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Yields Are Rising

July 12th, 2018

Treasury 2 yr

Double Click on Image for Full-Sized View

The graph above is of the 2-year treasury note yield. At 2.58%, it is at a 10-year high – and looks like it could continue to rise.

The stock market has had a rocky start to 2018. One of the big reasons is rising interest rates. There is a trade-off between stocks and bonds – as bond yields fall, stocks become more attractive to investors. This is based upon a couple of reasons: (1) lower interest rates mean that corporations borrow at lower rates, and the difference between the higher and the lower rates equates to increased net income for shareholders, which makes stock prices rise (all else being equal) – so rising rates mean just the opposite, lower earnings and lower stock prices; and (2) when valuing stocks, you are really looking at a discount of a company’s future earnings – those earnings are discounted using current short term treasury rates, so falling rates will yield a lower discount and produce a higher valuation – while rising rates yield a higher discount and produce a lower valuation.

As an investment manager, we watch treasury yields very carefully. Rising yields means rising risk – the risk that your investment portfolio will go down in value. Above, we discussed how rising yields impact stock prices, but they also negatively impact bond prices.

As yields rise, the value of bonds goes down. Think of it like this: you bought a 2-year treasury last year at a yield of 1.35%, but today you could buy one yielding 2.58%. The yield has almost doubled over the course of a year, so if you want to sell that bond to someone else, your bond yielding 1.35% with a remaining life of 12-months provides less return than the current bond yielding 2.58% with 24-months remaining life. You would have to sell your bond at a discount so that the yield moves from 1.35% to the current yield on a similar new bond with 12-months remaining life. Today, a 1-year treasury note yields 2.36%, or a full 1% above your bond. That is a big discount, or loss in value from its face value, that you would have to take to sell the bond today.

Rising interest rates are bad for both stocks and bonds as shown above. So what does an investor do? Sell everything and move to cash?

No, part of managing investments for clients means that you have to work hard to make money even at times when extraneous forces are presenting headwinds to stocks and bonds.

As far as stocks go, you have to find ways to deal with the two issues discussed above: earnings and valuation.

To deal with the earnings issue, you need to focus on: (1) companies that have no debt (not always possible) or at least companies that have a lower level of debt than their industry average; and (2) industries that do not need to borrow as much as other industries to operate their businesses. Reviewing ratios of debt to equity for individual companies, and comparing them to other companies in their industry, will help with the first issue above. Over-weighting your industry allocations to industries with little borrowing needs, like biotech and technology, while under-weighting industries with heavy borrowing needs, like manufacturers, help with the second issue.

As far as bonds go, you need to focus on building a ladder of individual short-term bonds and CD’s (say one to three years in duration), short-duration mortgage bonds that repay principal along with their interest payments, and adjustable rate bonds (we focus on mutual funds for these last two) all are good hedges against rising rates. The short-term ladder allows you to hold your bonds to maturity (since selling early can cause losses due to the discount to face value as shown in the discussion above) and then reinvest your proceeds in higher yields. The mutual funds are defensive by the nature of their investment portfolios – you just need to be very careful when looking at a mortgage bond mutual fund to make sure the average duration is short. Additionally, if rising inflation is the proximate cause of the rise in yields, mutual funds that focus on TIPS (treasury inflation protection securities) can be a successful investment as well.

For the classic rock fans out there, here is a classic: the Animals playing House Of The Rising Sun

For those who are fans of today’s music, here is a cut from Jurassic World: Rise by Skillet



What’s Up With The market?

