X-factor 102211 - Market is Not Cheap
Content
October 22, 2011
The Market Is NOT Cheap
On October 3rd we wrote a blog that said: “This is why the next rally that we likely see will be into the end of the year. This will most likely be a ‘suckers rally’ as it will suck investors in as the media bleats about the end of the bear market.” Here are some headlines from last week: “S&P sees longest weekly rise since February”
Inside This Issue:
The Market Is NOT Cheap Oversold and Cheap Are Different Earnings Can't Outgrow Economy Fed Model Is Broken
“Bulls insist common stocks are cheap as hell.” Technically Speaking “US Stocks are cheap – rally will last” There were many more but you get the idea. This week I wanted to spend a little time discussing this idea of whether stocks are currently “cheap” after the decline over the previous five months and whether or not this is the time to buying. However, before we can start any discussion about valuations on the market we have to establish that we will only be looking at 12-month trailing reported earnings. Trailing "as reported" earnings numbers which is the only method by which P/E ratios are ever viewed. When analysts began to use operating earnings, forward estimates or any variation thereof, they are not comparing apples to apples and they are being disingenuous to the valuation process. There are a number of major problems with not using trailing earnings besides just being deceitful. Over the last 110 years the S&P 500 has been priced at an average of 15 times earnings. However, and very importantly, the earnings used in the calculation were reported (GAAP) earnings, not operating earnings or estimates.
DISCLAIMER: The opinions expressed herein are those of the writer and may not reflect those of Streettalk Advisors, LLC, Charles Schwab & Co., Inc., Fidelity Investments, FolioFN or any of its affiliates. The information herein has been obtained from sources believed to be reliable, but we cannot assure its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Any reference to past performance is not to be implied or construed as a guarantee of future results. See additional disclaimers at the end.
Market Breaks Out Bear Market Still In Tact 401k Plan Manager May Be Getting Close To A Change – Sell The Rally. Click Here For Current Model Allocation. Disclaimer & Contact Info.
The problem with operating earnings, which were not used until the mid-tolate 1980s, is that they exclude write-offs of various kinds as determined arbitrarily by corporate management. Generally operating earnings are far higher than reported (GAAP) earnings. GAAP stands for "Generally Accepted Accounting Principles", and operating earnings do not conform to those standards. If the historical average P/E was calculated on the basis of operating earnings the P/E would be much lower. The use of estimated 12-month forward earnings is also completely ludicrous. The estimates are almost always wrong and most often on the high side. For instance the estimate for 2001 was $54.20 and came in at $36.85. Reported earnings that year were $24.89. Similarly, the estimate for 2008 was $99.15, but came in at only $49.54 while reported earnings were a paltry $14.88. Another big problem is the volatility of year-to-year earnings which constantly fluctuate from high to low and back again. Historically the market has valued peak earnings at an average P/E of 12 while valuing trough earnings at a P/E of 18. The markets move in very broad long term cycles as shown in the chart. These "secular" cycles on average last about 15-18 years in total from beginning to end. The driving factor behind these long term secular cycles is valuations. When valuations are low at the beginning of a period as they were in 1898, 1922, 1950 and 1982 the market experienced a bull market of significant proportions as valuations rose over time - this is called "multiple expansions". During the opposite periods, as markets experienced "multiple contractions", returns for investors were extremely low on a "buy and hold" basis. It is important to have a grasp, as well as a respect, for these secular cycles as it predicates how invested dollars should be allocated.
