QUOTES OF THE WEEK
“In a narrow market, when prices are not getting anywhere to speak of but move within a narrow range, there is no sense in trying to anticipate what the next big movement is going to be. The thing to do is make up your mind that you will not take an interest until the prices break in either direction.”
– Enjoy more of our favorite quotes –
SEPTEMBER 18, 2016
A SLUMP AND A POTENTIAL CATALYST
The S&P 500, Nasdaq Composite, and Dow Industrial indices each set all-time highs on Aug 15.
Since then, each has slumped. Is this bull market finally tired after a seven-year run?
A SLUMP AFTER SETTING ALL-TIME HIGHS
On August 15, each of three prominent US stock indices (S&P 500, Nasdaq, and Dow Industrials) recorded simultaneous all-time highs, an alignment that hasn't occurred since December 31, 1999 (shortly before the first significant market selloff of the 21st century).
Chart 1 shows the three indices price pattern for the last six months:
Chart 1: The S&P 500 Index, the Nasdaq 100 Index, and the Dow Jones Industrial Average all recorded record highs last Thursday.
This troika of record highs stands in sharp contrast to the abrupt selloff nine months ago to start the year. That correction, which ran from the end of December 2015 to the middle of last February, reminded many of the market's reaction to the last trio of record highs set in 1999.
Perhaps ominously, that last synchronicity of record highs was followed by the first historical, -50% market selloff of the 21st century. The NASDAQ index received the hardest hit of the three. With a rapid deterioration in stock prices that began just three months after the peak and continued for 2-1/2 years, losses to buy-and-hold investors on that bourse totaled more than -80%, which challenges the Depression-era decrement for brokerage-account pain.
Nevertheless, many investors steadfastly follow an approach of "buy high and sell higher," and continue to pour money into the market near all-time highs. With interest rates across the world at record lows, many believe they have no choice other than the stocks.
Will an equity-centric strategy continue to pay off, or is the trio of new highs the death knell of this long bull market, as it was in 1999? Is the party just getting started – or should we brace for a sweating, shaking, heaving hangover? We will delve into the bifurcated answers to that question in this week's editorial.
SECOND MOST EXPENSIVE MARKET IN HISTORY
By far, the most troubling aspect of the stock market for value investors is how expensive it has become. The current GAAP Price/Earnings ratio of the S&P 500 is 24.61 – the highest level since 1925 outside of a recession, with the exception of the late 1990s. (The Russell 2000 small-cap index is even more expensive because its composite, as-reported earnings are negative, and the Wall Street Journal reports its PE ratio is "nil!")
From 1925 to today, the average P/E ratio of the S&P 500 was about 15. Historically, a P/E ratio of 20 signified overvalued stocks and a selloff/correction invariably ensued, while a PE of 10 or lower meant stocks were deeply undervalued, and it was an excellent time to buy.
Unfortunately, the average investor’s timing is terrible. Our experience with investors since 1983 is that they consistently buy near the top of the market after a strong run (when stocks are expensive), and fear causes them to sell their holdings near the bottom (when stocks are cheap). Of course, this is the opposite pattern from successful value investors.
In the 1925-to-present chart below, notice that the S&P 500 index stayed within the Price/Earnings range of 10 (green; undervalued) to 20 (red; overvalued) for almost its entire history since 1925, with a clear exception in the late 1990s – and ominously – today:
Chart 2: The S&P 500 is above the non-recession, overvalued PE of 20 for the second time in 91 years.
Chart 3 zooms in on 1990-present:
Chart 3: A zoom in to 1990-present chart shows that the S&P 500 is 68% above the fairly valued PE of 15 the second-highest level in 91 years!
Notice that prices peaked 87.7% above 'fair value' in 2000 before the -50% selloff. Before the 2007-2009 crash which cost buy-and-hold investors -56%, prices were only at about 18 times earnings. As shown on the right-side of Chart 3, we can see that the S&P 500 is currently 68% above a 'fair value' at a PE near 25!
It is evident to most market watchers that stimulative central bank policies have created an acute asset-price distortion in the form of the current extremely expensive stocks (among other things). While the Federal Reserve and many pundits forecast higher interest rates in the coming year, the 18-month decline in corporate earnings, accompanied by slow economic growth, does not support that thesis. In fact, we believe the Federal Reserve overnight rate will stay below 0.5% for the foreseeable future and may even go lower.