June 11th, 2018

spx 2018-06-11

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A couple of weeks ago, I wrote that the market had a 60% chance of moving higher based upon the fact that it had cleared the blue downward sloping trend line and had broken above the May R1 resistance level. I noted that we could likely retest that downward sloping trend line and that if we then successfully moved back above the May R1 resistance level, we would likely see our next major stop at a bit above the 2800 level on the S&P 500 Index.
Above, I have updated the original graph to extend the two blue trend lines with orange lines and added an orange arrow at the point where the market did in fact retest the trend before a sustained move higher. I have also circled the area where we have broken above the June R1 resistance level. My Rule of Three states that now that we have broken above June’s R1, we need to stay above it for three days or three percentage points. Once that happens, the June R1 becomes a support level, just as the May R1 is now a support level since we have sustained a move above it for at least three days.
So, what’s next?
1. Let’s start at the bottom of the image in the panel that represents our Trend Analysis. As I noted in our previous blog post, we want to see the blue 50-day moving average move above the pink 100-day moving average. You can see that the blue line has curled upward and could move above the pink line in coming days. When that happens, you have a very strong up-trend in place with the 50-day above the 100-day above the 200-day above the 250-day moving average.
That stacking of the trend lines in order from short-term to long-term means that in all of the short-term to long-term time frames, the market is trending higher. Once a trend is in place, the market tends to follow that trend as the various trend following investment strategies add more money to be invested. It also means that investors that are on the sidelines jump in and add money to the market as it appears to be investor friendly.
2. Now, let’s move up one panel on the image to review our Sentiment Analysis. As I noted in our previous blog post, we see positive sentiment with (a) Cash Flow being consistently positive and rising and (b) Momentum moving into positive territory and rising. Since then, cash flow has continued to be strong (the orange area graph) showing money moving into the market, and momentum has gotten stronger (the black and red line graph) with both lines in positive territory and rising, and the black line consistently above the red line.
3. Finally, in the very top panel we have our Short-Term Relative Strength Analysis. This is the only worrisome item on the image. You can see that the line have moved above the upper threshold reading, which typically means that in the near-term, the price action has gotten ahead of itself and we are due for either a couple of down days or a couple of choppy sideways days until the price action gets less giddy.
So, when we combine the price movement of the primary graph and its need to stay above the June R1 resistance level with the relative strength line showing a need for the market to cool down a bit, my best guess is that we do not get our our three day rule confirmed and we drop back below the June R1 resistance level.
However, given the strong Trend and Sentiment that are in place, this will be a buying opportunity for those that have cash to invest, and they will add it to the market and push us back above the June R1 resistance.
So, lets give this a 65/35 chance of seeing ultimately higher prices where we hit 2,825 on the S&P 500 Index before we see another retest of the blue/orange downward sloping trendline.
Will we make it all the way to 2,875-ish all-time high? Stay tuned to the blog and I will keep you updated on the progress the market is making.



Where Do We Go From Here?

