This blog is intended to keep clients and friends current on my investment management activities. In no way is this intended to be investment advice that anyone reading this blog should act upon in their personal investment accounts. There are other significant factors involved in my investment management activities that may not be written about in this blog that are equally as important as the things that are written about that materially impact investment results. Neither is this blog to be construed in any way to be an offer to buy or sell securities. To be notified via e-mail when new posts are made, CLICK HERE TO SUBSCRIBE. To view previous investment strategies, click strategy downloads.


Investing During Inflation (Part Three)

May 10th, 2021

So Far

In the first post in this series, we took a look at how Large Cap and Small Cap stocks (as represented by the S&P 500 Index and the S&P 600 Index) performed during inflationary periods. We observed that there is a definitive negative correlation between inflation and both Large and Small Cap stocks.

In the second post in this series, we took a look at how Value and Growth stocks (as represented by the Dow Jones Industrial Average and the NASDAQ) performed during inflationary periods. We observed a negative correlation between inflation and Value stocks, but a somewhat positive relationship between inflation and Growth stocks.

Today, we are going to look at commodities to see how they perform during inflation.

Gold

Intuitively and based upon anecdotal observation of the past, gold seems to perform well during times of inflation. So lets look at the actual data:

As the anecdotal observations pointed out, Gold has a positive correlation with inflation.

Oil

When we think of inflation as a consumer, one of the key things we go to is the price of gasoline at the pump. As such, we assume that there will be a positive correlation between the price of oil and inflation.

This graph looks a bit wonky given that 200+% return on the price of oil at the 12+% inflation level, but putting it in historic context this we a result of the Arab Oil Embargo in the early 70’s. To get a possibly more accurate look at the correlation between oil and inflation, the graph below excludes 1974 from the data, so both the oil price increase and the inflation level are not shown in this graph:

The graph looks less skewed with the exclusion of 1974, but you can see a material positive correlation between Oil and inflation. What is beyond this blog post is whether the change in the price of oil is a cause or a result of inflation – maybe I’ll get ambitious and do that research when time permits – but we see a positive correlation and that is the purpose of this exercise.

Corn

One of the strange things I find in government reports is that the Core CPI, the number that the government wants us to focus on excludes the inflation of food and energy, two of the primary things that impact consumers. The graph above on Oil shows you the very positive correlation between energy and inflation, so lets take a look at food:

Not much of a surprise, we see a positive correlation between the price change of Corn and inflation.

Soybeans

Is this an isolated thing and not reflective of other agricultural products? Lets look at soybeans.

The correlation is less dramatic than corn, but there is still a positive correlation between the percent price change of Soybeans and inflation.

Implications

Commodities appear to have a positive correlation with inflation while the broad stock indices and the Value stock investing style have a negative correlation. At some point, when the artificial impact that government economic policies based upon Modern Monetary Theory and Modern Fiscal Theory wane, we will likely see these historic correlations return.

Market-beating portfolio returns will depend upon alpha and not beta, as discussed in Part One of this series. However, the time to prepare for that is now, not when the monetary and fiscal stimulus ends or is perceived by the market to be inevitable. By then, it is too late and the impacts will have been felt.

We are already seeing the impact of inflation on commodities, with prices for gold, energy and food up materially year-over-year. The question we need to ask is whether this inflation is transitory as the Federal Reserve states, meaning that once the stimulus is removed then inflation will fall back to pre-stimulus levels, or will it have embedded itself into the fabric of the economy and actual monetary tightening will be required to end it. At this point, given that the Modern Monetary and Fiscal Theories are a new thing and that we are swimming in unprecedented waters, I can’t really answer that. However, it is something that we will discuss in a future blog post as there could be other secular factors at work beyond government policy that will impact energy in coming years.

Up Next

We have looked at the commodities themselves, but most people cannot invest directly in commodities (except through ETFs and mutual funds, which is how we have to do it). So, we will take a look to see if the positive correlations shown above also are shown to exist with the commodity companies that mine, grow, process, sell, and transport those commodities so they get into the hands of producers and consumers.

—Mark

Stoking The Fires of Inflation

May 7th, 2021

I know this chart is difficult to read, but I am using one prepared by economist Peter Bookvar and he designed it for his purposes and not my blog.

The chart shows the readings from the National Federation of Independent Businesses survey. Here is his explanation:

Ahead of today’s payroll report we saw more signs of the tight labor market and the rising wage situation from the NFIB. Next week they report the full April survey results but yesterday they published the labor market components. Plans to Hire was little changed at 21% from 22% in March but trying to find help is becoming more and more difficult. Positions Not Able to Fill rose another 2 pts to 44%, the highest on record dating back to 1973. In response, wage intentions are rising. Current comp plans rose 3 pts m/o/m to 31%, matching the highest since February 2020 and future comp plans were higher by 3 pts to 20%, the highest since January 2020. Higher wages are what is now needed apparently to entice more people to take these jobs. 

