Archive for May, 2016

Yield Curve Ball

Thursday, May 26th, 2016

Inverted Yield Curve 2000Double click on any image for a full sized view

One of the things that I find really troublesome is the Yield Curve, or more specifically, what the Federal Reserve will do to stimulate the economy when we get to the next recession and stock market correction.

The Yield Curve is a line graph that plots the span of interest rates from overnight rates to 30-year bond rates on a single day.  In a normal situation, short-term rates are lower than long-term rates and the line graph has an upward slope to it.  But there are times, in particular when you are at a recession, that short-term rates are higher than long-term rates – this is called an inverted yield curve.  This situation comes from investors fleeing the stock market due to the risk of corporate earnings falling in the recession. The investors are reinvesting their money in the safety of bonds, driving the longer term rates down since there is so much demand.  The inversion can also be aided by a Federal Reserve that doesn’t cut interest rates fast enough to avoid the recession.

In the graph above from the peak of the stock market in 2000 (the red vertical line) you can see the yield curve on that specific day (the red downward sloping line) was inverted.  The recession was upon us and the stock market started its long journey down as corporate earnings were less than expected.

Normal Yield Curve 2003Fast forward to the bottom of the stock market in 2003 (again the red vertical line) and you can see that the Federal Reserve had cut short-term interest rates from roughly 6% to 1% in order stimulate the economy.  The yield curve resumed its normal shape and companies started to experience increased earnings coming out of the recession, those earnings increases translated into a bull market for stocks.

Inverted Yield Curve 2007Fast forward to the top of the market in 2007 and you can see that we again have an inverted yield curve.  Shortly after this date, the recession takes hold and corporate earnings begin to fall sending the stock market down decisively (this was a lack-of-liquidity driven market crash as much as falling corporate earnings).  To combat the recession and to add liquidity to the financial system, the Federal Reserve cut interest rates again.

Normal Yield Curve 2009You can see that at the bottom of the market in 2009, we again have a normal yield curve with short-term rates cut by the Federal Reserve from just under 5% to just above 0%.  Those near 0% rates fueled a rally in the stock market that ran to last May’s highs.  Unfortunately, corporate earnings have started to fall again and there is talk of another recession coming our way.

Flattening Yield Curve 2016This is the yield curve today.  You can see that it is still a normal yield curve, but that it is noticeably flatter than the one above (this could possibly presage an inverted yield curve – but it would be difficult to get long-term rates near zero, but anything can happen in this economy where we have no past history to learn from).  You can also see that the Federal Reserve has kept short-term rates at the near 0% level.  The question we should all want an answer to is what will the Fed do when we get to the next recession if it cannot lower interest rates since they never raised them as would be normal during an economic cycle.

There is a lot of speculation that our Federal Reserve will follow the European Central Bank in two ways:  negative interest rates and purchasing corporate bonds in a new round of quantitative easing.

We haven’t talked about QE in a while here on the blog because the Fed ended that practice a couple years ago – QE is where the Federal Reserve prints money to flood the economy with liquidity by buying government bonds.

Both of these actions, if the Fed were to follow the ECB’s lead, would be unprecedented.  Much of the economic stagnation we currently have comes from the 0% rates – consumers and businesses have loaded up on debt to record levels given the low rates.

Consumers have incomes that have not kept up with their debt fueled spending and they are not the catalyst for economic activity that they once were.

Corporations have used the debt to buy back their outstanding shares of stock, a financial trick that makes their earnings per share appear to go up simply because there are fewer shares to spread the earnings over.  The side effect of borrowing to buy back shares is that reinvestment into property, plant and equipment as well as research and development has been curtailed, adding to our economic stagnation.

What unintended harm can negative rates or QE for corporate bonds have?  I don’t know but it will likely continue to provide the wrong incentives for consumers and corporations while not doing anything to stimulate the economy.  This is our yield curve curve ball, or with a nod to Wheel of Fortune, our yield curve ball.

A Return to Volatility or Not?

Tuesday, May 10th, 2016

S&P 500 Index 20-yearsDouble click any image for a full sized view

There was a recent report from one of the Wall Street banks saying that the current volatility in the markets is a new phenomenon and that for the balance of the year investors should expect to experience more of it.

I’ll take the under on the first part of that statement.

Over the past 20 years, we have had similar volatility until just recently, so in effect the current bit of volatility is really a return to normal market action.  If you look at the graph above  you can see that the current volatility in the market started in the summer of last year, after roughly three years of calm upward movement in the market.  Prior to the fall of 2012, the graph shows similar volatility during its bigger secular bull and bear moves back to 1996.