May 21st, 2018



Double Click Image for Full Size View

I thought it was a good time to have a discussion about what is happening in the market and where we are going from here.
In the graph above, the large image in the middle with the two blue lines is the price graph of the S&P 500 Index (my proxy for the entire stock market). If you look at the blue arrow I’ve drawn, you can see that we had a breakout above the downtrend line that traded above the R1 resistance line for a couple of days, then fell to retest the downtrend line (you can barely see the red tail thave came down to the downtrend.
After a bit of back and forth over a few days, we have closed slightly above R1 resistance again. IF we are able to stay above this resistance for three days, then in my investment world we have broken out and should move up to R2 resistance, and then if we successfully hold that level, make an assault on the all time high we saw back in January.
You will note that there are lots of “ifs” in that paragraph. The reality is that no one knows exactly what the stock market will do – the various support and resistance level, trend lines, moving averages, and other indicators all play a role in helping us to make some educated assumptions. But there is never any certainty in the market.
Over the next couple of trading days, we need to have the S&P 500 index close above 2725.76 for there to be a chance for a move higher. If we don’t, then watch for another test of the downtrend line, around 2675. However, the market has some things in its favor:
1. Look at the Orange Arrow. It is point to the Money Flow indicator – which shows the indicator in positive territory and moving higher (albeit slowly). This is a good thing, when this indicator is in positive territory that mean investors are committing money to the stock market and that is supportive of higher prices.
2. Look at the Purple Arrow. It is pointing to the Price Momentum indicator. The black line is above the red line, both are pointed upward, the black line is pointing further upward than the red line, and both are above the 0.0 indicator line. This tells us that prices are once again in a rising trend and that they are gaining in velocity in their move upward.
3. Look at the Red Arrow. It is pointing to a Line Graph with various moving averages that give you an idea of the Trend. One of the simplest things to know about the stock market is when it is moving higher, it tends to continue to move higher – and visa versa. This is a pretty graph if you are an investor, one you would grade as a “B” maybe. Ideally, for an “A” rated graph, you would have the black price line above all of the moving averages, with the moving averages all in order: 50-day, 100-day, 200-day, and 250-day. You will see that the blue 50-day moving average is below the 100-day moving average – its not ideal, but it is far from a deal killer. You can see that the black price line is in a nice trend above the 100-day moving average – but the blue 50-day line is still pointed downward. What you want to watch for is the blue line starting to turn upward – that will give you some confidence that we have a chance to retake the old highs made in January.
So, where do we go from here? I’d say that based upon the positive readings from our indicators and the positive reading from our trend graph, I’d say the odds favor us continuing to move higher over near-term to test out the R2 resistance at 2803, or a roughly 2.5% move higher. Then we need to check our indicators and trend again.
1. Lets give this scenario of a move to 2803 a 60% chance of happening and a move back to the downtrend line at 2675 a 40% chance.
2. I’ll feel better in a couple of days if we can hold above the R1 resistance level. If we do, then I’d move our odds up to 75% of reaching 2803 and 25% of dropping to 2675.
3. If the 50-day moving average crosses above the 100-day moving average, I’ll move our odd up to 85/15.
4. If the price line remains above the 50-day and above the 100-day, then I’d move the odds to 95/5.
As usual, anything can happen in the stock market – we are always one tweet away from a 3% drop in the market as investors get spooked by something that may or may not come to pass. If that happens, then we have to check our indicators and trend to see what sort of damage was done and come back with a new look at where do we go from here.

Or for you closet Buffy fans…


First Quarter Update – Second Quarter Outlook

April 9th, 2018


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The 1st quarter of the year began on a high note with the stock market hitting new highs during January.  The anticipated tax cuts were implemented, and the stock market had a fairly standard “sell the news” reaction, meaning it had gone up in anticipation of the tax cuts being implemented, drawing in a lot of money that had been out of the market, just as the big institutions opted to take profits.

February brought us a major sell-off as the new investors panicked and sold trying to avoid a huge loss.  Just as we had written during 2017, we had a higher than average level of cash and short-term bonds on hand ready to invest it when a correction came about.  As such, we turned into buyers during the sell-off and rode the recovery higher during late February and early March.  Even though late March and early April brought another sell-off, it was a higher low than early February.  Our purchases during the February correction have profits as the market is now consolidating on the 200-day moving average line, a sort of “line in the sand” for the stock market between being in a bull market trend or bear market trend.  Look at the graph and you can see how the 200-day moving average (blue line) is acting as strong support for the current bull market trend.

Moving into the 2nd  quarter, the economy is positioned for short-term growth after Congress passed a hugely deficit budget.  This, coupled with the tax cuts, will provide fiscal stimulus for 2018, probably significantly so.  Corporate earnings are anticipated to show a roughly 12% growth rate based upon the tax cuts and economic growth.  The long-term question is whether the huge deficits from the spending bill on top of the deficits from the tax cuts, and on top of the deficits brought forward from previous years, can be offset by economic growth from the fiscal stimulus.  That is clearly what the government is hoping and planning, but it will definitely not be an easy road with the current policy of the Federal Reserve.