Looking at the chart, you can see that job openings that are not being filled is at the highest level since the 1970’s. This is the precursor to higher wages – a good thing for workers – and something we need to keep an eye on for signs it leads to cost-push inflation.

As noted above, the chart was released prior to today’s jobs report. In the jobs report, the government announced that “average hourly earnings for private nonfarm payrolls rose by 21 cents to $30.17, after dropping 4 cents in March, spurring fears of inflation. That’s up 0.7% M/M against the consensus estimate of no change (from reporting by Liz Kiesche).”

Here is an explanation of cost-push inflation from Kimberly Amadeo that is succinct and easy to digest:

Cost-push inflation is when supply costs rise or supply levels fall. Either will drive up prices as long as demand remains the same. Shortages or cost increases in labor, raw materials, and capital goods create cost-push inflation. These components of supply are also part of the four factors of production.

It may be because I grew up in the 60’s and 70’s and remember the impact of rising prices due to bad monetary and fiscal policy, so I am hyper focused on this at the moment. That is not a bad thing as it helps me prepare client portfolios for what is coming ( and to a large extent already here – copper hit an all time high today. More from Peter Bookvar:

The price of copper today is at an all time record high, not far now from $5 per pound. Copper is the most important industrial metal in a world that wants to go renewable and it is more than just a China play. For reference, it’s previous peak in February 2011 saw a Chinese economy that was $7.5 Trillion. Today it is almost double that at $14.3 Trillion. Years of disinvestment and now a flood of demand explains the record high. I don’t recall hearing about any copper SPAC’s over the past year but every single auto related EV SPAC is hugely reliant on procuring copper. 

Watch for Part Three of Investing During Inflation on the blog in the next day or so. In the meantime, if you are not already a client (or if you are and have other assets managed elsewhere) and you are interested in having us help with your investments, just contact me at the email address on the website.

—Mark

Investing During Inflation (Part Two)

May 6th, 2021

Continued from Part One

In Part One, we took a look at how stock market returns for Large Cap and Small Cap stocks are impacted by inflation. I showed linear regressions for the S&P 500 (Large Cap stock index) and the S&P 600 (Small Cap stock index) for various time frames, but we focused on the period of time in the 70’s and 80’s where the country last had an inflation problem.

The correlation analysis showed that there was a negative correlation between the broad stock market indices and inflation, meaning that Large Cap and Small Cap stock prices are negatively impacted by inflation as represented by the Consumer Price Index.

Today, we are going to perform the same analysis, except with the Dow Jones Industrial Average (representing the dividend paying value stock style of investing) and the NASDAQ 100 (representing the growth stock style of investing).

Dow Jones Industrial Average (Value Stocks)

Whereas we looked yesterday at the broad market, the DJIA is a more narrow index that represents, in large part, blue chip dividend paying stocks that should be a part of everyone’s retirement.

As we did yesterday, we are focusing on the time period of 1975 to 1986 (for more in depth on why we chose this time frame, please see Part One).

Here, again, we have a negative correlation between dividend paying value stocks and inflation. Given the results that we saw with the S&P 500, this should not be a real surprise since during this time period, the stocks that made up the bulk of the S&P 500 weighting were dividend paying value stocks. It is a recent development that the S&P 500 is now so heavily weighted by the high tech giants that dominate the NASDAQ 100, which leads us to examine its correlation with the CPI.

NASDAQ 100 (Growth Stocks)

Before we look at the graph, I think we need to remember that in the 70’s and 80’s, the NASDAQ 100 was quite a different index than it is today. Apple listed itself on the NASDAQ in 1980, and that was arguably the genesis of today’s technology dominant index.

This somewhat surprised me. We finally have found a part of the stock market that has a positive correlation with inflation. However, given that the makeup of the NASDAQ during this time period is so different than it is today, I wanted to look at other growth stocks vehicles to see if we have a similar pattern. Unfortunately, finding data on annual returns is challenging. I did, however, find that one of the premier growth stock mutual funds publishes their returns back to this time period: Growth Fund of America.

Even though it is not as dramatic a correlation, we still observe that a positive correlation exists between growth stock returns and inflation.

Let’s try one more classic growth story to see if it supports this theory: Berkshire Hathaway.

Again, we see a positive correlation between a growth stock and inflation.

Implications

This analysis presents a quandry. Historically, as an economy has come out of a recession and economic growth has taken off, value stocks – particularly cyclical stocks whose earnings increase during the positive phase of the economic cycle – outperform growth stocks. I’ve written about that here on the blog recently, but increasing economic activity will typically bring an increase in inflation, which seems contradictory with the data presented here.

