Archive for December, 2013

Is the S&P 500 Index Nearing a Near-Term Top?

Thursday, December 26th, 2013


Click on the graph to see a larger image

We talk a lot on this blog about the importance of the 200-day moving average to the S&P 500. In the past I’ve written several times about the fact that once the market moves above a band that is 10% above the 200-day moving average, it tends to pull back. This 10% band is the blue line that the index is just about touching in the graph above.

We have had a lot of extremely positive sentiment in the market this year, particularly with the largest of the large caps and the most speculative of the tech stocks. However, I noticed something today that has me a bit baffled: Twitter hit a market cap of just under $40 Billion. This is a really big number for a company that is losing a lot of money. I know, the investors in Twitter are buying it for the future growth and the prospect of enormous earnings to come. However, betting on the come is not an investment strategy – its a Craps strategy.

Take a look at this spreadsheet I put together:


Click on the image to see a larger image

This sheet lists out several fairly well known companies and their market caps, which collectively are not valued as much as Twitter, yet have over $2.1Billion in earnings compared to Twitter’s loss of almost $150Million.

Sometimes the market gets ahead of itself and euphoria builds to the point that investors do things that are not necessarily prudent – like putting a value on a company well above its current earnings power based upon a vision of the future. It has happened countless times in the past and will happen countless times in the future. However, it always is a coincident indicator that the stock market needs to pull back to shake some sense into investors so they focus on fundamentals.

Yes, growth stocks are my primary focus in investing – but it is in companies with growing earnings and market share. It is not in companies that have not proven they can make money.

If you want to own an aggressive growth company, I have been buying companies like CryoLife (Ticker: CRY) or Natus Medical (Ticker: BABY) which both have positive earnings that are growing and they are capturing market share, but there are lots of really good companies with great futures that can make great investments. You just need to do your research and find them.

Is the S&P 500 Index nearing a near-term top? Honestly, I think we could see a pullback in the first quarter – but if 2013 is an indicator, the investors that are under-invested in stocks will use that as a chance to add equity exposure. The Fed’s money stimulus will continue to provide support to the market and drive money into stock – until bonds become a viable alternative or until investors decide that placing valuations on companies well in excess of their earnings power is silly.

Based upon traditional measures of value like price to book and price to sales, the market is 30% to 40% over-valued. At some point either the market will correct in a big way to bring us back in line with mean valuations or it will trade sideways until earnings, sales, and book value catch up with current valuations. But, I don’t think we are at that point – and any correction will be bought, pushing the market higher. However, at some point, people will realize that owning several companies with earnings power in excess of $2.1Billion is better than owning a company with a $150Million loss – it just doesn’t appear that it is now.

Investing is not gambling – day trading is gambling. There is a place for gambling, and that’s Las Vegas.

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Treasury Note Yields Christmas Gift to Income Investors

Tuesday, December 24th, 2013


As I begin to pack it up for the Christmas Eve-shortened work day, I wanted to share this graph of the 10-year Treasury Note Yield which is currently yielding just under 3%. Savers have not had a 3% yield on a “risk-free” asset in a very long time [risk free being in the eye of the beholder].

As we enter 2014, this 3% yield will present a different sort of issue for investors in the stock market – with treasuries yielding more than the S&P 500, they present a viable alternative to dividend stocks for the more risk-averse income investors.

With the yield on the 10-year treasury more than double where it was a year ago this time, we will begin to see it impacting stock prices in two ways: 1) as an alternative for income investors, as discussed above, lowering demand for stocks; and 2) as a drag on the earnings of corporations that depend upon debt to finance their operations.

If we cross the 3% level and remain above it, I think we will see some negative impact on stock prices in the first half of 2014, but it will offset by quick action by the Federal Reserve to reverse or halt their tapering activity in order to drive rates down and stock prices back up.

But, there will be a lot of time in 2014 to discuss this and other issues on the blog. For now, I wanted to leave you with one last Christmas video and wish you all a very Merry Christmas and a Happy Holiday if you celebrate another holiday!

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Tricky Taper Timing

Thursday, December 19th, 2013


Yesterday, outgoing Federal Reserve Chairman Bernanke tricked the markets by announcing that they would start to reduce (ie, Taper) their purchases of government bonds starting in January. Most people believed that the Fed would begin to taper in March 2014 – I wrote on the blog that my view on the taper beginning was a first quarter 2014 start, which is in fact when the initial purchase the lower amount will begin, but I didn’t think they would announce it this month.