Offsetting the fiscal stimulus, we know that the Federal Reserve is in monetary tightening mode in a bid to offset increasing inflation. Monetary tightening negatively impacts economic growth, which puts it at odds with fiscal stimulus.  As the Fed continues to raise interest rates and sell bonds that they accumulated during their efforts to stimulate the economy, we will certainly have a war of competing economic policy that ultimately provides an uncertain forecast for 2018.  When we add in the hard line the government is taking on trade and the potential impact of retaliation by trading partners, investors are understandably concerned and quick to hit the sell button at any sign of concerning news.

The stock market has already shown how dependent it is on low interest rates to move higher.  The outlook for rising inflation and higher interest rates will yield a more volatile and cloudy near-term future for the markets.  If the fiscal stimulus provides us with an ultimately higher stock market in 2018 and an economy that grows anywhere near the target 3% that the government desires, we will likely see a point in the future when the stimulus has less impact. Rates materially higher than today with less impact of the stimulus will be a major headwind that could send both the economy and the market materially lower, raining all over our bull market trend.   However, that is not the likely scenario for at least the next couple of quarters.

Our strategy for clients invested in individual stocks is to focus on the areas of the market that benefit from higher interest rates (banks and brokerages), have macro catalysts behind them like demographics (hospitals and health insurance), a consumer with more disposable income after the tax cuts (restaurants, retail), agriculture that benefits from inflation (the producers and the commodities themselves), domestic technology and telecommunications infrastructure (cloud companies, cell phone towers),  geopolitical turmoil (defense, cyber security, precious metals), and companies that have less exposure to foreign trade (many of the industries above).

Our strategy for clients invested in the bond market is to focus on keeping durations short, adding adjustable rate securities, inflation protected securities, and laddering individual bond portfolios where the account size allows.


Strategy and Themes Update

December 22nd, 2017


Double click on any image for a full sized view

As we approach year-end, I wanted to update you on our investment strategy and themes going into 2018.  But first, I thought a review of the market year-to-date would be interesting.

In the graph above, you can see that the large companies’ stock prices (as represented by the S&P 500 Index in the Red bar) soundly out-performed small companies’ stock prices (as represented by the Russell 2000 Index in the Purple bar).  And Growth style companies (as represented by the Russell 1000 Growth Index in the Green bar) trounced Value style companies (as represented by the Russell 1000 Value Index in the Pink bar).  What this tells me is that investors focused on the largest and fastest growing companies in the country when investing their hard earned money, and ignored to a large degree the smaller companies and the companies in more traditional industries like energy and food production.

One item to note is that beginning in November, the value style companies began to out-perform the growth style companies, but we cannot know if this is the beginning of a structural change in the character of the market or just a one-off occurrence.  There is more discussion of this later in this blog post.


In the graph above, I have plotted the performance of the various economic sectors of the S&P 500 Index so you can see for yourself which ones were driving the index higher.    The Green bar showing the performance of the Technology sector explains why the Growth style companies were this years price performance leaders.  However, overall, every sector except Energy was positive year-to-date.  But look at these same sectors when we view the market excluding those large companies:


This graph shows a much different picture year-to-date.  Small and mid-sized companies in the Technology sector still performed well, but the overall market performance was pretty pathetic.  Small and mid-sized energy companies really took it on the chin this year followed by utilities and consumer staples.

One of the signs of a mature market is that the largest companies start to significantly outperform smaller companies.  It is based upon human nature where people who typically do not invest in the stock market see it going up and decide to put money in the market, either buying shares of the companies they know that are doing well (e.g., Facebook, Google, Microsoft) or they buy mutual funds that are heavily weighted into those same large cap companies.  Historically, this is a sign that we are due for a correction – however, there is no way to know when that will occur.

