europe and Japan have been growing of late
After decades of tepid or no growth, European and Japanese economies have been growing again. With the strong linkages between the European, Japanese, and U.S. economies, it will not be surprising for the U.S. markets to benefit from the continued growth in these regions. Hence, it is likely that U.S. companies that sell a high percentage of their products globally, like Facebook (F), Apple (A), Amazon (A), Netflix (N), Google (G) -FAANGs, have powered the rally will continue to do well and grow.
Back in the Fall of 2000, Bill Clinton was on his way out, a new Republican president George W. Bush was just sworn in, everyone was expecting tax cut. However, that did not stop the tech bubble from bursting starting April 2000.
2018 might turn out to be like 2000 in many respect; a correction (sell off) in technology stocks is likely although there are many other reasons to be cautious while remaining optimistic for the long term.
Also, in the midst of the selloff from Sept 2008-March 2009, the market at one point hit a 12-year low. I remember saying to myself that I will never feel bad about missing part of a rally in the stock market again. I realized that at that point in 2008, I could have been out of the market during all the dot com craze and all the housing market bubble and still have the chance to reenter the market at the same prices of 1996. Who knew? I hope we never hit a multi-year low again, but I have seen it happen a few of time in the past twenty years. Hence it is important to sell positions and lock in some gain from time to time and not chase the market. It is also important to maintain exposure to the market even with the knowledge that from time to time it we will experience corrections and bear markets. The important thing is to have a long-term perspective that is flexible to changing conditions.
Some Investing Rules:
#1) Always maintain 30 to 50% exposure to stocks at all times
#2) Limit debt during booms and raise some cash
#3) Invest heavily during downturns with funds raised during booms
#4) Take some gains from time to time
#5) Keep emotional and cognitive biases in check
(email me: Ousmane@timbuktucapital.com for the emotional and cognitive bias check-up test.
#6) Enjoy the journey!
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Analysis with some basic numbers:
Here’s a quick analysis of P/E
Average 10-year P/E, called CAPE, is at 31.
Historical average CAPE P/E is 16.8.
I like to look at E over P, where P = $100, meaning how many dollars of earnings one can buy for every $100 invested.
- Current CAPE P/E = $100/31=$3.22
- Average historical CAPE P/E =$100/16.8=$5.95
So to return to the average P/E here are three main things that can happen:
- Earnings (E) increase: an average of 84%
- Price (P) decreases: The S&P 500 falls by 45%
- A mix of both Earning increasing and Prices dropping or staying constant for a while. For example, Earnings can increase by 30% and stocks fall by 20%, which will lead to a CAPE PE of about 19.
Momentum Trading, Return Chasing, and Predictable Crashes by Benjamin Chabot, Eric Ghysels, Ravi Jagannathan
Julian Robertson of Tiger Management, one of the best value managers calls it quit in March 2000 right before the dot com crash
Seth Klarman of Baupost, one of the best hedge fund managers returns money to investors to avoid poor returns back in Sept 2017.
How the economic machine works in 30 min by Ray Dalio of Bridgewater Associates
Chart of P/E ratio of S&P 500
High level of consumer credit- Federal Reserve Bank of Saint Louis
Investors should be wary of earning shenanigans
MCI WorldCom scandal
Growth returns in earnest in emerging markets
7 consecutive quarters of growth in Japan