I think what we have is a situation where not all value stocks are created equally. So here is my theory:

  • (1) as an economy is ramping up GDP growth coming out of a recession, it has a positive impact on earnings growth in cyclical stocks while at the beginning of the recovery, inflation is tame.
  • (2) Then as we move through the recovery and inflation starts to build, the impact to earnings growth for the part of the value stock universe that is cyclicals begins to ease
  • (3) and the part of the value stock universe that is positively impacted by inflation takes over ( we are going to look at energy, miners, chemical producers, ag companies, and precious metals in this blog series to see if there is a positive correlation, but for purposes of this theory we will assume it exists).
  • (4) Additionally, as cyclicals start to lose steam and inflation plays heat up, investors begin to look for consistent earnings growers in the growth stock universe and growth stocks perform in the late recovery phase as inflation is peaking, giving growth stocks a positive correlation with the CPI.

Whats Next?

Since we mentioned it above, the next post will analyze the types of companies that we assume benefit from inflation: energy, miners, chemical producers, ag companies, and precious metals.

If you ever feel like the investment world is overwhelming or you tire of winding your way through the choices, please contact me. We can discuss your situation and set up an investment portfolio that meets your objectives.

—Mark

Investing During Inflation (Part One)

May 5th, 2021

In my last blog post, I provided some details on why prices are on the rise and inflation is becoming an issue. Since then, I’ve been doing some research on which investments perform positively and which perform negatively during inflation.

Below will be a series of graphs I put together that compare the historic performance of various asset classes to the levels of inflation at that time. I’ve have added a linear regression that will help you see the positive or negative relationship between the level of the Consumer Price Index and the returns on that asset class. Please understand that these graphs do not present the data in chronological order.

S&P 500 Index (Large Cap Stocks)

Below are a series of graphs that analyze the correlation between Large Cap Stocks (as represented by the S&P 500 Index) and the Consumer Price Index. The first graph covers the period for which all data is available, 1926 to today:

I know this graph is difficult to read if you are not used to looking at statistical correlations, so let me walk you through it. (1) Qn the left side, you will note that the Y Axis is the return for the S&P 500, going from -50% to +75%. (2) On the bottom, you will note that the X Axis is the level of inflation for various years and ranges from -10% to + 20%. (3) For each annual inflation reading, there is a blue dot that shows the return of the S&P 500 at that level of inflation. (4) The red line through the dots is a linear regression best fit line that helps us visually define whether there is a positive or negative correlation between inflation and stock market returns.

Looking at the red line, you can sort of make out that there is a slightly negative relationship here, meaning that inflation has a slightly negative impact on stock prices over the long term. To confirm this visual analysis, I also calculated the statistical Correlation at -0.00787, so it is definitely a very slight negative correlation.

This is all well and good, but that doesn’t really get to the heart of how stocks perform during periods of significant inflation. To examine that, I isolated the time period of 1965 to 1986, a 21 year span that saw inflation move from 0.97% in 1964 to high of 13.29% in 1979 ( along with other double digit years during this time span) and back to 1.1% in 1986.

Visually, this is a lot easier to conclude that a period of rising and then falling inflation has a negative impact on large cap stock returns. To confirm that, I calculated the statistical Correlation to be -0.260998, a materially larger number than the Correlation of the 1926 to present day calculation.

The above analysis looks at an entire inflationary cycle. Since we are just at the beginning of a new cycle, lets refine the data further and just examine the period of time from 1965 to 1978, where inflation was building prior to its peak.

As we might guess, the visual examination shows the impact is even greater negative as inflation is building. The calculated correlation is even more revealing at -0.560582.

S&P 600 Index (Small Cap Stocks)

From the above, we see that rising inflation has a negative impact on the returns of Large Cap Stocks. However will it have the same impact on Small Cap Stocks. To determine that, I performed the same analysis on the S&P 600 Index. Unfortunately, there is not the same amount of data available for this index as there is for the much wider known S&P 500. Our data starts in 1975 for this analysis, so it doesn’t make sense to analyze the data prior to the 1979 peak in inflation, so we will examine the 1975 to 1986 period, comparable to the second graph above.

We again see the negative correlation between stock market returns and inflation. The calculated Correlation is -0.217613.

Implications

Based upon this analysis, the broad stock market is a bad place to be during times of inflation. Given the dominance of index funds and passive investing over the past decade or so and their dominant percentage of investment vehicles in the stock market – over half of all stock market investment is now through index funds – any negative impact on the broad market will have an oversized impact on individual investors.

The beta side of the stock market potentially is in trouble so we, as investment managers, need to rely on alpha to provide acceptable stock market returns and to reduce the risk of loss for clients. Beta is emblematic of the saying “a rising tide lifts all boats.” Many stocks have moved higher over the past decade because they were included in an index, and as money came into index funds, their stock prices went up whether they were a desirable investment or not. That is because the index funds have to mimic the make-up of the index so they have to buy the bad with the good.

Over coming days, I will show you various other analyses of markets, sectors, industries, and investment styles that illustrate which benefit from inflation and which do not. We are at the leading edge of this economic change so I want you all to understand what we are doing and to know how to manage your investments that you do not have with us.