Countering this historic pattern, we have the corporate tax cuts that were just signed into law.  These cuts will have a huge impact on corporate earnings, particularly for companies that whose operations are primarily domestic.  For companies that have significant foreign operations, the impact on their income will be less.  They will, however, be able to bring those earnings from foreign operations back into the US will a significantly smaller excise tax beginning in 2018, which many will do.  Its hard to know how they will use that money when it is repatriated – some will pay bigger dividends to their shareholders, some will increase their stock buyback programs, some will increase wages for their employees, some will invest it in expanding their business, and some will do multiple of these things.   Honestly I was struck by the announcements from several large companies that are beneficiaries of the tax cuts that they would pay $1,000 bonuses to their employees while others were raising their base wage to $15 per hour.  I didn’t see that coming.


Given that the value style companies are weighted heavily in domestic operations, the out-performance we saw starting in November could be investors anticipating the impact of the tax cuts on those companies earnings beginning next year.  In the graph above, you can see that for the overall market excluding the S&P 500, the companies that had been underperforming (energy, staples) show positive performance whereas technology was down.


For the S&P 500 since November 1st, you see a similar pattern, with energy and staples both outperforming technology.

In October, we rebalanced client portfolios ahead of year-end based upon changes we believed were going to occur.  This rebalance began to transition our clients’ portfolios to reduce exposure to technology and add shares of energy and staples based upon our view that those sectors would benefit from tax cuts more than the technology companies that have significant foreign sales.  We also began to swap within the technology sector, paring back our big winners with higher P/E ratios to focus on lower P/E companies and technology companies that had recent price declines, all as part of our updated Investment Strategy and Themes heading into year-end and 2018.  The additional benefit of this move is that portfolios became more defensive in posture so that they will ride out the next correction (whenever it may occur) with less downside – and when we have lower prices we can be opportunistic and more aggressive again to maximize portfolio performance on a recovery.

Below is a short summary of our updated strategy and themes which has been guiding our investment activity the past ten weeks or so:

      2017 Investment Strategy

Based upon equity valuations being in the 95th percentile, weak corporate earnings, tepid economic growth, and a slew of unknowns with a new president that has no experience in politics, we view the markets cautiously.

We plan to maintain our above average cash & short-term bond positions in portfolios at the max 10% of equity exposure, but invest the balance in the themes noted above.

     Fall 2017 Strategy Update -> Moving into 2018

We have moved to a more defensive posture within our portfolios, adding shares of mega cap (HON, MMM, UTX) as well as defensive (ADP, ECL, CTAS) industrials.  We have also reduced our technology exposure and added some defensive staples (DPS, PEP, MKC) and health care (PFE) to client portfolios – while maintaining our overall equity exposure.  We will also reduce the overall P/E valuation of our holdings and be opportunistic when price corrections occur.

Based upon the Fed continuing to increase interest rates and their plan to reduce their balance sheet by $0.5 Trillion next year, the tightening monetary policy will eventually have a negative impact on stock prices.  These moves will help to maintain client portfolio values if/when we get a correction.

We will also add to portfolios the companies that should benefit from the tax cuts being discussed.  The companies that will benefit the most or those with primarily domestic operations and the mega caps that have large cash balances outside the US.

2017 Investment Themes 

  1. Cloud Computing
  2. Mobile Internet
  3. Improving Consumer Spending
  4. Energy Recovery
  5. Aerospace & Defense
  6. Baby Boomers’ healthcare
  7. Selfie generation
  8. Stay at home entertainment (video games, TV & movies, food delivery)
  9. Industrial Recovery
  10. Bank & Life Insurance Stock Rally
  11. Weak Dollar
  12. Rising Short Term Interest Rates
  13. Flat to Down Long-Term Interest Rates 

Fall 2017 Themes Update -> Moving into 2018

  1. Mega Cap Industrials
  1. Defensive Industrials
  2. Defensive Staples
  3. Defensive Pharmaceuticals
  4. Casinos/Gambling
  5. Reduced Technology Exposure
  6. Lower P/E Technology
  7. Industries that have not participated in the 2017 bull market
  8. Beneficiaries of tax cuts

There are other themes that will develop as we get into 2018.   We are on the sidelines watching the Bitcoin mania and do not plan to participate.  However, the technology that runs the bitcoin network is a different story – it is revolutionary and could have a major impact on businesses in coming years – likely long after bitcoin bubble has burst.  With Bitcoin dropping from $19,000 to $11,000 in four days, that bubble may be bursting right now.