I also wrote that I thought the taper would bring some downward pressure on stock prices because any reduction in liquidity has historically been negative for the stock market. As you can see from the chart above, the market had a knee jerk reaction down but almost immediately it began a significant climb higher, ending the day at a new record closing level.

I thought it would be instructive to look at what has happened to the stock market historically when the Federal Reserve starts to restrict its monetary policy. So, below I have included a chart, courtesy of Lance Roberts, of the 18 times over the past 56 years that the Fed has tightened monetary policy and what has happened to the stock market rally that was going on at the beginning of their tightening cycle.


What we learn from this chart is that in most of the 18 cases, the stock market rally peaked four to six months after the beginning of the Fed’s tightening phase, with four exceptions taking a year or more. In all cases, the stock market peaked during the tightening or shortly after the Fed’s reduction in liquidity ended.

I think this information is pretty important, but we have a pretty major difference this time: in these past 18 instances, the Fed had not used Quantitative Easing (ie, the purchase of bonds as a way to print new money for the economy). So, to a certain extent, we are in uncharted territory and we will have to make some assumptions about the future.

As part of the Fed’s announcement, they stated that they would keep interest rates low for an extended period of time which means that absent any major economic upturn in the economy or increase in reported inflation, they will keep the current Zero Interest Rate Policy in place through 2015 and possibly 2016. This will continue to provide significant monetary ease that will offset the tapering.

However, what they did not address was the size of the Fed’s Balance Sheet. Their balance sheet is roughly $4 Trillion in size, up from under $1 Trillion at the beginning of their Quantitative Easing activities. The graph below comes from the St Louis Fed and show the exponential growth in their balance sheet during their QE activities.


What happens to our debt-based government, and in turn our economy, if they opt to not reinvest those bonds when they mature? Also, since the Fed has been the primary purchaser of our government debt during the QE time frame, will someone step up to buy the debt of the world largest debtor at the current level of interest rates?

Let’s take a look at what the 10-year Treasury Note did yesterday.


When the Fed made its announcement at 2pm, the yield on the 10-year skyrocketed higher, then tumbled, and began to inch its way back toward where it was trading prior to the announcement. Today, the yield is all the way up to 2.93%, moving toward the psychologically important 3% level. Over the past 18 months, the yield on the 10-year has increased 88%, which means that the borrowing costs for our treasury have increased 88% during that time period as well. Any new debt that they incur (and at the $700million level of our deficit that is substantial) and on any refinancing of matured debt, the borrowing costs have nearly doubled over the past 18 months.

If the Fed begins to reduce the size of its balance sheet over time, I think logically, the only thing that can happen is that yields in the bond market will continue to move higher. At some point, that will impact the stock market in two ways: (1) borrowing costs for corporations will increase, negatively impacting the earnings per share of companies with debt on their balance sheets – and subsequently reducing their share prices; and (2) bonds become a more attractive alternative to stocks for investment purposes, reducing the P/E’s from currently near-record levels (see the graph of the Schiller P/E Ratio in the last blog post) to more average levels – and subsequently reducing their share prices.

The question is, as always, timing. Since we are in uncharted territory, we can only make educated guesses and watch the time-tested indicators we follow (you can check out past issues of this blog and you will find them discussed in-depth). We will likely be cautious, and act to raise cash in equity portfolios at the first sign the Fed is going to reduce its balance sheet or that bond yields have begun to entice income investors out of dividend-paying stocks and into bonds.

Until then, as 14 of 18 historic instances demonstrate, we still likely have some period of time where the stock market will continue to move higher as investors are not yet feeling the impact of higher interest rates. Since the Fed vows to keep its Fed Funds rate low nearly indefinitely, this period of time could be several months or longer. However, if the 10-year yield goes above 3% or 3.25% we may begin to see some movement out of dividend paying stocks into bonds, and that could happen sooner rather than later, as investors in the bond market get spooked and worry that there are no buyers willing to fund our treasury at current yield levels.

It’s tricky.

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And, for those of you that were looking for a Christmas video, here is one that you probably haven’t listened to yet this season:

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Here’s wishing everyone a Merry Christmas!