Overseas, negative interest rates on sovereign debt have become routine, without compensation for the risk of a fragile government’s ability to repay.
“When one stops to realize that the amount of global debt yielding negative interest rates now exceeds $12 trillion, it should be clear how extreme central bank distortions have become. To imagine that equity valuations have not already fully responded to this situation after years of yield-seeking competition is, quite frankly, ignorant both of reliable valuation measures and of financial history."
– John Hussman, Hussman Funds
Also, central banks desperate for economic growth (such as the Bank of Japan and the Swiss National Bank) are buying massive amounts of equities on their country's stock exchanges. In so doing, these central banks are expanding their mandates for steady employment/inflation with unknown consequences.
Inevitably, there is a tendency to believe, "this time is different," stimulation will continue, and stocks will respond by moving even higher (as they have for the last eight years). Central bank policies have succeeded in prompting investors to take additional risks with financial and real assets (but without the sought-after economic growth). As a result, stock prices have spiraled higher. This has created what we call 'Bull Market Complacency,' which includes the almost universal view that central bank stimulus will limit any significant downturn in market prices. As a result, a "buy the dips" mentality pervades the stock market.
“The trend in equity prices here in the U.S. remains upward despite the egregiously, the almost preposterously, over-brought nature of the market.” Investors are still dancing with TINA: There Is No Alternative. The music manufactured by the central banks continues to be played and investors continue to dance.” – Dennis Gartman, The Gartman Letter
Higher stock prices are certainly possible (for a while). After all, "this time is different" is the same logic that caused the most overvalued market ever in the "dot-com"/"new economy" gold rush of the late '90s. At that time, stock prices climbed above the overvalued level of 20 times earnings for 6.5 years and peaked at 88% above the "fairly valued" level of 15 times earnings. Without an effective market-timing system (such as IntelligentValue's IMRA) most investors discover too late that it is never 'different' for very long.
POTENTIAL MARKET OUTCOMES
There are only two possible long-term outcomes for any extremely expensive market:
1) Prices stay mostly flat, potentially with high volatility (this is what has occurred in the last year) while earnings catch up to prices, and PE ratios come down.
2) The market enters into a steep decline to return to normalized conditions and a more reasonable P/E ratio.
For those who believe the first outcome to be most likely, there is an inconvenient fact to consider: since Q1 2015, earnings have been deteriorating – for six quarters straight! Unless something inconceivable occurs that will unexpectedly turbocharge the US and world economies, it is unlikely that corporate earnings will reverse course and catch up with stock prices.
That leaves the second outcome. What could be the trigger for a correction/selloff/collapse in equity prices? Well, almost anything; such as the shock from an exogenous political (a Trump/Clinton October surprise?) or geopolitical (a Euro-country default?) event to a continuing decline in corporate earnings.
If a crash happens, what can the Federal Reserve do then to push stock prices back higher? Not much now, considering that the Fed has kept interest rates at the zero-bound since late 2008 and by the Fed’s own admission, QE is impotent now. Are negative interest rates in the US a possibility? In the context of what the Fed has done over the last eight years; definitely!
However, remember that Einstein said that the definition of insanity is repeating the same thing over and over and expecting a different outcome. Central banks around the world have pushed the cost of money ever lower, and asset prices ever higher, in hopes to stimulate the economic growth – without results.
When the Federal Reserve raised overnight rates for the first time, by about 0.25% last December and forecasted raising rates four times this year, the market threw a tantrum and plummeted -12% in January. Now the Fed is signaling that it could raise rates again soon.
Of course, this is likely just calculated jawboning by the Fed in an attempt to put a cap on overpriced assets. If the market responds with a selloff, the Fed will probably initiate more manipulative double-talk about easing and stimulation to push the market back up (that's what happened in February this year to spark the current 18% rally).
Unfortunately, this Fed-created security blanket for investors distorts stock and bond markets, creating artificial conditions that make any fundamental assessment of genuine asset prices an afterthought. Also, the today-tightening and tomorrow-easing flip-flopping by the Fed creates a crisis of confidence among investors.
