Archive for January, 2013

S&P 500 – Historical Analysis

Tuesday, January 29th, 2013

S&P 500 Log Scale Historical Prices with Linear Regression

As the stock market moves to the top of the current secular bear market trading range, it got me wondering how the current action in the index compares to its historical movements.

To get the data, I went to Dr. Robert Schiller’s website and copied the Monthly S&P 500 Index prices going back to January 1, 1871. Obviously, the index was not in place back that far and he has worked backwards from its inception date in the 1950’s to derive the prices prior to this date.

I plotted the data on a log scale chart, and added a linear regression line so we can see the trend, and calculated the compound annual growth rate.

As you can see from the chart above, over the past 142 years, there is a decisive upward trend that survived numerous recessions, wars, and a depression, and has provided a compound annual growth rate of price appreciation equal to 4.17%. When you add the average dividend yield of 4.44% over that same 142 years, you get a total return of 8.61%.

When I look at the chart, I see that we moved significantly away from the linear regression line starting with the 1982 tax reform that kicked off the 18 year secular bull market.

Since the peak on the chart in 2000, we have been moving up and down within a well defined trading range. You can see it on the chart above, but its easier to spot on the graph below that isolates this time period:


What I am very concerned about at this time is whether there is some catalyst that will cause us to break out of this trading range and begin a new secular bull market – or whether we will continue to move up and down within the range over the next several years until the orange line on the top graph meets up with the linear regression line, providing a reversion to the mean.

This is a competition between two investment theories, one will be right and one will be wrong. One means higher stock prices the other means lower stock prices.

I’ve written here before about the difference between a cyclical bull market and a secular bull market. The cyclical bull is short term and is generally a positive upward move in prices within a larger/longer secular bear market. The big move higher in stock prices from the March 2009 lows that is so easy to see on the second graph above is a good example of a cyclical bull.

The secular bull market is a larger/longer push higher for stock prices that will contain some painful cyclical bear moves during its run. Many of you will either remember the 1987 stock crash because you lived it or you will have heard about it. It is a perfect example of a cyclical bear within a secular bull that lasted from 1982 to 2000.

A secular turn requires some major change in the investment landscape that fundamentally revalues stocks either lower or higher. In 1982 we had tax reform that revalued stocks higher for investors as corporate earnings grew and p/e ratios expanded, in 2000 investors finally realized that triple digit Technology P/E ratios were insane and valued the market lower.

Do we have some major catalyst today that will move both corporate earnings and P/E ratios higher – the golden goat of stock market investing? I am having trouble finding it – but welcome your emails if you see it as I’d love your input.

My best assessment is that the current secular bear market continues on and something will spook investors as we approach the mid-1500’s on the S&P 500 index (1565 is the all time high) sending it lower.

We have been selling into the rally, raising cash as I’ve mentioned here on the blog in previous posts – the March 1st sequestration deadline has the potential to take several percentage points off the index, and I want to have cash available to buy some of my favorite companies significantly lower than today’s prices.

However, just as I don’t see any catalyst to drive us into a new secular bull market (but would love to hear from anyone that does see one – unfortunately housing isn’t it, not enough impact) – I also don’t see anything that will drive us to the bottom of the trading range like 9/11 in 2001 and the 2007/2008 subprime/financial crisis.

I think we are in a trading range from 1125 to 1550, with most of the action in the 1300 to 1550 area. We would need something critically negative to drive us down 25% to 1125 – maybe the sequester will do it but that will likely only reduce GDP to the 1% or 1.5% range – probably not enough negative impact to fall that far.

I think it would take a true recession to push the market down 25%, and even though economic growth is very slow – unless the bond market starts to rebel against all of the debt we are piling on and we see yields move significantly higher in spite of the Fed keeping short-term interest rates at 0% – I can’t see that we are in for a recession.

One very important thing to keep in mind: you have to invest what you see and not what you believe. Stock prices can move up or down completely divorced from current economic fundamentals as investors commit or reduce money allocated to stocks based upon their perception of the future.

The stock market can act as a leading indicator and push higher because investors think the future will be better. Its quite possible that this is what we are seeing happening now.

I’ll leave you with a graph I watch that gives me more than just a feeling for major turns in stock price trends:

Stock Market Trend Indicator

I’ve circled some important times on the graph that were turning points for intermediate stock market trends. The way this works is that when the stock index crosses over its moving average at the same time the relative strength reading is at an extreme, we are in for a change in market direction.

I’ve been watching this for the past few months, and we have finally moved to an extreme in the relative strength, but we do not have anything close to a crossing of the index over its moving average.

This indicator tells me that no change in trend is imminent. We will likely pull back toward the trend line (low 1400’s) since the relative strength tells us we are getting ahead of ourselves, but that is only natural as stocks do not move straight up.

So, in summary I am cautious about the fundamentals and the potential impact of political decisions coming from our capital, but do not see any immediate move significantly lower on the horizon. We have cash on hand to reinvest when we get the inevitable move down to the trend line on the final graph above (low 1400’s on the S&P 500 index), but as long as we do not have a complete change in trend, the market can be higher at year-end than where it started 2013.

We will watch for a move above 1565 to determine if we have a new secular bull market underway and we will watch for a drop below the low 1400’s for a change in intermediate trend from cyclical bull to a resumption of the secular bear.

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Tuesday, January 15th, 2013


There are two pieces of big news this week in the equity world – Apple stock has dropped back below $500 per share (from its high of over $700 per share not long ago) and Dell is considering being taken private by a private equity group and its stock is up 15% in the past two days and 40% in two months.

I won’t comment on Apple in this blog post, I’ll save that for another time, but I did want to discuss Dell.

Many of you know that we have been accumulating Dell between $8.99 per share and $12.70 per share, starting last May when the stock dropped by a third. I discussed Dell in this post about Facebook’s valuation [ Value Matters ] comparing the valuations of several “old” tech companies we had started to buy compared to the valuation for Facebook.

What we are seeing today with Dell is a recognition that they have a strong business with very good cash flow that has transformed itself from a primarily desktop PC maker to a primarily IT service company much like Accenture and IBM.

Accenture trades at 19 times earnings because it does not have the hardware business, just the consulting business. IBM trades at 13 times earnings because it does have the hardware business. Dell however trades at 8 times earnings.

The private equity firms have recognized what we saw starting last May – that this is a severely under-valued company based upon the successful transition of its business to a more relevant model. Hat tip to Charlie, who you read periodically here on the blog, for finding this company for us to add to client portfolios.

If we look at Dell’s projected 2013 earnings per share of $1.71 and say that it should be trading closer to IBM’s valuation (we can use 11.5 instead of 13 just to be conservative), this gives us a projected value per share for Dell of $19.65.

When you compare this to normalized valuation to our average cost basis during the accumulation period of $10.18, this gives us a potential upside for this particular company of 93%.

Will the private equity companies take it private at $19.65? Absolutely not. They are in it to make a killing, not to reward those of us that have recognized the potential in this company. However, Michael Dell as the largest shareholder will not sell it to them at fire sale prices, so we certainly have some nice upside yet to realize over and above the 23% unrealized profit we currently see based upon the current $12.56 price per share for Dell over our average cost per share.

Is it a done deal? Definitely not. This will be a huge private equity deal and the talk is that multiple companies will have to partner on it to get it done. That will be quite a feat and require a significant amount of debt. The good news is that Dell has more than enough cash flow to service the debt that the PE firms would need to buy out the existing shareholders.

As we move forward in our slow-growth world, three types of equity investing will be successful. All three have their pluses and minuses, but we employ all three in the management of our portfolios:

> Deep Value: the Dell situation is an example of a deep value investment where the market was not recognizing the worth of a strong company – these are tough to find, but when you do, you can hit a home run in terms of return as long as you are patient. Our holding period for these companies is only as long as it takes for the market to realize their true value.

> Core Holdings: these are companies in mature businesses that continue to growth their book value and their capital, pay consistent and growing dividends, have strong balance sheets that can weather swings in the economy, and significant cash flow to pay the dividends and add to capital. The returns on these companies tend to be more steady and are a combination of current income from dividends and capital growth from increasing their book value. Valuations for these companies in terms of P/E tend to be a bit less, in general, than the broader market. Our holding period for these companies tend to be longer than for the other two types and can last as long as the company continues to perform as described above.

> Earnings Growth: these are companies that are in growing segments of the economy who have the ability to increase their sales, market share and earnings per share faster than the broader market. The ideal investment candidates have the advantage that the segments of the economy they are in have some macroeconomic catalyst that pushes their business forward even in tough economic times. The returns from these companies tend to be higher, but the volatility is also higher and can provide wide price swings in short time frames. Valuations for these companies in terms of P/E tend to be above the broader market, but we also look at the PEG ratio to tell us whether the P/E is reasonable in terms of their estimated growth. Our holding period is based upon the company’s ability to maintain the competitive advantage that allows it to grow faster than the broader market.

Apple was one of the holdings that we owned as part of the Earnings Growth investment type. In a coming post, we will discuss whether Apple can continue to be an Earnings Growth holding or whether it is at the point that it should transition to a Core Holding based upon their business model and their position vis-a-vis their competition.

For now though, we will leave you some immortal words of the Dell Dude from their heyday as a PC maker:

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Fed Minutes Surprise Market

Thursday, January 3rd, 2013

As some of you are aware, Mark is out of the country for the week. In his absence, I wanted to post a short update on what will likely be a fairly significant event over the coming year. Earlier today, the Fed released the minutes from their December 11-12 meeting. The minutes showed that several members of the FOMC wanted to consider ending the bond buying program before the end of 2013. This seems to be a significant change from what the market was expecting. One of the key market reactions, at least initially, has been a fairly sharp rise in interest rates.

The shorter end of the bond market has seen relatively little impact, but the longer end has seen quite a move today, which has the effect of steepening the yield curve. The ten year treasury rate has risen from 1.837% this morning, to 1.902% as I write this. That may not sound significant, but it is quite a move in one day. Also, remember that as interest rates rise, prices of existing bonds fall. The price of a ten year treasury bond (this is a good proxy for high grade bond funds with longer durations too) is down about 0.60% on the day. The chart below shows the moves over the past two days in TLT (a good proxy for 20yr duration bonds) and SHY (a good proxy for 2yr duration bonds).


As you can see, the price of longer-term bonds was down quite a bit today. Of course, that also means the yield went up, so investors buying today are able to lock in higher rates of return. This will be a pretty important market to watch over the coming months, as it will have an influence on most of investment markets, from precious metals to stocks, commodities, and real estate.

I wish you all a happy and prosperous new year.