Quantitative Easing, or the Pompatus of Love for Easy Money

Tuesday, December 10th, 2013

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The stock market has been on a remarkable run higher over the past year, fueled by the Federal Reserve’s easy money policy known as Quantitative Easing (aka QE). In its QE activities, the Fed creates money by paying for bonds it is purchasing by crediting the sellers accounts for the purchase with funds that didn’t previously exist.

The Fed’s theory for doing this was that they could create a wealth effect that would make people more likely to spend this newly created wealth and drive the economic momentum of the country higher.

In essence, this new money makes its way into the investment markets and drives the prices of stocks higher, giving investors a feeling of wealth (the opposite feeling to what they had after the 2008 stock market crash) and encourages them to spend that wealth, driving the GDP numbers to better than expected levels.

All-in-all, the first half of the plan worked pretty well. If you look at the graph above, you can see that the S&P 500 Index has moved higher with barely a pullback during the year. It has spent much of the year flirting with the band that is 10% above the 200-day moving average (it’s the dashed blue line). I’ve written on this blog several times in the past about the importance of the 200-day moving average and the distance of various stocks or indices from it, so if you need a refresher, please review some of the previous blog posts. However, it has only touched the 200-day moving average twice this year – a pretty amazing feat.

The question every investor and money manager should be asking themselves is what will happen to the stock market when the Federal Reserve stops printing money. Is it rhetorical to ponder whether the move higher will all be repealed once the flow of money that fueled the purchasing demand stops? I don’t think so especially if you look at what we have experienced.

Stock prices generally increase or decrease based upon two primary factors: earnings growth and investor sentiment. This year, earnings have grown 4% but the stock market is up 20% due to an increase in sentiment that has caused investors to jump in and buy each minor pullback in stock prices. The sentiment in the market now is such that people are afraid to not be fully invested – traditional risk management measures are frowned upon and any moves by an investment manager to hold onto cash are viewed negatively by clients.

If you look at what is happening inside the S&P 500 Index, you see a very different story developing than the one told to the investing public and it is leading them to be more aggressive than is warranted by fundamentals.

One very important thing I like to watch is how the companies within the S&P 500 Index (ticker SPX) are performing relative to the S&P 100 Index (ticker OEX). The OEX represents the 100 largest most liquid companies trading in the market and is a subset of the500 companies in the SPX. In the graph above, the bottom panel is a graph of the relative performance of the SPX to the OEX. You can see that for most of the year, the SPX outperformed the OEX, but as more of the investing public has gotten interested in investing in the stock market, the OEX has started to outperform (you can tell that by the downward tilt in that line starting in October).

The logic behind using this as an indicator is that when the under-invested or the outright bearish investors finally capitulate and move money into the stock market, they buy the largest most liquid companies because those are the ones they are familiar with. The same thing happened at the end of the great 1982-2000 bull market; in 1998 the OEX began to outperform as investors who normally didn’t buy stocks started to put money into the market (and many started day trading) but their focus was on the largest most liquid companies with which they were familiar. This is a classic sign that a market advance is getting long in the tooth.

Additionally, we are beginning to see that the number of companies trading above their 200-day moving average is declining. Check out the graph below:


Earlier in the year, 85% of the companies in the New York Stock Exchange were trading above their 200-day moving average (the red line), we are now down to 65%. Traditionally, the blue line at 60% is an indicator of when stock market investors are overly excited or bullish. We have traded consistently above that level for most of the year – when it dropped below there in June and September, we used those times as entry points to put cash to work and it proved profitable.

The fact that we are seeing a weakening of this graph since October coincides pretty closely with the strengthening of the OEX discussed above. What we are seeing is money flowing into the largest companies, pushing their prices up, while the bulk of the companies in the index are weakening in price. The fact that the index continues to move higher is an oddity of how the index is calculated: the largest companies in the index are weighted higher than the smaller companies. Apple makes up about 5% of the weighting in the index and we have seen its stock move up 40% in price the past five months. This type of move is masking the price performance of the bulk of the companies in the index.

Additionally, the market continues to get more expensive. I’ve posted the Shiller P/E Ratio Chart several times in the past, and it continues to show the increase in the valuation of this market multiple. We are now well above 25 times average trailing 10-year earnings, with only two clear points in the past when the market was more expensive: 1929 and 2000 before their respective crashes.