Because of these very unusual conditions that have caused extremely high equity prices, proven, fundamental valuation approaches have been rendered ineffective. As a result, our portfolios ( largely based on fundamental value ratios) have remained mostly in cash for an extended period.
REVERSION TO THE MEAN
Obviously, people invest to make money, and every investor has in common with another the desire for stock price appreciation. However, if we want price appreciation, the place to look for it is counterintuitive.
Price appreciation is unlikely to be found where most look for it: in the strong, popular, high-flying growth companies profiled on TV, in Internet blogs, and in magazines. It is unlikely to be found in companies with high analyst recommendations. In fact, profits are more likely to be found by investing in companies enduring financial losses and plunging stock prices.
Why would this be? As Tobias Carlile said in his seminal book Deep Value,
The reason is a pervasive, enduring phenomenon known as mean reversion.
Mean reversion can be observed in fundamental business performance, security prices, stock markets, and economies. It returns high-growth stocks to earth, and pushes down exceptional returns on investment, while lifting moribund industries, and breathing new life into dying businesses.
Value investing is inherently a contrarian approach. While exceptionally profitable over the long term, there are times when a value strategy is forced to stand aside while the market moves from pure speculation. IntelligentValue has utilized cash both when there are few undervalued opportunities available (like today) and when the overall stock market is declining (like 2008-2009). We will likely purchase new undervalued companies for our two value-based portfolios after a correction in prices.
However when the time is appropriate, we still plan to introduce ETF portfolios we have previously discussed. While we didn't make this clear before, we have been successfully running ETF portfolios since the early 2000s on another website. The track record of these portfolios is quite good, with excellent returns, moderate drawdowns, and steadily rising equity curves, even during the financial crisis.
Based on hundreds of companies, ETFs cannot beat the performance of individual, undervalued stocks, but they offer ample diversification and liquidity in a single equity. There is no need to purchase 20-50 positions to protect a portfolio from the potential collapse of one company. A diversified portfolio can consist of one ETF. Also, since our algorithms rotate into the optimum sector/asset at the appropriate time, we can make money in virtually any market environment.
WHY ARE EARNINGS A CONCERN?
A few weeks ago, when we did our survey of subscribers about preferences for our coming ETF portfolios, we also solicited comments and one was the following:
"It seems to me that earnings are a concern to you. I don't know why that is..."
Here's the full comment:
“It seems to me that earnings are a concern to you. I don't know why that is. I follow earnings carefully, every day. Today for instance, of 19 companies reporting, 16 either met or exceeded expectations. It has been running like that for a long time. Earnings look ok to me. I don't get your concern."
Of course, the reason earnings are important is that they are fundamental to investing analysis: over the long haul, stock prices are based on earnings and all the other accounting derivatives that flow from top-line revenues, such as operating income, EBIT, EBITDA, operating earnings before depreciation, cash flow, free cash flow, return on equity, dividends, and much more.
However, the subscriber's comment actually focuses on earnings expectations. We fear that the ubiquitous Wall Street brainwashing machine has seduced him/her into believing that Wall-Street generated earnings expectations are as valuable a metric as actual earnings. That is not said in derision at all, because Wall Street has convinced millions of other investors of the same thing. The reliance on forcasted earnings is fare more pervasive than anything else in investing.
Actually, the subscriber was asking why we do not give more weight to future (estimated) earnings instead of current and historical earnings. The short answer is that we know earnings expectations are nothing more than manipulative propaganda foisted on investors by Wall Street bankers.
Now, why could we know for sure that analyst's earnings expectations are just manipulative propaganda? Is that just an opinion? Well, consider this:
Some 35 years ago, this writer accepted a job offer as a stock analyst at a very well-known Wall Street brokerage firm. It turned out to be a psychologically scarring experience because it was my first exposure to the inner workings of the investment industry and my ideas about Wall Street integrity were shattered! I learned that there is virtually no fiduciary responsibility in the investment industry, save for something like the selection constraints placed on mutual funds. Commissions and bonuses are all that seem to matter. Buyer beware! Nevertheless, I came away from the experience with valuable insider knowledge about how the game works, and regularly put that information to use for our subscribers today.