As for the balance of the year, I agree that the markets will continue with the current level of volatility, albeit in a downward direction.  In the two most recent blog posts that I wrote, I discuss this very thing.  To summarize those posts, the intermediate to long term direction of the market is down and investors need to have a defensive asset mix including a healthy allocation to cash so that when there are short-term movements up or down within the major trend, they can use it for trading purposes.

If investors are not comfortable with trading for short-term gains, then buying a bond fund has historically acted as a hedge against major market crashes.  Here are a couple of graphs depicting how stocks and bonds trade in near mirror image, this first one shows the Dot Com boom and bust:

S&P V Bonds - NASDAQ Crash

and this second one shows the Subprime Mortgage crash:

S&P V Bonds - Subprime Crash

The downside with the bond fund is that if the Fed really gets into interest rate hiking mode, the bond funds will go down in value commensurate with the size of the rate hikes and the duration of the fund.

However, if the market crashes (and it is always possible given the risks to the financial markets that are out there) then a high quality US Treasury fund will be the best investment imaginable.   Since US economic activity is pretty tepid, there is little chance of significant rate increases in the near future, so booking profits in your stock portfolio (or stock mutual funds) and buying a high quality US Treasury Fund plays the percentages pretty well.

Why do I mention crashes?  Well, a lot of smart investors are already talking about it.  One is Carl Icahn whose hedge fund is 150% net short.  He is on record of stating that the market has a greater change of going down 20% than going up 20%.  Carl may or may not be right, but having some protection for your portfolio and structuring it in a defensive manner when the market is near an all-time high with falling earnings and poor technicals seems to be the prudent thing at the present time instead of swimming against the tide.

Price Momentum Guidance

Monday, May 9th, 2016

PMODouble click on any image for a full sized view

After Thursday’s post on the Fair Value of the S&P 500 along with a technical analysis demonstrating investor sentiment, I received a couple of emails from readers who wanted to know a bit more about the technical aspects of what I follow to help determine market direction.

For a big picture intermediate-long term view of where we are headed, I use a 20-year monthly price chart and compare it to the Price Momentum Oscillator (PMO).  I know sounds like Sanskrit for some folks so let me explain.

The price graph (the top panel of the image) above is based upon the monthly movement of the S&P 500 compared to the 10-month moving average of the index.  You can see that the red/black line moves above and below the moving average, indicating bull Vs bear markets.

You can also see a bunch of red circles which I’ll explain in a bit.  For now, though, look at the one on the price graph far to the right.  You can see that the market is moving up and down across the moving average.  To me, this says the market is in a topping process – investors no longer have the conviction to keep pushing it higher but there are still some dip buyers out there that will jump in if it falls to a certain level.

Those red circles are pretty important when you compare them to the PMO.   The PMO is an indicator of the strength of price movement within the market.  Instead of a visual analysis of the index itself, this indicator measure the activity in the market and tells you if investors are acting bullishly or bearishly.

When we look at the PMO on a long-term chart like the one above, you can see in the red circles points in time when the blue line crosses over the red indicator line.  Those crosses are critical as they demonstrate that investors’ are acting in either bullish or bearish manner and that the direction of the market is taking a change.

So for now, we are being cautious and defensive is critical as a strategy but being nimble and putting cash to work on a short term tactical basis when the market gets short-term oversold.  Then when it gets short-term overbought (there are other indicators that I use for short-term market movements that I’ve highlighted here on the blog previously), we are raising cash again to get back to a defensive position.

Our typical practice is to utilize  index exchange traded funds (ETF’s) for this short-term tactical investment activity.  I’m actually pretty grateful that ETF’s have come to such prominence in the past few years given their liquidity and ease of trading, making this a much more efficient and effective process.  As an example, when market was at the February lows, we purchased shares of the Russell 2000 ETF then as the market became short-term over-bought we sold it for a 5% gain after three weeks or so and reinvested the proceeds back into a cash equivalent until the market gets back to short-term over-sold.  Wash, Rinse, Repeat :)

As I write this, the market is hovering around break-even with little volume – another sign of the indecision among investors.  When there is indecision, the best thing to do is sit back and watch for signs that a sustainable move will develop in one direction or the other.   Unfortunately, given the reading of the PMO, breaking out to new highs is unlikely so our defensive strategy is the best choice for now.

S&P 500 Fair Value

Thursday, May 5th, 2016

S&P valuationDouble click on any image for a full sized view

With the market appearing to rollover and head lower, I thought it would be informative to take a look at our S&P 500 Fair Value calculation again.  Its been a while since I’ve written about it, but with the annual “sell in May and go away” slogan being bantered about in the financial news and opinion articles/interviews now seems a good time to determine if the market is overvalued or undervalued at current levels.