As we close out the year, I want to wish everyone a Merry Christmas, Happy Hanukkah, and Happy New Year!


What To Do With An Over-Valued Market

October 29th, 2017

NASDAQ CrashesDouble click on any image for a full sized view

I have been very skeptical about this market for a very long time. With valuations stretched above the 95th percentile and complacency running rampant with investors, professional and individual, the risk of being in the market is high.  However, nothing says that this situation cannot go on for a long time into the future before stock prices revert to the mean.

My clients’ cash equivalent allocations in their portfolio are at their max level allowable by policy, so I have been working on booking profits in some high beta holdings (ie, the more volatile ones that have been screaming higher) and moving into things that have been beaten down or haven’t participated in the recent run up, like retail.

I now have a market weight allocation in retail in client accounts, but to get there I had to buy things like Tractor Supply (which I initially had a loss in but now a nice profit), TJ Max, Ross Stores, and Home Depot – companies that seem to be able to weather the Amazon juggernaught.  In income accounts, I bought a couple of companies that were smashed by the Amazon-induced retail bear market, Kohls and Nordstroms (Kohls I have a nice profit but the headline news in Nordstroms has kept that one down). However, I don’t think that is enough to keep portfolio values up if we get a solid correction in the momentum tech companies. So I wanted to share the next step in the strategy I am beginning to put into place.

When we went through the 1999 stock market melt up with the NASDAQ stocks hitting unimaginably high P/E valuations, one of the things I did to prepare for the inevitable fall back to earth was to pick an asset class or industry that was just the opposite from the momentum companies in terms of being in a bear market while the dot.coms were in a bull market.

In analyzing the dot.coms, you saw that people were throwing money at concepts that had no tangible value. The most opposite asset class or industry that I could come up with was the oil industry. It had been going through a mega bear market with oil dropping to $10 a barrel and companies going out of business. I started to accumulate oil companies very cheaply and reducing tech sector exposure.

By over-weighting the energy sector, when the crash happened, my clients portfolios were protected by the rush into deep value investments like oil companies. By maintaining the overall equity allocation, they were able to participate in the upside during 1999 until the crash in 2000, but because they were in the opposite industry to tech – an industry that had already been in a bear market – they were able to recover from an initial market-wide sell-off while the tech investors continued to be underwater.   You can see the chart below comparing the performance of oil to the NASDAQ from 1999 to 2006.


Today, we have the mobile Internet companies, the cloud companies, and the e-commerce companies that have skyrocketed in valuation. At some point we will need to reduce our exposure to those industries and invest in the opposite industry. Since the Ag industry and commodities have been in a bear market since 2011, it is a natural place to begin – take a look at the graph below.


I added a 1% Potash position this week to client accounts to begin our move to overweight the Ag industry. I will also likely start a position in the commodity fund DBA and begin to search for other suitable investments that have been left behind.

Are there other similar industries to Ag? Well, energy seems to be a viable candidate again:


Maybe this is finally the time for the “Scarcity of Water” theme to play out, too. Given all of the droughts around the world, I thought it would be a winner – but until earlier this year when my research came across he company Xylem the theme just wasn’t playing out as I thought it would.

The mining industry also seems to fit the bill.


Anyway, I understand this is a contrary idea, but since it has worked for me in the past and the current momentum push higher reminds of the dot.coms, dusting off the old invest-in-the-opposite playbook seems as wise as anything else that allows us to stay invested but reduces risk.

Being prudent and protecting hard won gains is critical to long-term investment performance.  Its not the end of the world if the market goes down, but managing through the ups and downs of the investment cycle is always better than being caught by surprise with a huge down swing if you haven’t prepared for it.


Is the Stock Market Overvalued?

