Strangers with Candy

The Yinzer Analyst is back in the Burgh and just in the nick of time. After spending five days in beautiful Iowa, I got to play with a combine and eat too many pork tenderloin sandwiches but most importantly managed to gain a new perspective on life.  We’ll save the re-piloting for later but getting some distance between yourself and the market is always a great way to regain a sense of balance and understand what’s truly important, even if it’s standing in a horizon-less soy bean field and working on the farmer tan.

So for all the drama on CNBC and in the financial press that I managed to pick up in greasy spoons in the heartland, since the Yinzer Analyst went to Iowa last Saturday the S&P 500 is down about 1.85% while the Russell 2000 is off 2.01%. While that 1.85% was a significant chunk of the 2014 advance, how much damage has been done to the market and what can we expect going forward.

Shorter-Term

First let’s take a look at the short term technical picture for the S&P 500 before considering what could come next. Everyone has been passing around this chart showing the S&P 500 cracking the uptrend line dating back to the start of the 2012 rally. As you can see, we’re not too far away from the last leg of the uptrend back at 1904 while there’s more support at 1900 from both prior overhead resistance and the 200 day moving average. Momentum scores are in fact are at the same low levels of August 7th before the market ripped an over 4% advance over the next month. Not saying history is going to repeat itself, but given that breaking of an uptrend line, prior support and recent weakness; we could see a small bounce over the next few days as the S&P continues to right itself.  We’ve already had two promising signs as breadth has improved the Russell 2000 bounced today after hitting key long-term support but the prior support at 1950 might turn into resistance now so be prepared for a slog back to 2000.

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Longer-Term:
Pulling back to the weekly viewpoint, the S&P 500 has been showed signs of weakness several times this year as the long-rally off QE3 looks to be spent. Take a look at the chart below; it’s one that I put together in March when the S&P 500 first closed below the uptrend line that had been supporting it since 2012. You can see that there was a reaction bounce back above the trend line but the move has become exhausted as investors pull back on valuations. So what were your expectations for 2014?

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The chances you’ll be able to forecast something like the annual return of the S&P 500 and be anywhere within say 300 bps of the actual return is about nil, so why do thousands of paid professionals try to do just that every year? Because it pays really well and investors want to have some number they can anchor themselves too no matter how ludicrous it is. Some of those forecasters will use “sophisticated” financial models, others will assume return to the mean historical performance, and a few will simply take last year’s performance and assume it will continue indefinitely.  But if you’re taking a wall street “pro’s” word on where they think the market will be next you, remember that it’s like taking candy from a stranger.  You have no idea what he’s giving you or why, so why would you expect he’s doing it out of the goodness of his heart?

The Yinzer Analyst grew up in a horse racing town and when it comes to setting return expectations, it helps to think of it as handicapping. You’ll never know the actual outcome ahead of the event, but you can use your observations to try to get a sense of where the market could be heading based off a few principles including mean reversion and the knowledge that the P/E ratio tends to move in cycles. Peter Oppenheimer at Goldman Sachs did some tremendous work on P/E cycles and one of the key observations is to understand that the ratio expands based on investor confidence; in the late 90’s it was confidence in the new tech boom, in the mid-2000’s it was confidence in lower interest rates and leverage. In the strong rally we’ve been in that dated back to October of 2011, the confidence in the Federal Reserve has been the key catalyst but that role is changing. Going into the end of 2013, what could anyone discern from studying the last few years of equity returns?

  1. Since the end October of 2011, the S&P 500 returned 47.48% with earnings growing about 8.5%. The bulk of investor returns came from the trailing P/E multiple rising from 14.4 to about 19.58 or nearly 36%. Remember the average trailing P/E is around 15.52.
  2. Corporate profit margins as a % of GDP was close to an all-time high but showing signs of waning.
  3. QE3 was going to end; the FED had announced the first in a series of graduated drawdowns of their bond buying activity. While there was a lot of discussion around “data dependent” most FED watchers acknowledged that the drawdown was likely on a preset course.

If you had just those three bullet points to work with (and you could totally cut out #2), what direction would you have taken your equity allocation? Would you have had 100% in equities? What about a trailing stop loss?

Now consider this:

  1. In 2014, the S&P 500 has returned 5.29% through today with earnings up around 9.3% while the trailing P/E multiple has fallen -3.73%. Even with that pullback, the trailing P/E ratio is at 18.85 and in the 88th percentile of monthly values since May of 2010.
  2. The forward P/E is still well above 15 (a level many analysts consider to be the upper end of reasonable) and if it were to fall to 14.1, the S&P 500 would be valued around 1826.94 using the S&P’s tracking consensus for 2015 earnings. Since earnings estimates tend to be overdone by around 5%, if we discounted those earnings to 123.09 we’d have a fair value of 1735.
  3. QE3 is dead and there’s no plan to resuscitate it anytime soon. In fact, the debate has shifted to how quickly we can expect rates to rise and how far that move will go.

So is the S&P 500 a good bargain at these prices, my answer is still no although you should have some exposure to domestic equity in case a stranger on the internet happens to not be telling you the truth. If the market is topping out, it pays to remember that the process tends to be long and drawn out, not something completed in a quarter.

If you’re planning on adding large new positions, remember that valuations are still high, earnings will have to carry the load going forward and if the FED does raise rates in could have a negative short-term impact on earnings growth. Like Warren Buffet once said, price is what you pay but value is what you get.

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