Next up, we will look at the proxies for the growth and value styles of investing, the NASDAQ and the Dow Jones Industrial Average. Until then, keep this fact in mind so that you are sure to read the next post: today the 3-year breakeven inflation rate is 2.82%, the highest level in 15 years while the 10-year breakeven inflation rate is the highest in eight years. The breakeven inflation rate is a signal given by the bond market and has proven to be exceptionally accurate over the years.

Inflation is here, we now need to prepare our investment portfolios accordingly.

—Mark

Prices On The Rise

April 30th, 2021

Signs Of Inflation

It is earnings season which means I am reading a lot of company earnings reports. One thing that is very noticable is that companies are talking a lot about the increase in their cost of inputs.

In looking at some of this inputs themselves, is apparent why companies are seeing their costs increase.

  • Lumber increased in price 27% just this past month
  • Soybeans, corn and wheat are at multi-years high prices
  • Copper, aluminum, lead, zinc, tin, iron and steel are at multi-year highs
  • Oil is up more than $100 per barrel over the past year from negative prices and up from $19 to $63 once the short-term negative pricing cleared up
Lumber Graph from Investing.com
Corn Graph from Investing.com
Oil Graph from Investing.com

Government economic reports are coming in that show inflation is becoming an issue

  • This week’s Chicago Purchasing Managers Index reported that prices paid at the factory gate (cost of production-only and not including transportation, marketing, mark-ups, etc.) surged to a 41 year high, last seen prior to Paul Volker taking over the Federal Reserve to combat the double digit inflation of the 70’s.
  • The Atlanta Fed’s sticky-price consumer price index (CPI)—a weighted basket of items that change price relatively slowly—increased 3.5 percent (on an annualized basis) in March, following a 2.3 percent increase in February. 
    • The flexible cut of the CPI—a weighted basket of items that change price relatively frequently—increased 21.8 percent (annualized) in March and is up 6.3 percent on a year-over-year basis.
  • Core PCE ( the measure of inflation that the Federal Reserve follows) saw the largest month-over-month increase since October 2009

Where is all of this coming from?

  • Supply constraints due to covid lockdowns of production and shipping facilities
  • Bad planning by miners and millers who did not anticipate the demand
  • Increased demand from the housing boom we see
    • People are moving out of the big cities because they can now work from home
    • They seek a home in the suburbs for a better lifestyle instead of a cramped apartment in the city
    • People are moving to southern states for a variety of reasons (weather, taxes, etc.)
  • Anticipation of an infrastructure boom coming from increase government spending
  • Reduced energy supply due to shut down of pipelines

The Federal Reserve states that this is transitory and will ease after a few months

I can see their point of view to an extent: shipping facilities will come back to full strength and production lines will be fully staffed again. However, we are seeing a secular change in how people work and where they want to live. The tidal wave of people moving from the cities to suburbs and those moving to southern states may slow, but it will not stop anytime soon.

With trillions of government dollars on the table and the plans to undertake multi-year projects means that fiscal stimulus will likely have an impact for an extended time period.

The Federal Reserve has stated that they do not see any sort of increase in over-night interest rates until after 2023. The Chairman also stated that he does not anticipate ending their bond buying activities anytime soon. Both of these monetary stimulus tools will continue to stimulate the economy and fuel the fires of inflation.

My belief is that inflation will go on longer and reach higher than the Federal Reserve wants to admit at the current time.

Investment Strategy

We have not seen inflation of any sort for a very long time. Most people managing investments today were not around in the 70’s and early 80’s to see the devastation it can cause, nor do they understand how to position portfolios to withstand the impact of increasing prices.

Precious Metals, Oil and Commodities (in particular the companies that produce these items) are a necessary component to portfolios. These companies get increasingly higher prices for their production and their share prices increase accordingly. Some of the companies we have in client accounts include:

  • Gold and Silver Miners: Newmont Mining, Barrick Gold, Agnico Eagle, Kirkland Lake Mines
  • Lumber Company Weyerhaeuser
  • Agriculture companies: Deere, Agco, Mosaic, CF Industries, and Nutrien
  • Energy producers: ExxonMobil, Conoco-Phillips, Chevron, Devon Energy

Real estate, hard assets, and collectibles all increase in value during times of inflation. Some of the companies we have in client accounts include:

  • Real estate companies: Florida landowner and developer St. Joe, Dallas and Atlanta landowner and developer Green Brick Partners, Florida lemon producer and landowner Limoneira

Companies that have the ability to pass along price increases because the buyers need their products:

  • Consumer Staples Companies: Hershey, Kellogg, Pepsi, Coca Cola, Procter & Gamble

Given all of the stimulus in the economy, both fiscal and monetary, we should see the economy growing. This means that there are certain investment styles that perform well:

  • Value stocks that are cyclical in nature will see their earnings increase as economic momentum builds
  • Small Cap stocks that are more domestic-focused than the multi-national companies see greater benefits from a resurgent US economy
  • Banks whose earnings go up as bond rates go up benefit from the increased demand for financing
    • Our Blue Chip portfolios are perfectly situated for this type of economy
    • Our Growth/Core/Fully Diversified portfolios have been rebalanced so they are positioned with large exposure to cyclical industries, banks, and small cap companies

Keep watch for updates here on the blog as we navigate the coming challenges posed by inflation. At the current time, the stock market is near all-time highs and not all that worried about the impact of inflation. However, when things change, they change fast. We have to be ready for any sort of correction that might come along.