As a refresher for long time readers of the blog, the calculation above takes four different metrics of the market based upon the historical mean valuation levels and computes a current value for the market using current data.

1.  Historic Mean P/E Ratio X Projected 2016 Earnings Estimates

  • Valuing the market based upon the underlying earnings of the companies computes a value based upon the returns that investors should expect to receive.  Our calculation shows that the value of the S&P 500 under this metric is 1800 compared to our current value of 2058  [Market is Overvalued]

2.  Historic Mean Shiller P/E Ratio X Projected 2016 Earnings Estimates

  • This metric uses the same calculation above except it substitutes the Shiller P/E for traditional P/E.  The Shiller P/E is calculated as a rolling 10-year average of the traditional P/E Ratio.  The idea is to smooth out the volatility of any one year for a more representative valuation.  Our calculation shows that the value of the S&P 500 under this metric is 1925 compared to our current value of 2058  [Market is Overvalued]

3.  Historic Mean Price to Book Value X Current Book Value

  • Price to Book Value is different from Price to Earnings in that P/E values the market by its earnings potential and P/B values it by the collective value of the assets of the companies in the market.  Our calculation shows that the value of the S&P 500 under this metric is 2028 compared to our current value of 2058  [Market is Fairly Valued]

4.  Historic Mean Price to Sales Ratio X Current Sales

  • Price to Sales is different from either P/E or P/B in that P/S values a company according to its operational efficiency in generating revenue.  Our calculation shows that the value of the S&P 500 under this metric is 1600 compared to our current value of 2058  [Market is Significantly Overvalued]

 The Final Step

  • To come up with an overall value, I use a weighted average of the above four calculations.  To me, the two most important valuations are the Shiller P/E value and the P/S value because I prefer to have the smoothed earnings valuation that minimizes volatility and I prefer to look at a company’s ability to generate revenue over the value of its assets which by its very nature is a liquidation value for a company and not an ongoing business.
  • Using the weighted average calculation on the chart above, you can see we come up with a Fair Value of 1823 for the S&P 500, or roughly 11% below the current value.

So how do we use this?  I like to take a graphic look at the market to see what technical levels based upon investor sentiment tell us:

S&P 500 2016-05-05This graph tells me a lot about the market that supports the fair value calculation.

First, if you look at the horizontal line I’ve drawn at the bottom of the graph, it shows you where the market fell to on the February correction.  That line corresponds fairly closely with our current Fair Value calculation.  We should view that as a major support level for the market for two reasons:

  • (1) its the prior correction low and it coincides with our fair value – this is the obvious one, and
  • (2) if you look at the far left side of the graph you will see some red and green bars; these represent the volume of buyers and sellers at the various price levels; down at the 1823-ish level on the index you see a small red bar which indicates that level has primarily seen selling but not a lot of it which tells me most investors view that level as one to hold onto their investments because they are not being paid to sell and there is not any panic feeling about the market falling to that level.

In just the opposite reading, look at the second bar from the top.  You see it is much larger than the bottom bar meaning there was a lot of trading volume at that level (which currently corresponds with the price level we are at now) and the bar is pretty closely split between green and red (with green slightly larger if you look really closely).  This tells me that investors have no conviction at that price level for the index, the buyers will be likely sellers if the market doesn’t move up and the sellers will likely be buyers if it does.

So since the market has rolled over, the former buyers will on whole want to lock in the current price before the market goes down more, adding to downward pressure.  Then as the selling gathers momentum, it should slow at the next level lower since there were fewer historic buyers.  Interestingly enough, that level provides some additional technical support as both the 50-day moving average and the 200-day moving average are right there.

The market has the opportunity to turn higher at that level, between 2043 and 2013, however if it doesn’t, it will then likely head toward our 1823-ish horizontal support line.  There will be other lesser support levels below 2013 and above 1823 which we can discuss if the market heads that way. However, you see the diminishing volume on the way down is predominantly green which means there are former buyers that will want to lock in their profits so they down show a loss, which will add to downward pressure on the index.

For now, though, my view is pretty bearish overall and view the market as headed lower.  It is VERY significant that (1) corporate sales and earnings continue to fall putting more downward pressure on our Fair Value and (2) the market has been unable to break above the all time high set last May and from a technical standpoint it looks like in the near-term the market is headed lower and will not make an assault on that peak anytime soon.

Because of this, we have an overweight of cash and bonds in client portfolios in order to (1) protect their capital and (2) to give us ammunition to pull the trigger on buying some of our favorite companies at lower values.

As things progress, check back here or you can subscribe by clicking the link above and get an automated shout out via email when a new post is made.

 Mark