The first rule in the mythical "Wall Street Analyst's Insider Handbook" is to calculate forward quarterly and 12-month earnings significantly higher than real analysis dictates. When I asked why we would do such as thing, my trainer told me, "We must be optimistic about the future! We never know how well results can turn out!" In other words, the not-so-subtle message was that it is better to overestimate than to underestimate (or give an actual, reasonable expectation based on facts). This point was driven home again-and-again over several years, not just once.
It made some sense to my young ears at the time, but after some experience, I learned that earnings expectations are just one of many Wall Street sales tools. Analysts are taught to set earnings expectations for individual companies (and therefore, the overall market) to increase by about 15% for each year - even during years of recession or when a company is in decline! For example, at the depths of the 2008 stock-market debacle, analysts estimates of S&P 500 earnings were still expected to increase by 17% for the coming year!
Wall Street analysts then gradually lower earnings expectations for the companies they are assigned each subsequent quarter until they are about 7% below the analysts actual, expected earnings for each company for the upcoming quarter. As an analyst with a major Wall Street brokerage, I was instructed to manipulate my real estimates in this manner. It is a well-known game in the concrete canyons of Broad and Wall. In this manner, next year always looks wonderful, and quarterly earnings reports almost ALWAYS beat expectations! The writer of the comment said, "it has been running like that for a long time." He is correct; since the early 1900s, an average of 77% of mid-size and large companies beat their earnings expectations, even during quarters when corporate earnings are collapsing!
It is a game rigged to manipulate investors, and this process has snared millions of innocents into the trap. Earnings expectations are manufactured by the brokerages for the sole benefit of the brokerages - not to benefit investors. Yes, stock prices are a discount of future earnings (not past), but future earnings are impossible to know! I learned in real-time experience as an analyst that as a group, analysts true expectations seldom come close to reality – but our manipulated earnings expectations would always turn out right! Forward 12-month earnings forecasts were always optimistic, sucking in unwary investors, and next quarter's artificially lowered estimated earnings would always be beaten, and the stock price would pop when earnings came in; again sucking in unwary investors.
What matters is price relative to earnings, and price relative to other fundamentals such as cash flow, operating profits, tangible assets, and other fundamentals. Those ratios are the tools of value investors. As pointed out, the current market is extraordinarily overpriced on that basis, especially with six consecutive quarters of sales and earnings declines.
Last June 28, 2015, we correctly identified a coming period of severe market risk. Then last February, our IMRA technical system gave us the signal that it was safe to buy stocks. However, we have been unable to find undervalued companies that also meet our criteria for safety, quality, and positive technical patterns. As value investors, we are looking for companies that Warren Buffet has called a "fat pitch." Until we can identify companies selling at a significant discount to their intrinsic value, our deep value, Aggressive Portfolio will remain in cash. We may have new selections for our Conservative Portfolio soon.
We believe there needs to be a healthy correction for there to be new 'fat pitch,' deep-value opportunities. This is why we are adding new ETF portfolios to our roster: for times like this when there are few qualified, undervalued investment opportunities.
A MAJOR MARKET-MOVING EVENT COMING NEXT WEEK
A very important event will occur on September 26 that could be the catalyst to move markets either higher or lower dramatically. It is likely that this event will cause either an enormous selloff or a surge higher. We have just posted our analysis of that potentially powerful catalyst, and you can read about it in our Value Secrets blog.
OUR plan for this week
In the words of Jesse Livermore from our Quote of the Week: "In a narrow market, when prices are not getting anywhere to speak of but move within a narrow range, there is no sense in trying to anticipate what the next big movement is going to be. The thing to do is make up your mind that you will not take an interest until the prices break in either direction.”
The catalytic event referred to above is determining our near-term outlook for the market, and we will not be changing our current portfolio positioning until we see what occurs.
Don't forget that if you are not a subscriber, you can access all our content (including Market Risk Analysis, all Value Alert newsletters, our Portfolio selections, and Stock Analysis) instantly with a free trial. If you have questions about this newsletter or our approach, please feel free to contact us.
We hope that we have competently discussed the issues addressed in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the subjects discussed, market environment, company or ETF SEC filings. Investors may wish to consult a qualified investment advisor. The information in this material was obtained from sources believed to be reliable, but were not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.