We are positioned with cash in client accounts that we can deploy into our highest rated companies if we see any sort of pullback in prices from investors fear of ballooning inflation.

—Mark

Roadmap to Investing During Inflation

February 18th, 2021

The thing that is top of mind for investors at the moment is inflation.  It seems that on a daily basis, the yield on the 10-year Treasury Note rises as the congress talks about another round of stimulus for the economy.  This talk of stimulus has investors worried that it is more than needed, and that worry is leading to the fear of inflation moving materially above 2%.

We all know that as inflation rises, bond yields rise as well because investors require ever higher yields to compensate for the lost purchasing power of the dollar due to inflation.  This, of consequence, sends the value of the bonds people already own down and they slow losses in their bonds portfolio holdings.

So, inflation up = bonds lose money.  It’s a very standard bit of knowledge that investors possess.

However, inflation’s impact on the stock market is less well understood.  We all believe that when inflation goes up, stock prices come down, and the graph below from Ally Invest confirms that since 1990, or over the last 30 years, at least for the first twelve months we see reduced stock market returns when inflation is reported above 2% compared to when it is reported below 2%.

1

 

Double Click on Image for a Full Size View

So why is this?  Stock market returns may be adversely affected by inflation because those inflationary pressures may threaten future corporate profits.  As investors value stocks for investment purposes, nominal discount rates used to value future corporate profits rise under inflationary pressures, reducing current value of those future profits and thus the value of the stock market.

Our job, then, as investment managers is to position portfolios so that they are defensive against the impact of inflation by including stocks of companies that will benefit from inflation or that have pricing power to raise prices of their goods and services as inflation rises.

What are these companies?  The easy ones to identify are precious metals miners, agriculture related companies, energy companies, real estate, or any other company in a commodity business.  All of these companies act as insurance for your portfolio during times inflation is rising or at a high level.

The more difficult ones to identify are the ones that are not commodity producers.  A rule of thumb for investment managers is that Value Stocks out-perform the market during times of rising or high inflation and Growth Stocks out-perform the market during times of falling or low inflation.  We have seen this over the past several years as growth stocks have outperformed value stocks in the post 2008 stock market crash era.

So why would Value Stocks out-perform?  Value Stocks in general have material amounts of current cash flows and dividends, and many have pricing power for their products and services.  As inflation rises, their current cash flows rise and dividend increases tend to follow as the prices for their output rise with inflation.  As valuations for these companies are calculated, during the initial phase of rising inflation, the cash flows are rising faster than the increase in the rate at which investors discount those cash flows.

Unfortunately, there is level of inflation above which the discount rate rises faster than the companies can increase prices, thereby leading to a slowing of cash flow growth rates.  From the studies I’ve read, as inflation rises to 3% above then current inflation levels, cash flow growth will increase as companies can raise the prices for their goods and services without a material impact on demand.

In fact, the height of the out-performance of Value Stocks over Growth Stocks is when the rate of inflation has risen to between 2% and 3% above then current levels as this is where the price increases have been maximized and demand has not been impeded.  When inflation increases greater than 3% above the then current levels, demand begins to fall along with wider economic conditions.

From the period when inflation rises greater than 3% above then current levels until it tops out is a really bad time for the stock market because all values are discounted at rates greater than companies can increase cash flows.  This is when you have to watch for stock prices to bottom, generally ahead of the ultimate top in inflation, and watch for Growth Stocks to begin to out-perform the market once again.

So here is your roadmap to investing during an inflationary period:  based upon an analysis of the history of inflation and stock prices, when inflation starts to rise the initial 12 months shows pressure on the broader stock market as investors begin to adjust to the new reality.  During this time, Value Stocks begin to out-perform the wider stock market and expand their outperformance as the rate of inflation increase to a level of 3% above current.  Beyond a 3% rise, both Value Stocks and Growth stocks perform poorly until investors being to anticipate a top in inflation, then Growth Stocks begin their period of out-performance as inflation falls.

Please note that this road map imples just buying Apple, Google, Facebook, Amazon, Netflix and Tesla will lead to you outperforming the stock market.  Nor can you rely on your index funds as we are  entering a period where stock picking will be key to the health of your savings and investment.  If you do not want to try your hand at picking stocks that will outperform the market during an inflationary time, use a professional who understands the implications of inflation and proper portfolio management.  If I can help, please let me know.

 

 


 

Step #3 In Detail

February 12th, 2021

Last week, I posted about Gambling Vs Investing and gave you a step by step guide on how to be an investor.  I’ve had some questions about parts of the process, so I thought it would be a good blog post to discuss some of those steps in more detail.  So, I thought we would start with Step #3 since steps 1 and 2 deal with deciding to buy a stop and choosing one to research.

“Step #3:  examine the macro issues impacting the stock:

·   is the stock market itself in a bull phase or a bear phase;

·   do you believe from a timing standpoint that now is a good time to buy ANY stock;

·   is the industry within which the company operates in a bull or bear phase:

·   are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)”

Examine the macro issues impacting the stock provides you a big picture overview.  There is an old investment saying “A rising tide lifts all boats” that applies here – meaning that if the stock market itself is going up, then all of its participant companies have a force pushing their stock prices higher.  However, the opposite also applies as a falling stock market will take prices of good companies down along with bad ones.  What you want to do is determine which way the tide is flowing in order to know if your timing is right to buy from a macro perspective.

How do you do that?

  • You can look at the valuation of the market and see if its overvalued or undervalued
  • You can look at the trends to see if it is trading above or below its moving averages.
  • You can look at breadth to see how many companies are moving along with the price of the market
  • You can look at sentiment so see if investors are euphoric or frightened

Today, lets focus on valuation and figuring out where we are in the macro picture.  A future blog post will look at trends, breadth and sentiment.

I have a number of ratios I calculate and indicators I follow that tell me this, but as in individual investor you have more limited time and access to information than I do as a professional.

So the easiest things you can do are:

  • Look at the P/E Ratio of the S&P 500 Index and see if it is trading below 10 (extreme undervalued) below 15 (undervalued) or over 20 (overvalued)
    • I could go thru the calculation for you, but the Wall Street Journal is nice enough to just tell you what the current P/E ratio is today compare to a year ago, so you get a picture of the trend – a P/E Ratio that is higher today than a year go tells you that the stock market is more expensive today than a year ago so some caution is warranted.
      • https://www.wsj.com/market-data/stocks/peyields
      • From the table below copied from this link, you can see today’s P/E of 43.92 is materially higher than last year’s 26.10
    • Since 43.92 is above 20, this simplistic measurement tells you the market is overvalued.

1

Double click on any image for a full size view

  • Apply the Rule of 20 to determine the timing:  the sum of the S&P 500 P/E Ratio based upon estimated earnings for next year + the Projected Rate of Inflation must be less than 20
    • We know that we can get the P/E ratio from the WSJ link above, but they are also kind enough to provide you with the P/E Ratio based upon next year’s estimated earnings, or in this case 22.71.  This is already over the Rule of 20 threshold for overvalued, but roll with me…
    • We also need to know the Projected Rate of Inflation to complete our formula.  Again, our friends at the WSJ provide this data for you
      • https://www.wsj.com/graphics/econsurvey/?mod=nav_top_subsection    Once you navigate to this page, just choose CPI along the left side of the page in the Economic Indicators section
      • From the table below, you are given choices on timeframes for the projection.  I usually use the 6month projection since that is the average number of months overwhich our earnings projection covers.  There is no science here, just use one of them and you will be close enough, but make sure you have a basis for your selection
    • Our Rule of 20 calculation yields 22.71 + 2.8 = 25.51, or a number greater than our threshold of 20

1

  • Compare the total value of the US Stock Market to the output of the US economy.  This is Warren Buffet’s favorite indicator for determining if the stock market is overvalued or undervalued from a macro standpoint.  You can do the research to figure out the total value of the stock market and the current reading of GDP (the measure of economic output), but I cheat and go to the gurufocus website and they provide the information for me – you just need to the the “X” at the bottom of the log-in pop-up screen to access it
    • https://www.gurufocus.com/stock-market-valuations.php
    • The chart they provide gives you a visual that is easy to follow – looking at it below you can see that the stock market is significantly overvalued compared to the economy and that they overvaluation has grown wider over since it was last on par in 2009

1

 

They also provide us with this chart that bring the graph relevance:

1

 

Why is valuation at a macro level important?  Because today’s valuation helps determine your future returns.  Again our friends gurufocus provide us a graph that explains this.

1

This is a busy graph, but it shows that the mover overvalued the market, the lower the forecast future returns are for the stock market.  This graph shows you that the most significantly overvalued level shown (i.e., the ratio of the value of the stock market to GDP) is 130%, leading to a projected negative 7% forward return.  They do not calculate the forward return when this ratio is at 195% (see the chart above) but the forward return would logically be significantly lower than negative 7%.

However, let me stress this point:  this is not the Bible, its more like government ethics – it is a guideline that is rarely adhered to by the stock market.  There are two factors to remember:  (1) this really only applies if you are a buyer of the broad stock market TODAY; and (2)you can find companies to buy today that will return significant profits for you in the future, even if the broader stock market has a negative return over coming years.

Don’t let this analysis convince you to sell everything you own simply because these guidelines provide an answer that is not pretty.

Do, however, let these calculations tell you that from a macro standpoint, now is not the best time to be a buyer of initial or expanded stock market exposure – there will be a time when the market is more supportive than it is right now of expanding your allocation to stocks.  You can use these tools to help you determine that, or you can hire a professional to do the work for you.  I believe the right answer is to hire a professional that understands this stuff – not all do, some will tell you that the market is set to go higher indefinitely, you can watch them on stock bubble television all day long, but that is not reasonable or logical – and let that professional use the tools in their toolbox to determine when the macro environment says to be a buyer.

Gambling Vs Investing

February 5th, 2021

1

Double Click on any Image for a Full Size View

It has been a crazy couple of weeks in the stock market.  If you haven’t watched the investment news for awhile, you missed a wild ride in a few heavily shorted companies.  Gamestop is one of those companies, and in the chart above you can see that its price was in the $11 range for several months then rose to the mid-upper-teens for a period of time before being pushed up to nearly $500 in a short squeeze before backing down to the $50 level.  This is the essence of volatility and one of the things that you see when stock markets are nearing a top – people forget about basic risk management and turn investing into gambling.

If you are wondering how this sort of thing happens, here is a short explanation in bullet point format:

·  Gamestop as a business historically sold video games in cartridge format

·  Most video games are now downloaded directly over the internet, leading to a significant decrease in revenue over time and a subsequent drop in its stock price

·  Gamestop acquired a new major investor that recently sold their own internet driven business for more than a billion dollars who has said he plans to help Gamestop transition to a new internet-based business model

·  Many large hedge funds were short the stock of Gamestock, which is bet against the company in the belief that it would go down even further in price

·  However, small investors were discussing this change on internet discussion boards and as a group decided to try to drive the stock price higher with buying, forcing the hedge funds to cover their shorts by buying stock, starting a process that feeds upon itself:  buying begets more buying

·  Once the ball got rolling, and the stock price started to move, the discussion boards detailed how the small investors could buy calls on Gamestop which ultimately would move the stock higher because the brokers would have to buy the stock of Gamestock as a risk management measure which put more pressure on the hedge funds to buy as the stock price moved up

·  Here is an Article Posted On Reddit re: Gamestop Investing that helped to fuel the fire, and which the hedge funds missed – there  is another Reddit post out there (I can’t find it now to provide you the link) that told people to sell when the stock reached $480…guess what the high was on that chart:  $483

·  A lot of people who bought at the beginning of this frenzy made good money, but it was still a bet that that the Reddit community could drive the stock to a level where the hedge funds would be forced to buy stock to cover their short position

·  However, many more people lost money because they were a buyer at prices above $50 and didn’t sell into the frenzy – and the hedge funds who were forced to buy at $483 or some other price significantly above today’s $62 price have lots hundreds of millions of dollars, putting two major hedge funds on the brink of bankruptcy

·  This frenzy also forced a number of brokers to halt trading in Gamestop shares, causing a number of investors to lose money, either actually or from an opportunity cost standpoint, and the class action lawsuits against them are starting to come forward

Let me make it clear, what the small investors did was not illegal, but it is not investing.

What is investing?  Let me walk you through a process that I use that entails a significant amount of due diligence.  Due diligence is a process used to find the stock of a company that has the opportunity to outperform the rest of the stock market.  If you invest your own money, I hope you are engaging in a similar process – if not, I would be happy to manager your nest egg so that it follow process.

Due diligence involves research into companies to determine whether they would make a good fit as part of an overall portfolio designed to achieve an objective.  I won’t discuss in this post how you design and develop a portfolio nor how to position a portfolio to achieve an objective, but those will make interesting posts for the future.  However let’s take a look at buying one stock so you get a feel for the process.

Step #1:  you determine that you need to buy a stock – there are many reasons for this, like you have some cash to invest or you want to swap a current stock in which you have lost faith into one that you believe will outperform the market.

Step #2:  you decide on a stock you want to research – there are a number of ways to determine your research candidate, like you hear about it on investment television, from a neighbor, or perhaps you are a fan of their products, to name a few.

Step #3:  examine the macro issues impacting the stock:

·   is the stock market itself in a bull phase or a bear phase;

·   do you believe from a timing standpoint that now is a good time to buy ANY stock;

·   is the industry within which the company operates in a bull or bear phase:

·   are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)

Once you determine that the overall market is at a place where buying stock makes sense and that the industry for your company is not facing significant headwinds, then we turn to examining the company itself

Step #4:  examine the fundamentals – this involves math, so be prepared to do it or trust the wall street analysts numbers (I don’t trust them since they are predominantly bullish and will sometimes use unconventional methods to justify a future stock price target higher than today’s price)

 ·   you need to determine an intrinsic value for the company’s stock (this is different than a price target that analysts publish) and compare it to today’s stock price since you want to buy the stock near or hopefully below that intrinsic value – this is complicated

·   an intrinsic value involves examining the company’s cash flows an discounting them so you determine what they are worth today

·   if the stock market is in a bull phase, it can be difficult to find a stock trading below its intrinsic value – so you will have to decide it buying above intrinsic value makes sense or whether it would be better to buy it once the price moves closer to intrinsic value

·   you need to determine if the company’s ongoing operations will support a move higher in stock price

·   you need to examine a company’s earnings growth (historic and projected) and its return on equity (historic and projected) to see if they meet you desired levels

·   there are two ways a stock’s price will move higher or lower:  (1) rising or falling earnings; and (2) how much investors value those earnings – a high level of earnings growth and return on equity will help you make sure you are meeting (1) above

·   you need to examine a company’s financial strength to make sure they will be around for the long term and can withstand a recession when it happens

·   debt levels,  cash on hand, owners equity levels, and free cash flow generation are critical

Step #5:  you need to look at a company’s valuation to determine if it is an acceptable time to buy or whether you should wait until the stock price comes down to acceptable valuation multiples – see (2) above

·   price to earnings multiples, prices to sales multiples, price to book multiples, price to earnings growth multiples, price to intrinsic value multiples all need to be examined at a minimum to see if the stock is trading at an acceptable valuation level to buy it

·   studies show that more money is lost in the stock market buying a company that is over-valued than lost based upon buying those with bad fundamentals

Step #6:  you need to look at a chart to see if technically it is time to buy or not

·   a stock chart is just a visual representation of the collective investor view on this company

·   sentiment and momentum play a big part in the short term outlook for a stock’s price

·   buying a stock when it is near the bottom of its short-term trading range can produce significantly higher long-term returns than buying a stock near the top of its short-term trading range

·   this helps you determine what price you want to pay for the stock and what price you will accept paying for the stock if it never gets to the price you want (if your analysis supports buying it at the higher price

Step #7:  buy that bad boy!

·   if everything aligns and you are satisfied you have a company that you want to own with good fundamentals at an acceptable valuation and current stock price, then buy it

Step #8:  determine what price you want to sell the stock

·   set an upper price target for the stocks – this doesn’t need to be a hard sell target, it might be the price where you want to rerun the steps above to make sure owning the stock makes sense (e.g., an example of this is buying a cyclical stock tied to the ups and downs of the economy – you want to buy it when the economy is a catalyst for the stock price to go higher but you want to sell it before a downturn in the economy becomes a headwind; setting a price target will force you to re-examine your reasons for owning the stock and will tell you whether to continue to hold it or whether to sell it – just remember to set a new target price if you continue to hold it)

·   set a price below your purchase price where you draw the line on losses – a common one is 9% so that you avoid any double digit losses on an investment

·   this can be tricky because many times you hit your loss limit and sell the stock only to see it recover and excel to the price target you set – but it is more important that you maintain standard practices because over the long-term you will be more successful than if you are haphazard in your actions

·   sometimes something can happen and a stock will plummet below your loss limit price (it’s just the way the market works and is typically news related relative to some non-public negative information becoming public) – you have to decide whether to cut your losses and sell at this lower price or you determine that this is an over-reaction by the market and it has provided you an opportunity to buy more shares at this cheaper price

Step #8:  document your analysis and your reason for buying the stock and for ultimately selling the stock

·   one of the major benefits of documentation is so that in the future you know why you bought a company and so that if you sell it you have done a significant portion of your due diligence in case you want to buy it back

Investing is not gambling – due diligence ensures that your stock portfolio will not go to zero and that you will have the best chance possible to meet your objectives

·   yes, some non-public information can become public and drive the price of one stock to zero or close to it, but that is why you build a portfolio and diversify that single company risk away

·   you can also have publicly available information drive a stock’s price to zero or close to it, but that is why we have this due diligence process that forces you to periodically review the company you bought and to sell it if something changes or your analysis was wrong (hey, it can happen, it does to professional investment managers all the time for many different reasons:  if your projections of future earnings and returns do not pan out, if investor sentiment changes, if your view of an acceptable valuation level to buy that stock is wrong, or any of countless other things happen)

Over the years, I have developed spread sheets that automate a significant portion of this due diligence process.  They help guide me to determine if what I want to buy will outperform the overall market and they help guide me to determine if I want to sell it.  However, if you are managing your personal portfolio, it is important for you to follow this process or another one that you develop on your own.  Sticking to a process will help keep you out of trouble, will help you achieve your objectives, and will make the weight of these critical decisions a bit lighter.

–Mark

 

Archives