I think that in the next several weeks, maybe sooner or maybe toward the end of the first quarter or next year, we will have a normal type of pullback in stock prices where we see the index meet its 200-day moving average. This is a healthy occurrence, and it will likely be brought about by the Fed’s decision – or maybe even investor’s perception about the Fed’s decision – on when to reduce the amount of monetary stimulus it is providing through QE.

If you remember back to the discussion’s the Fed had about QE, it stated that its intention was to generate a wealth effect that would translate into people spending more money – our economy is roughly 2/3 consumer driven, so for our economy to expand the Fed needs consumers to take on debt to make purchases of consumer goods.

We can tell from the chart above that the wealth effect is in full swing just by looking at the S&P 500 Index’s significant move higher. But, we really need to look at where the consumer is in their personal spending pattern. For that, lets check out the graph below from the St Louis Federal Reserve Bank:


On the right side of the graph, you will notice the upturn in household liabilities levels after the big drop during the 2008 market crash. The granularity on this graph is a bit lacking, but what I’d like you to focus on is the near vertical increase at the tail end of he graph. In my opinion, this rapid increase in the rate at which consumers are acquiring debt will weigh heavily on the Fed’s decision process to reduce their QE activities. They will view this as an indicator that their plan has worked and consumers are getting more aggressive which will ultimately translate into increased economic activity.

When the Fed tapers (reduces QE activity) my assumption is that it will happen in the first quarter of 2014. They will likely go from buying $85 billion in bonds per month to something like $65 billion, keep it at that level for a bit, then continue to reduce it in step fashion until the purchase program has ended. However, if the economy softens noticeably, if the stock market corrects greater than they find acceptable (say, greater than 10%), if unemployment increases, or any other economic event happens that they feel would send the economy back toward 2008 levels, be prepared for QE to move back to current or even higher levels.

At this time, I do not expect that we will see a major selloff like the 2008 crash. The Fed has already stated that they plan to keep interest rates low until 2015 at the earliest, so monetary policy will continue to be very accommodative – it just will not provide a direct source of funds to go into the stock market. That accommodation will provide price support to the stock market so that if it goes down it likely won’t be past the 200-day moving average which would be a roughly 8% correction based upon today’s levels in the index.

From a more systemic standpoint, I believe the market is probably 40% over-valued based upon measures like price-to-book and price-to-sales. However, with interest rates and inflation still at low levels, and corporate earnings at historic highs with steady albeit low growth rates, that over-valuation could continue for a long time into the future until interest rates rise, inflation increases or earnings fall. Until then, or some other systemic event occurs, we will likely continue to be over-valued on the more traditional measures. This will likely add to the investor complacency and risk management aversion we are seeing, but will someday matter in a very big way.

I know I am going to get some questions about the title of this post. For those of us that grew up in the 60’s and 70’s, you are likely familiar with the term Pompatus of Love from a couple of songs – I’ve posted both of those videos below for your enjoyment.

In essence, this entire post is saying that investors have grown complacent and willing to pay an ever-increasing price for stocks in spite of the fact that earnings are growing much slower than justified by the increase in valuations. They are experiencing the totality of love for easy money and throwing caution to the wind – particularly those folks that are just now getting into the market near its all-time highs – just at a time when risk management should be a more prudent option.

For me all of this results in a set of tactical moves relative to our investment management activities. We will implement the plan discussed multiple times this year – when the index exceeds the blue dashed line on the graph that represents a value that is 10% above the 200-day moving average we will raise some cash in the holdings that have gotten furthest away from their intrinsic value (as we calculate it). I’ve shown you historic graphs that depict the market’s movements in relation to this level, and statistically it is important to raise cash when you get there because the market has always moved back toward the 200-day moving average and a more realistic valuation level.

Since we are still below the dashed blue line, we will stay invested but rotate out of certain companies that have had big runs and into others that have not or that may have pulled back in price (remember the graph above of the decreasing number of companies trading above their 200-day moving averages). For new clients with recently added money, we are selectively buying those that have pulled back in price but will add more when we get a broader move of the market toward the key 200-day moving average.

These tactical moves are subject to constant review and adjustment. If we see something systemic coming at us – watch for this month’s Macro Update in a few days, or refer back to last months since there hasn’t thus far been much change – that is cause for a significant increase in cash levels in portfolios, we will make those changes and advise you here on the blog (unless you have told us to be 100% invested at all times).

Until then, let’s enjoy some rock n’ roll history…this first video is probably one that you weren’t expecting to hear:

This second video is likely the one you expected: