It’s December people and that means it’s time for more than just peppermint lattes and the Charlie Brown Christmas Special. We’re just a few weeks away from sector rotation time when investors of all sizes will revisit their strategic allocations and billions upon billions of dollars will be reallocated. Think of this as your final exam and me, the professor who has woefully underprepared you for this moment. Sort of like John Oliver in Community so for this very special edition of the Sunday Night Recap, we’re going to try and scrap together a few quick ideas on how to think about your investments as you start the process.
As you all know, I’ve been turning into an uber-bull on Europe over the last few months and during a long drive home on Tuesday followed by a few days getting over a head cold, I started working on a longish piece trying to describe my methodology for asset allocation and establishing broad guidelines for return expectations. At the end of the day, as much as people hate it, modern portfolio theory remains the best tool for setting your market return expectations and I rely on it heavily including using a modified version of the Gordon Growth Model. I know, it sounds so quaint but since I have most of the inputs, I can modify the formula to determine whether investors return expectations are in-line with reality. And the coming shift in the interest rate environment here in the U.S. is going to have a major impact on the markets going forward. I’m a firm believer in going where monetary policy is loose and loosening and very shortly, that’s not going to be here at home although I still believe in having the U.S. as a core portion of your portfolio.
But it’s late on a Sunday night and the last thing you need from some yahoo in Pittsburgh is a long lecture on the dividend discount model, although still a huge fan. So instead we’re going to do this in stages and I’m going to explain it to you the same way I used to explain it to the advisers I used to work with; through gambling analogies. There’s a world of difference between investment and speculation and gambling is pure speculation no matter what strategy you try to use for the penny slots, but growing up in a horse racing town you learn there is one thing gamblers, speculators and investors have in common and that is they like to buy when they think they have a sure thing, when the odds are in their favor. At the end of the day, the chances of you knowing something that the rest of the market doesn’t is pretty slim; it’s what you do with the information you have that makes the difference.
Part 1: Domestic Equities: Not Such a Sure Thing?
Let’s start with domestic equities and as always, I’ll use the S&P 500 as my benchmark. After six solid years, the S&P 500 has proven itself to be a sure winner, there’s no doubting that. After the initial bounce from March of 2009 to the end of April 2010, the market took a breather for over a year to digest the gains and let valuations catch up but since the fall of 2011, it’s been nothing but a strong solid advance with only brief pullbacks to cool the tempo and after pushing past the previous highs, any mention of a “cyclical bull” or “secular bear” got dropped by the wayside.
But does that strong performance mean that 2015 will be just like 2014? Projecting the recent past into the future may be a favorite tool of market prognosticators and that’s sure to be exactly what a lot of investors are thinking, but we need to take a deeper dive to see where we go from here. Remember, the problem with being the heavy odds on favorite is that the payouts are often not that great.
- Where does your food come from: While cleaning some files I came across something I wrote in late 2013 that used a chart from the pragmatic capitalist.com showing the 2013 equity return breakdown with most of the return coming from multiple expansion rather than earnings growth with the admonition that the only way we could see as strong a year would be for the trailing p/e multiple to climb over 23. I also used the supposed favorite tool of Warren Buffet, total share holders equity to Gross Domestic Product with an updated chart here from dshort.com. Instead, 2014 has seen close to 100.5% of its return come from earnings growth rather than through multiple expansions. The trailing p/e is still above 19 while the forward p/e ratio has risen to a high level last week not seen since 2005 as earnings expectations dropped another 1%. And as to Buffet’s favorite tool:
- Prior Performance: I know people hate this argument, that because the past performance was so strong, the future is automatically guaranteed to be bleaker. Really it’s not, but when market valuations get as stretched as they are now after a strong run-up, the market likes to take a breather. In my former life I did a study of trailing and forward five year annualized returns and when the trailing five year return for the S&P 500 gets stretched beyond 10% on an annualized basis, the forward five year returns tend to be of the single digit variety at best.
- Payouts: Call me old fashioned, but I like having my money in my hand (or brokerage account) and not sitting in some corporate treasury collecting dust and I was certainly not disappointed in 2013. Over the trailing 4 quarters, payouts via dividends and share repurchases hit a new high but how much more room is there for that to grow? Payouts in the 3rd quarter grew 2%, the slowest rate of growth since the 3rd quarter of 2011. According to Factset, most sectors have cash to debt ratio below their 10 year average and the S&P 500 constituents paid out close to 95% of their earnings from 7/1/13-6/30/14 in the form of dividends and buybacks. Debt could continue to rise to finance capex, but internal financing would be cheaper and wouldn’t add to financial leverage. Dividends have also grown far faster than the long term trend which closely matches the median change in GDI of around 4.1%. The time to buy for faster dividend growth was in 2010-2011, not in 2014 with peak margins and already high payouts.
- Sentiment: Using that most despised of sentiment surveys, the AAII Investor Sentiment Survey, 2014 is likely to end on a better (less positive) note than 2013. The last reports from 2013 showed the bullish% well above the historical average and the bullish-bearish spread back to levels not seen since late 2010. A similar spike occurred in November after the S&P 500 finally broke through 2000 but has since cooled with neutral and bearish readings climbing slightly. This compares favorably to my own momentum scoring system that’s seen short-term scores cool after the initial rally wore down around mid-November while longer term scores continue to climb back to old highs. Using VOO and ETFG.com, the put/call ratio remains elevated while short interest has fallen to the lower quartile of its historic average.
- Technical: I know how much a lot of investors hate using charts for their analysis but remember what we’ve said before on the subject. If a lot of money managers take this seriously, you should at least know the fundamentals. Start with this weekly chart of SPY you can see that at the end of 2013, SPY had been probing the boundary of its uptrend line and the subsequent RSI (14) score was showing a clearly overbought condition with the market in need of cooling off. Fast forward to the present and you’ll see that although the RSI score is below the overbought zone at 70, the CMF score for the trailing 20 weeks has been declining on weaker volume which would indicate that the recent bounce has more to do with a lack of selling pressure rather than strong buying pressure. The previous pattern set in 2012 was also decisively broken and while SPY has pushed hard to get back into the uptrend channel, there is insufficient buying pressure to take it much higher.
- Prime Mover: When you think back to the tech rally of the late 90’s, what do you think of? Tech stocks of course, when companies like eToys.com could go public with hardly any revenue and command a market cap higher than their bricks and mortar counterparts. In the mid 2000’s it was the real estate and financing boom. What sparked this rally? An accommodating Executive Branch and Federal Reserve. Well Congress decided it was time to end the party years ago and the Federal Reserve has made its position on the issue of lower rates for an extended period very clear as Stanley Fischer has been sent on the lecture circuit to spread the news. While the latest GDP report owes a great deal to the temporarily expanding military purse, even Republican dominance of the Legislative branch might not be enough to stop these ridiculous budget issues.
These are just some of the highlights of my process which I hope to expand upon this week and while it’s impossible to assign a specific target for the market with any accuracy that’s never been my goal. There is absolutely nothing here that says the S&P 500 can’t have another positive year in 2015, it can still be positive but the likelihood of another 2013 is very slim. My focus is on trying to determine whether there’s sufficient return to be had for the amount of risk I could be taking on by adding NEW domestic equity positions and either holding them for a year or longer. Remember, the highest purses come with the longest odds and that’s something we’ll pick up on later this week.