Archive for March, 2017

Our Schizophrenic Economy

Wednesday, March 22nd, 2017

00Thanks to Zero Hedge for the above graphic

Double click on any image for a full sized view

 As I do most mornings, I read through various news papers and financial websites to see what is happening in the world, the markets, and our economy.  This morning, I was listening to the business news on CNBC and a guest was talking about our booming economy at the same time as I was examining the chart above that appeared under this caption:  “Industrial Production has never declined on a 24-month basis without the US economy being in recession.

How can two sources reach such diametrically opposed conclusions?

If you look at the stock market, you would think that CNBC is reaching the correct conclusion.  Check out the 5-year graph below of the S&P 500 Index:

00Looking solely at the price graph in the middle, you see a fairly consistent upward trend with only a couple of corrections and the index near an all-time high.  That sort of price action can be intoxicating and draw in investors who have been on the sideline waiting for another of those corrections in order to invest.

However, if you look at a couple of the indicators on the graph, I read those as troublesome for the market.

First, you see the two pink dashed lines that bracket the price graph in the middle.  Those two dashed lines represent a level of 10% above and below the 200-day moving average.  In previous posts here on the blog, I’ve written that these two levels are strategically important as the index historically has oscillated between levels that are either 10% above the index’s 200-day moving average or 10% below the 200-day moving average.

What this means is that from a historical perspective (and obviously there is no guarantee that the market will act in the same fashion as it has in the past), a safe time to buy stocks is when the market hits the line that is 10% below the 200-day moving average and important time to sell is when the market hits the line that is 10% above the 200-day moving average.

If you look closely, the market touched the 10% above line a few days ago and has been weak ever sense.  If you look back to the two corrections in August 2015 and January 2016, both of those drove the price down to that lower line, but the market soon recovered to higher prices.

Below is a 20-year view of the index with a weekly instead of daily price graph:00This 20-year view gives you some longer-term perspective.  Even when the market falls apart like it did in 2001-03 with the NASDAQ crash and 2008-09 with the Subprime Debt crash, with the price graph dropping below the lower line, it is still a good indicator that you should consider putting some money into the market and NOT selling at the bottom.

The other indicator that is bothering me is the PMO (price momentum oscillator) at the bottom of the 5-year graph above.  On the far right, you can see that the black indicator line has has fallen below its red signal line.   This is telling us that even though the index has not yet materially fallen, the momentum behind the move that has pushed prices higher has weakened significantly.

Check out the longer term graph below and you can see from a historical perspective the relationship between the two:

00This chart is a monthly view of the index instead of a daily.  You can see that I’ve circled that spots where the PMO changes direction and the market follows suit.  This has been a fairly reliable indicator of when the market is going to change direction.

So which is right?  Are the economic indicators that are flashing warning signs of recession correct or is the stock market that has continued to power higher based upon the hope for tax cuts and simplified regulation correct?

For what its worth, I don’t have the answer – only time will tell which right.  However, what I do know is that the stock market is over-valued by 10% or so and that we are due for it to correct back to the 200-day moving average or maybe more (see the prior blog post for a discussion of my fair value model for the S&P 500 Index to understand the 10% or so over-valued statement).

Prudent investment management dictates that we maintain a conservative posture with regard to our investment activities.  Because of this, we will maintain above average cash and fixed income reserves in order to have liquidity to buy our favored companies when the inevitable pullback occurs.

To The Moon, Alice, To The Moon

Wednesday, March 1st, 2017

MarketClick on any image for a full sized view

Well, we had a huge day in the market today and I thought that it deserved a bit of discussion.  As everyone who reads the blog knows, I am very cautious on the markets right now given their level of extreme excitement, extreme greed, extreme overvaluation, and negligible expected forward returns.

Take a look at the graph above – in the RSI indicator at the top of this S&P 500 Index graph, you can see the huge turquoise area above the top line.  This indicator is telling us that there is extreme excitement and buying interest in the markets and that they are due for either a pullback or a rest with some weeks of sideways movement.

greedCheck out the Fear and Greed Index above – this is one of the highest readings I can remember seeing on this indicator.  Contrary to what you are hearing on tv, market do not go in a straight line like a rocket to the moon.

Fair ValueAbove is a spreadsheet I’ve posted on this blog in the past – it is one I use to gauge where the market is valued compared to its historical valuation levels.  It uses four  different valuation measures and comes up with a weighted average valuation.  Right now, it shows that the market is 13%+ overvalued.

Expected ReturnsThis is another spreadsheet that you have seen in the past here.  It is one that I use to calculate the expected forward returns for the S&P 500 Index over the next decade.  Based upon today’s valuation for the market, we should expect a forward average annual return of 3.86%.

I know it is fun to watch your portfolio value go up when the market is on fire like it is now.  However, it is equally as gut wrenching to watch the value of your portfolio go down when the market takes a major tumble.  That is why it is imperative that investors employ risk management techniques to make sure they keep the gains in their portfolio when the market goes down.

We are employing those risk management techniques, booking gains on certain holdings, keeping cash and short term bonds on hand to protect the portfolio from the inevitable downdraft that will take the valuation down toward or below its fair value.

Our strategy will be one we have used over the decades I’ve been managing money – use that cash and those short term bonds to buy shares of companies we want to own that have superior investment characteristics at liquidation prices from investors that did not manage their risk and are panicking during the inevitable correction.

Warren Buffet has said that “You pay a very high price in the stock market for a cheery consensus.”  And that “the time to buy is when there’s blood in the streets” (I believe he was paraphrasing one of the Rothchilds in the last half).

This is in essence what we are doing – employing the greater fool theory of investing:  we sell appreciated shares of stock to someone and book our gains, then buy it back from them later at a significant discount.

The market does not go in a straight line like a rocket heading to the moon – there will be a day of reckoning  when fear “trumps” greed.  But until then our strategy will be to continue to make money off the investments we have in the market, book profits when the fundamentals so dictate, and manage our risk so that we can take advantage of any corrections and the people who did not manage their risk.

–Mark