July 19th, 2017


Double click any image for a full sized view

It has been eight years since the 2008 stock market crash bottomed and the current bull market began.  There have been a couple of corrections along the way, even a couple of double digit ones, but all in all it has been a fairly straight move up.

We can discuss some of the reasons for this, but it has been engineered to a large extent by the Federal Reserve and their money printing activities (called Quantitative Easing – a process of buying bonds with newly created money).  That liquidity has been used by corporate America to buy back shares of stock (as opposed to investing in research and development or expanding operations) which has pushed the market forward in a fairly consistent manner.  In its simplest from, its Supply and Demand – as long as corporate America has the demand to buy back their own stock and the supply of shares is limited to what people are willing to sell, there is always an upward pressure on stock prices.

The Federal Reserve has been raising interest rates for the past several months, which has begun to curtail liquidity.  However they are about to embark on a reversal of their money printing activities – possibly as soon as September.  In essence, they will be flooding the bond market with government bonds hoping to suck up excess cash that has been flowing into the stock market over the past eight years.  This process (called Quantitative Tightening) simply sells bonds into the market and the money they receive for them is retired from the system.

This is a really big deal and you are likely not hearing much about it.  But from a logic standpoint, if flooding the system with money led to the stock market going up due to a consistent buyer willing to pay market price for their own stock, then logically starving the system of money will remove the principal buyer of stock and send the market down.

How far?  Clearly since this is new territory for all of us, there is no way to know for sure.  But realistically, any over-valuation in the market will likely be erased and potentially, depending upon investors’ emotions, a correction could go further than that.

So I thought it was time to break out my trusty S&P 500 Fair Value Calculators to see what sort of exposure we might have.  Lets check out the Ratio Based version:

Fair Value Ratio

This version is based upon the theory that everything eventually reverts to the mean.  It compares current readings of the S&P 500 – like earnings, sales, and book value – to historic median valuation levels for the S&P 500.  This shows what the index would be valued at using current numbers but historically typical valuation levels.

This calculation uses a weighted average of the various ratios – in the graphic above, you can see that there are two calculations.  One of calculations is an outlier so the first column underweights that one with a 10% weight and the other one gives it 0% weight.   For simplicity sake, we will say that the ratio based analysis tells us that the S&P 500 is 13% to 15%  over-valued.

But lets take it one step further.  Below is a discounted earnings based valuation of the S&P 500.  The earnings estimate comes from Standard & Poors and is a bottom up GAAP estimate of all 500 companies in the index projected through 12/31/2018.  The growth rate is the actual 2017 growth rate and the discount rate is a calculated number based upon the historic S&P 500 return since 1950 + the rate of inflation + the increase in GDP (the calculation is shown as Discount Rate Two).   I have disregarded the alternate version of the discount rate calculation that is an interest rate based calculation ( shown as Discount Rate One) given the artificially low level of interest rates.

Fair Value Disctd Earnings

This discounted earnings calculation uses a ten year period of earnings growth at current rates and a an earnings growth rate of 2% into perpetuity.

Based upon the calculation, we show an over-valuation of over 7%, which is half the ratio based valuation result.

Which is correct?  Realistically you cannot look at it that way.  Each of the calculations could be changed with a different selection of data that would give higher or lower results.  The real benefit of this sort of calculation is to give us a feel for whether the market is over or under valued based upon some reasonable set of assumptions about the future using current data about the market.  We can reasonable say that the market is over-valued by 7% to 15% and that any correction we might have (in September or otherwise) would be within that range – and absent some other factor we are not considering, we should not have a crash like we had in 2008.

So, given the uncertainly in the market’s potential reaction to the Fed’s September Quantitative Tightening, I am comfortable with the conservative position we have in client portfolios with cash and short term bonds on hand.  That will give us liquidity to buy shares of our favorite companies a lower prices than currently available.  Until then we just need to have some patience…

and show some smarts.


2017 First Half Update

July 13th, 2017

00Double click any image for a full sized view

We are halfway through 2017, and it’s been a good six months for stock markets at home and abroad.

Year to date, international stocks have enjoyed the highest performance, with emerging markets showing double digit returns based primarily on the falling dollar, which was down over 5% year-to-date.  Since most emerging market countries peg their currency to the dollar, when the dollar falls, their currency falls and the companies in those countries being primarily exporters enjoy higher net earnings due to the falling exchange rate.

In terms of the US stock market, large cap companies significantly outperformed small cap companies and growth stocks outperformed value stocks during the first half of the year.  You can see a summary of first half returns in the image above.


When we examine the month of June, the tables turned on the first half winners.
U.S. small caps made up for their relative weakness earlier in the year by having the strongest returns, significantly besting large cap stocks.  Growth stocks were thumped by value stocks while international stocks were mixed in June, with developed-market stocks down and emerging markets up.  You can see these returns in the image above.

Bonds are positive for the year but they experienced a negative return in June as yields rose late in the month.

The most striking thing noted during the first half of the year is the low level of volatility in the markets. June had zero days on which the S&P 500 moved by more than +/-1%. Such movement has happened on only four days this year, which is a material contrast to the volatile first half of 2016.


The image above is a graph of the VIX Volatility Index since the year 2000.  The VIX is the red line and the S&P 500 is the blue line.  You can see the inverse relationship between the two indices – the VIX typically leads the S&P 500.  A low level on the VIX indicates complacency in investors – a high level on the VIX indicates fear in investors.

There was only one other time since 2000 that the VIX has been at 10 or below and that was leading up to the 2008 crash.  This image does not say we will have a crash, but rather it just flashes a warning sign that investors have gotten too complacent and they are not prepared for a correction.

The eight-year bull market we have seen in the stock market since the March 2009 post-crash bottom is getting long in the tooth.  Many of the things that you saw in the first half of the year are typical of aging markets that are readying for a correction:

·    The low economic growth we have seen in the face of rising interest rates pushes investors toward growth stocks that have earnings growth in spite of weak economic times, and growth companies do it with little debt to be impacted by rising rates;

·    Investors favor less volatile large cap companies as they see markets moving toward a top over more volatile small cap companies; and

·    Complacency settles in with investors who have gotten used to markets drifting higher and they do not sell when valuations are high.


The image above compares the Fed Funds Rate (the overnight lending rate controlled by the Federal Reserve) to the S&P 500 Index.  The Fed Funds Rate is in black and the S&P 500 is in blue.  This graph is again from 1998 forward and I wanted you to see the relationship between interest rates and stock prices.  The oldest date for Fed Funds Target Rate in my data service is 1998, but I think you can see the relationship between rising and falling Fed Funds Target Rates and the S&P 500 Index.

Again, there is nothing in this chart that says a correction is imminent.   However, the relationship between rising rates and an eventual correction in stock prices is pretty clear.

We have written to you many times that as valuations on companies move further from their averages, risk increases within stock portfolios.  As risk increases, the prudent thing to do is to employ classic risk management techniques, like increase liquidity in the portfolios and, cull the weakest companies from the portfolio, and book profits on winning positions.

We have been using each of these strategies and feel we have adequate liquidity on hand in preparation for the next correction so that we can be a buyer when others who did not prepare for the correction are forced to sell at lower prices.  Remember, investing is not a linear activity like earning interest on a certificate of deposit.  You want to buy companies when they are low priced and sell them when they are high priced – that does not happen within the constraints of a 12-month calendar nor are the starting points nor ending points clearly delineated.

Greed often leads people to hold onto companies too long and miss a selling opportunity in the hope or assumption that prices will go ever higher.

Unfortunately, with rising interest rates, tepid corporate earnings, slow economic growth, and valuations that are above the 95th percentile, now is the time to be prudent before prices come under pressure so that we can be aggressive buyers when the opportunity presents itself.