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Oversold And Cheap Are Two Different Things The talking heads and promoters are mostly saying that either there will be no new recession any time soon and/or the stock market has already priced one in. First of all, just because the market bounces from a very oversold condition after being down five months in a row, which we said was very likely to happen in our September 30th blog post, does not mean that a recession has been forestalled. Time will tell on this point. However, the second point is much more important as the argument that has been used repeatedly is that the average price-earnings ratio of the U. S. stock market in recessions is 13.7, but stocks are selling at 10-11 times 2012 estimated earnings. Bah! The problem with it is that those 2012 earnings estimates are based on upbeat, non-recessionary earnings estimates and, more importantly, are consistently higher than the actual numbers when they are reported. Whoops! If there is to be (or, if there already is) a recession any time soon, investors need to remember that a great many companies are highly leveraged in various ways. This of course includes many financial companies, but it also includes a good many others. This in turn means that earnings can turn on a dime. They do and they will. Andrew Smithers asserts that the only two proven valuation measures are earnings adjusted for their average over many years, a concept known as
page 3
cyclically-adjusted price-earnings ratio (CAPE), and a totally different measure known as q. Q is a measure of what it would cost to replace the assets of companies. The importance of these two measures is critical to understand. While the analysts and the mainstream media continually tout that based on one factor or another stocks are a great buy the reality is that they are quite expensive. Shiller’s price to earnings ratio smoothed with a 10-year average strips out the annual volatility in earning to reveal the longer term trend. As we stated above; when the multiples of earnings are contracting, as they are now, market returns tend to be low over a long period of time. As they have been for the last decade. Secondly, bear markets have NEVER, and I repeat NEVER, been resolved when earning were above, equal to or slightly below their long term average. Bear markets are completed when valuations are near single digits (between 7 and 10x trailing earnings) historically. The problem is that today the accounting gimmickry and game playing has gone beyond rationality. Therefore, the measure of Tobin Q-Ratio strips most of this non-sense out. The Q-Ratio is a measure of what it would cost to replace the assets of the companies. Liabilities and assets are much harder to fudge than earnings. Furthermore, no one uses any measure of “forward liabilities and assets” when trying to make a case as to why you should be buying stocks. Therefore, the elegance of combining these two different measures, as we have done in the chart above is that it gives you a much clearer picture as to the relative overvaluation of the market. Earnings Can’t Outgrow The Economy So, back to the stream of talking heads in the media proclaiming that based on 2012 expected earnings stocks are undervalued, and, of course, no one ever challenges them. Never mind the impending issues with Europe and their economy, the slowdown in China or the drag of the U.S. consumer on the domestic economy. Don’t pay any attention to the fact that 22% of wages and salaries are being eaten up by food and energy or the fact that 1 in 5 Americans are unemployed or working part time for economic reason. Don’t discuss the 1 in 6 Americans on food stamps, unemployment benefits or welfare. The view that stocks are cheap based on expectations of continued earnings growth in this environment is a result of flawed reasoning. The analysts state that the S&P 500 at about 1200 is selling at about 11 times estimated 2012 operating earnings of about $108, well below the historical average of 15 times. In addition when the $108 of earnings is multiplied by 15 the result is a target of 1620 on the S&P 500 by the end of 2012. In other words they are multiplying 12-month forward estimated operating earnings by 15.
STREETTALK ADVISORS
What makes us different? It’s really pretty simple. We believe that managing risk is the key to long term success. Conserve the principal and the rest will take care of itself. Risk = Loss Seems like a simple concept – yet most people take way too much risk in their portfolio which is fine as long as the market goes up. The problem comes when it doesn’t. Managed Risk = Returns By applying varying levels of risk management to a portfolio of assets the potential for large drawdowns of capital is reduced thereby allowing the portfolio to accumulate returns over time. Total Return Investing We believe that portfolio should be designed for more than just capital appreciation. There are times when markets do not rise. During those periods we want income from dividends and interest to be supporting the portfolio. If you are ready for something different then you are ready for common sense approach to investing. Get Started Today!
page 4
That is all fine and dandy until you realize that the economy is growing around 2% currently and well below the long term trend of nearly 6%. Why is this important? The companies that make of the S&P 500 are a reflection of the economy and not vice-versa. Consumers, which make up roughly 70% of GDP today are the drivers behind the revenue and, ultimately, the net earnings of corporations. Therefore, in a slower growth economy earnings are going to grow more slowly. The massive surge in earnings that was witnessed post the financial crisis of 2008 came courtesy of a massive draw down in inventories which had to be replaced and a relaxation of accounting rules that allowed for a whole cycle of fictitious accounting numbers and gimmicks. Also, a huge part of the rise in profitability was due to the massive layoffs and cost cutting by corporations which has now, for the most part, run its course. Therefore, as earnings are now back towards their peak, on a reported basis, the question to be asking is now much further can earnings stretch before a reversion to the mean occurs as shown in the chart. Could earnings go higher from here? Absolutely. With recent announcements of more layoffs, cost cutting measures in full swing, investments to increase productivity and suppress labor costs, combined with the ongoing massaging of the books through creative accounting, earnings certainly could rise. The issue, however, is that since secular bear markets typically bottom at P/Es of 10 or under, there are only two ways to resolve that valuation issue. The first is that earnings rise as prices remain fairly stable OR there is a sharp and rapid drop in price. Either will resolve the overvalued market and we suspect that the next recessionary bear market will suffice to make that happen.
page 5
The Fed Model Is Broken
Earnings yield is a different matter altogether and a completely bogus investment strategy. This has been the cornerstone of the "Fed Model" since the early 80's. The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa. The problem here is two fold. First, you receive the income from owning a Treasury bond whereas there is no tangible return from an earnings yield. Therefore, if I own a Treasury with a 5% yield and a stock with a 8% earnings yield, if the price of both assets do not move for one year - my net return on bond is 5% and on the stock it is 0%. Which one had the better return? This has been especially true over the last decade where stock performance has been significantly trounced by owning cash and bonds. Yet, analysts keep trotting out this broken model to entice investors to chase the single worst performing asset class over the last decade. It hasn't been just the last decade either. An analysis of previous history alone proves this is a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50's and 60's the model actually worked pretty well as economic growth was strengthening. As the economy strengthened money moved from bonds into other investments causing interest rates to have a steadily rising trends. However, as we have discussed in the past in "The Breaking Point" and "The End Of Keynesian Economics" as the expansion of debt, the shift to a financial and service economy and the decline in savings began to deteriorate economic growth the model no longer functioned. During the biggest bull market in the history of the United States you would have sat idly by in treasuries and watched stock skyrocket higher. However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost a large chunk of your principal after the crash of the markets in 2008.
page 6
Currently, you are back in again after missing most of the run up in the current bull cycle only most likely to be left with the four "B's" after the next recession ends - Beaten, Battered, Bruised and Broke. The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine "WHAT" to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining "WHEN" to make an investment. In other words, I can buy fundamentally cheap stock all day long but if I am buying at the top of a market cycle I will still lose money. As with anything in life - half of the key to long term success is timing. Right now, with virtually all of the economic indicators weakening and pointed towards recession, a lack of support by the Fed in terms of stimulus and a vast array of varied risks from credit downgrades, Eurozone issuers on the brink of default, valuations not extremely cheap and a breakdown of technical strength in the market - timing right now could not be worse for long term investors. Of course, this is all assuming that "The Bernank" remains silent on the next stimulus induced market rally...otherwise the game is changed temporarily. Have a great weekend and I will talk to on the radio next week. Lance Roberts
page 7
Technically Speaking
Market Breaks Out – Time To Buy?
The market broke out of its trading range this past week and is now challenging resistance from the break of the “head and shoulders” neckline back in August. Currently, as we have stated many times, that a rally was likely this month and such has been achieved. We are now into the seasonally strong time of the year as well. So, with that, we should be allocating more equities into portfolios to participate on the back of the next cyclical bull market? Right? Not so fast. While things have improved on the surface the bulk of this rally has occurred for three reasons: 1) The markets were massively oversold after five months of declines leading into October. 2) Short covering has been a major source of the rally. 3) The catalyst for the rally has primarily been the rumor of a bailout for Europe which may or may not occur. With that said, our two major weekly signals are still in “SELL” territory as well which also predicts more caution at the current time. As you can see these signals have kept you out of trouble. No, you didn’t get the exact top or bottom, but you did participate in the majority of the move up and missed the bulk of the downside. Currently, the market is working on a pretty normal retracement of the previous sell off. IF the market gets above this dashed blue line AND our weekly “BUY” signal kicks in (lower chart) then we will recommend adding exposure to portfolios.
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It generally doesn’t pay to go against these indicators but if you feel you must be investing in the market now we recommend that you do so cautiously. Bear Market In Tact This is further confirmed by our standard deviation chart. As you can see in the chart below the market got two standard deviations oversold in August and September and we are now experiencing a normal retracement of that decline to the moving average.
In normal bear markets the index tends to trade in the lower half of the standard deviation range. A move into the upper half of the band will be a much more positive development for longer term investors. Finally, our McClellan Oscillator is extremely OVER BOUGHT which signals that the next week most likely will offer some sort of correction. The magnitude of that correction is critical to whether we upgrade our allocation to equities in the next week. Caution is still highly advised.
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401K Plan Manager
The rally that has run over the last three weeks has now worked off a lot of the oversold condition that existed at the end of September. We may be getting close to being able to upgrade our allocation model but the all clear signal is not yet in as shown in the “Technically Speaking” section above. At the current time we suggest that you SELL all positions that have not performed well over the past few months (ie worse than the market) and reduce exposure to international markets until something is resolved in the Eurozone. This will provide cash to allocate back to the portfolio model should a buy signal be triggered in the next couple of weeks. Caution is still advised but things may finally be turning around. If you need help after reading the alert; don’t hesitate to contact me.
Current 401k Allocation Model 35% Cash + Future Contributions
These options include: Stable Value, Money Market, Retirement Reserves
X-Factor (Equity Allocation Adjustment) 50% Target Allocation Tactical Allocation
Cash 5%
35% Fixed Income
Bond funds are a play on the direction of interest rates Short Duration, Total Return & Real Return Funds
Cash 35% Equity 30%
30% Equity
The majority of funds track their respective index. Therefore, select ONE fund for each category. Keep it simple. 30% Equity Income/Balanced/Growth & Income 0% Large Cap Value 0% International VALUE
Bonds 35%
Equity 60%
Bonds 35%
___________________________________ ALL NEW MONEY (Monthly Contributions)
100% Cash
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Disclaimer & Contact Information
Disclaimer The opinions expressed herein are those of the writer and may not reflect those of Streettalk Advisors, LLC., Charles Schwab & Co, Inc., Fidelity Investments, FolioFN, or any of its affiliates. The information herein has been obtained from sources believed to be reliable, but we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is not a guarantee of future results. Any models, sample portfolios, historical performance records, or any analysis relating to investments in particular or as a whole, is for illustrative and informational purposes only and should in no way be construed, either explicitly or implicitly, that such information is for the purposes of presenting a performance track record, solicitation or offer to purchase or sell any security, or that Streettalk Advisors, LLC or any of its members or affiliates have achieved such results in the past. ALL INFORMATION PROVIDED HEREIN IS FOR EDCUATIONAL PURPOSES ONLY – USE ONLY AT YOUR OWN RISK AND PERIL. Registration Streettalk Advisors, LLC is an SEC Registered Investment Advisor located in Houston, Texas. Streettalk Advisors, LLC and its representatives are current in their registration and/or notice filing requirements imposed upon United States Securities & Exchange and State of Texas Registered Investment Advisors and by those states in which Streettalk Advisors, LLC maintains clients. Streettalk Advisors, LLC may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Performance Disclosures Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by adviser), or product made reference to directly or indirectly on this Website, or indirectly via link to any unaffiliated third-party Website, will be profitable or equal to corresponding indicated performance levels. Different types of investment involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. No client or prospective client should assume that any information presented and/or made available on this Website serves as the receipt of, or a substitute for, personalized individual advice from the adviser or any other investment professional. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have [the] effect of decreasing historical performance results. Disclaimer of Warranty and Limitation of Liability The information on this site is provided “AS IS”. Streettalk Advisors, LLC does not warrant the accuracy of the materials provided herein, either expressly or impliedly, for any particular purpose and expressly disclaims any warranties of merchantability or fitness for a particular purpose. Streettalk Advisors, LLC will not be responsible for any loss or damage that could result from interception by third parties of any information made available to you via this site. Although the information provided to you on this site is obtained or compiled from sources we believe to be reliable, Streettalk Advisors, LLC cannot and does not guarantee the accuracy, validity, timeliness or completeness of any information or data made available to you for any particular purpose. Copyright or Other Notices If you download any information or software from this site, you agree that you will not copy it or remove or obscure any copyright or other notices or legends contained in any such information. All investments have risks so be sure to read all material provided before investing.
STREETTALK ADVISORS
Lance Roberts Director of Fundamental & Economic Analysis Michael Smith Director of Alternative Investments Luke Patterson Chief Investment Officer Hope Edick Compliance Officer Leah Miller Operations Manager Lynette Lalanne General Partner – Streettalk Insurance Office Location One CityCentre 800 Town & Country Blvd. Suite 410 Houston, TX 77024 Tel: 281-822-8800 Web Sites www.streettalkadvisors.com
Email (For More Information)
[email protected]
FOR APPOINTMENTS
Mary McKelvy [email protected]
page 11
The Market Is NOT Cheap
On October 3rd we wrote a blog that said: “This is why the next rally that we likely see will be into the end of the year. This will most likely be a ‘suckers rally’ as it will suck investors in as the media bleats about the end of the bear market.” Here are some headlines from last week: “S&P sees longest weekly rise since February”
Inside This Issue:
The Market Is NOT Cheap Oversold and Cheap Are Different Earnings Can't Outgrow Economy Fed Model Is Broken
“Bulls insist common stocks are cheap as hell.” Technically Speaking “US Stocks are cheap – rally will last” There were many more but you get the idea. This week I wanted to spend a little time discussing this idea of whether stocks are currently “cheap” after the decline over the previous five months and whether or not this is the time to buying. However, before we can start any discussion about valuations on the market we have to establish that we will only be looking at 12-month trailing reported earnings. Trailing "as reported" earnings numbers which is the only method by which P/E ratios are ever viewed. When analysts began to use operating earnings, forward estimates or any variation thereof, they are not comparing apples to apples and they are being disingenuous to the valuation process. There are a number of major problems with not using trailing earnings besides just being deceitful. Over the last 110 years the S&P 500 has been priced at an average of 15 times earnings. However, and very importantly, the earnings used in the calculation were reported (GAAP) earnings, not operating earnings or estimates.
DISCLAIMER: The opinions expressed herein are those of the writer and may not reflect those of Streettalk Advisors, LLC, Charles Schwab & Co., Inc., Fidelity Investments, FolioFN or any of its affiliates. The information herein has been obtained from sources believed to be reliable, but we cannot assure its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Any reference to past performance is not to be implied or construed as a guarantee of future results. See additional disclaimers at the end.
Market Breaks Out Bear Market Still In Tact 401k Plan Manager May Be Getting Close To A Change – Sell The Rally. Click Here For Current Model Allocation. Disclaimer & Contact Info.
The problem with operating earnings, which were not used until the mid-tolate 1980s, is that they exclude write-offs of various kinds as determined arbitrarily by corporate management. Generally operating earnings are far higher than reported (GAAP) earnings. GAAP stands for "Generally Accepted Accounting Principles", and operating earnings do not conform to those standards. If the historical average P/E was calculated on the basis of operating earnings the P/E would be much lower. The use of estimated 12-month forward earnings is also completely ludicrous. The estimates are almost always wrong and most often on the high side. For instance the estimate for 2001 was $54.20 and came in at $36.85. Reported earnings that year were $24.89. Similarly, the estimate for 2008 was $99.15, but came in at only $49.54 while reported earnings were a paltry $14.88. Another big problem is the volatility of year-to-year earnings which constantly fluctuate from high to low and back again. Historically the market has valued peak earnings at an average P/E of 12 while valuing trough earnings at a P/E of 18. The markets move in very broad long term cycles as shown in the chart. These "secular" cycles on average last about 15-18 years in total from beginning to end. The driving factor behind these long term secular cycles is valuations. When valuations are low at the beginning of a period as they were in 1898, 1922, 1950 and 1982 the market experienced a bull market of significant proportions as valuations rose over time - this is called "multiple expansions". During the opposite periods, as markets experienced "multiple contractions", returns for investors were extremely low on a "buy and hold" basis. It is important to have a grasp, as well as a respect, for these secular cycles as it predicates how invested dollars should be allocated.
page 2
Oversold And Cheap Are Two Different Things The talking heads and promoters are mostly saying that either there will be no new recession any time soon and/or the stock market has already priced one in. First of all, just because the market bounces from a very oversold condition after being down five months in a row, which we said was very likely to happen in our September 30th blog post, does not mean that a recession has been forestalled. Time will tell on this point. However, the second point is much more important as the argument that has been used repeatedly is that the average price-earnings ratio of the U. S. stock market in recessions is 13.7, but stocks are selling at 10-11 times 2012 estimated earnings. Bah! The problem with it is that those 2012 earnings estimates are based on upbeat, non-recessionary earnings estimates and, more importantly, are consistently higher than the actual numbers when they are reported. Whoops! If there is to be (or, if there already is) a recession any time soon, investors need to remember that a great many companies are highly leveraged in various ways. This of course includes many financial companies, but it also includes a good many others. This in turn means that earnings can turn on a dime. They do and they will. Andrew Smithers asserts that the only two proven valuation measures are earnings adjusted for their average over many years, a concept known as
page 3
cyclically-adjusted price-earnings ratio (CAPE), and a totally different measure known as q. Q is a measure of what it would cost to replace the assets of companies. The importance of these two measures is critical to understand. While the analysts and the mainstream media continually tout that based on one factor or another stocks are a great buy the reality is that they are quite expensive. Shiller’s price to earnings ratio smoothed with a 10-year average strips out the annual volatility in earning to reveal the longer term trend. As we stated above; when the multiples of earnings are contracting, as they are now, market returns tend to be low over a long period of time. As they have been for the last decade. Secondly, bear markets have NEVER, and I repeat NEVER, been resolved when earning were above, equal to or slightly below their long term average. Bear markets are completed when valuations are near single digits (between 7 and 10x trailing earnings) historically. The problem is that today the accounting gimmickry and game playing has gone beyond rationality. Therefore, the measure of Tobin Q-Ratio strips most of this non-sense out. The Q-Ratio is a measure of what it would cost to replace the assets of the companies. Liabilities and assets are much harder to fudge than earnings. Furthermore, no one uses any measure of “forward liabilities and assets” when trying to make a case as to why you should be buying stocks. Therefore, the elegance of combining these two different measures, as we have done in the chart above is that it gives you a much clearer picture as to the relative overvaluation of the market. Earnings Can’t Outgrow The Economy So, back to the stream of talking heads in the media proclaiming that based on 2012 expected earnings stocks are undervalued, and, of course, no one ever challenges them. Never mind the impending issues with Europe and their economy, the slowdown in China or the drag of the U.S. consumer on the domestic economy. Don’t pay any attention to the fact that 22% of wages and salaries are being eaten up by food and energy or the fact that 1 in 5 Americans are unemployed or working part time for economic reason. Don’t discuss the 1 in 6 Americans on food stamps, unemployment benefits or welfare. The view that stocks are cheap based on expectations of continued earnings growth in this environment is a result of flawed reasoning. The analysts state that the S&P 500 at about 1200 is selling at about 11 times estimated 2012 operating earnings of about $108, well below the historical average of 15 times. In addition when the $108 of earnings is multiplied by 15 the result is a target of 1620 on the S&P 500 by the end of 2012. In other words they are multiplying 12-month forward estimated operating earnings by 15.
STREETTALK ADVISORS
What makes us different? It’s really pretty simple. We believe that managing risk is the key to long term success. Conserve the principal and the rest will take care of itself. Risk = Loss Seems like a simple concept – yet most people take way too much risk in their portfolio which is fine as long as the market goes up. The problem comes when it doesn’t. Managed Risk = Returns By applying varying levels of risk management to a portfolio of assets the potential for large drawdowns of capital is reduced thereby allowing the portfolio to accumulate returns over time. Total Return Investing We believe that portfolio should be designed for more than just capital appreciation. There are times when markets do not rise. During those periods we want income from dividends and interest to be supporting the portfolio. If you are ready for something different then you are ready for common sense approach to investing. Get Started Today!
page 4
That is all fine and dandy until you realize that the economy is growing around 2% currently and well below the long term trend of nearly 6%. Why is this important? The companies that make of the S&P 500 are a reflection of the economy and not vice-versa. Consumers, which make up roughly 70% of GDP today are the drivers behind the revenue and, ultimately, the net earnings of corporations. Therefore, in a slower growth economy earnings are going to grow more slowly. The massive surge in earnings that was witnessed post the financial crisis of 2008 came courtesy of a massive draw down in inventories which had to be replaced and a relaxation of accounting rules that allowed for a whole cycle of fictitious accounting numbers and gimmicks. Also, a huge part of the rise in profitability was due to the massive layoffs and cost cutting by corporations which has now, for the most part, run its course. Therefore, as earnings are now back towards their peak, on a reported basis, the question to be asking is now much further can earnings stretch before a reversion to the mean occurs as shown in the chart. Could earnings go higher from here? Absolutely. With recent announcements of more layoffs, cost cutting measures in full swing, investments to increase productivity and suppress labor costs, combined with the ongoing massaging of the books through creative accounting, earnings certainly could rise. The issue, however, is that since secular bear markets typically bottom at P/Es of 10 or under, there are only two ways to resolve that valuation issue. The first is that earnings rise as prices remain fairly stable OR there is a sharp and rapid drop in price. Either will resolve the overvalued market and we suspect that the next recessionary bear market will suffice to make that happen.
page 5
The Fed Model Is Broken
Earnings yield is a different matter altogether and a completely bogus investment strategy. This has been the cornerstone of the "Fed Model" since the early 80's. The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa. The problem here is two fold. First, you receive the income from owning a Treasury bond whereas there is no tangible return from an earnings yield. Therefore, if I own a Treasury with a 5% yield and a stock with a 8% earnings yield, if the price of both assets do not move for one year - my net return on bond is 5% and on the stock it is 0%. Which one had the better return? This has been especially true over the last decade where stock performance has been significantly trounced by owning cash and bonds. Yet, analysts keep trotting out this broken model to entice investors to chase the single worst performing asset class over the last decade. It hasn't been just the last decade either. An analysis of previous history alone proves this is a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50's and 60's the model actually worked pretty well as economic growth was strengthening. As the economy strengthened money moved from bonds into other investments causing interest rates to have a steadily rising trends. However, as we have discussed in the past in "The Breaking Point" and "The End Of Keynesian Economics" as the expansion of debt, the shift to a financial and service economy and the decline in savings began to deteriorate economic growth the model no longer functioned. During the biggest bull market in the history of the United States you would have sat idly by in treasuries and watched stock skyrocket higher. However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost a large chunk of your principal after the crash of the markets in 2008.
page 6
Currently, you are back in again after missing most of the run up in the current bull cycle only most likely to be left with the four "B's" after the next recession ends - Beaten, Battered, Bruised and Broke. The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine "WHAT" to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining "WHEN" to make an investment. In other words, I can buy fundamentally cheap stock all day long but if I am buying at the top of a market cycle I will still lose money. As with anything in life - half of the key to long term success is timing. Right now, with virtually all of the economic indicators weakening and pointed towards recession, a lack of support by the Fed in terms of stimulus and a vast array of varied risks from credit downgrades, Eurozone issuers on the brink of default, valuations not extremely cheap and a breakdown of technical strength in the market - timing right now could not be worse for long term investors. Of course, this is all assuming that "The Bernank" remains silent on the next stimulus induced market rally...otherwise the game is changed temporarily. Have a great weekend and I will talk to on the radio next week. Lance Roberts
page 7
Technically Speaking
Market Breaks Out – Time To Buy?
The market broke out of its trading range this past week and is now challenging resistance from the break of the “head and shoulders” neckline back in August. Currently, as we have stated many times, that a rally was likely this month and such has been achieved. We are now into the seasonally strong time of the year as well. So, with that, we should be allocating more equities into portfolios to participate on the back of the next cyclical bull market? Right? Not so fast. While things have improved on the surface the bulk of this rally has occurred for three reasons: 1) The markets were massively oversold after five months of declines leading into October. 2) Short covering has been a major source of the rally. 3) The catalyst for the rally has primarily been the rumor of a bailout for Europe which may or may not occur. With that said, our two major weekly signals are still in “SELL” territory as well which also predicts more caution at the current time. As you can see these signals have kept you out of trouble. No, you didn’t get the exact top or bottom, but you did participate in the majority of the move up and missed the bulk of the downside. Currently, the market is working on a pretty normal retracement of the previous sell off. IF the market gets above this dashed blue line AND our weekly “BUY” signal kicks in (lower chart) then we will recommend adding exposure to portfolios.
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It generally doesn’t pay to go against these indicators but if you feel you must be investing in the market now we recommend that you do so cautiously. Bear Market In Tact This is further confirmed by our standard deviation chart. As you can see in the chart below the market got two standard deviations oversold in August and September and we are now experiencing a normal retracement of that decline to the moving average.
In normal bear markets the index tends to trade in the lower half of the standard deviation range. A move into the upper half of the band will be a much more positive development for longer term investors. Finally, our McClellan Oscillator is extremely OVER BOUGHT which signals that the next week most likely will offer some sort of correction. The magnitude of that correction is critical to whether we upgrade our allocation to equities in the next week. Caution is still highly advised.
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401K Plan Manager
The rally that has run over the last three weeks has now worked off a lot of the oversold condition that existed at the end of September. We may be getting close to being able to upgrade our allocation model but the all clear signal is not yet in as shown in the “Technically Speaking” section above. At the current time we suggest that you SELL all positions that have not performed well over the past few months (ie worse than the market) and reduce exposure to international markets until something is resolved in the Eurozone. This will provide cash to allocate back to the portfolio model should a buy signal be triggered in the next couple of weeks. Caution is still advised but things may finally be turning around. If you need help after reading the alert; don’t hesitate to contact me.
Current 401k Allocation Model 35% Cash + Future Contributions
These options include: Stable Value, Money Market, Retirement Reserves
X-Factor (Equity Allocation Adjustment) 50% Target Allocation Tactical Allocation
Cash 5%
35% Fixed Income
Bond funds are a play on the direction of interest rates Short Duration, Total Return & Real Return Funds
Cash 35% Equity 30%
30% Equity
The majority of funds track their respective index. Therefore, select ONE fund for each category. Keep it simple. 30% Equity Income/Balanced/Growth & Income 0% Large Cap Value 0% International VALUE
Bonds 35%
Equity 60%
Bonds 35%
___________________________________ ALL NEW MONEY (Monthly Contributions)
100% Cash
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Disclaimer & Contact Information
Disclaimer The opinions expressed herein are those of the writer and may not reflect those of Streettalk Advisors, LLC., Charles Schwab & Co, Inc., Fidelity Investments, FolioFN, or any of its affiliates. The information herein has been obtained from sources believed to be reliable, but we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is not a guarantee of future results. Any models, sample portfolios, historical performance records, or any analysis relating to investments in particular or as a whole, is for illustrative and informational purposes only and should in no way be construed, either explicitly or implicitly, that such information is for the purposes of presenting a performance track record, solicitation or offer to purchase or sell any security, or that Streettalk Advisors, LLC or any of its members or affiliates have achieved such results in the past. ALL INFORMATION PROVIDED HEREIN IS FOR EDCUATIONAL PURPOSES ONLY – USE ONLY AT YOUR OWN RISK AND PERIL. Registration Streettalk Advisors, LLC is an SEC Registered Investment Advisor located in Houston, Texas. Streettalk Advisors, LLC and its representatives are current in their registration and/or notice filing requirements imposed upon United States Securities & Exchange and State of Texas Registered Investment Advisors and by those states in which Streettalk Advisors, LLC maintains clients. Streettalk Advisors, LLC may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Performance Disclosures Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by adviser), or product made reference to directly or indirectly on this Website, or indirectly via link to any unaffiliated third-party Website, will be profitable or equal to corresponding indicated performance levels. Different types of investment involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. No client or prospective client should assume that any information presented and/or made available on this Website serves as the receipt of, or a substitute for, personalized individual advice from the adviser or any other investment professional. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have [the] effect of decreasing historical performance results. Disclaimer of Warranty and Limitation of Liability The information on this site is provided “AS IS”. Streettalk Advisors, LLC does not warrant the accuracy of the materials provided herein, either expressly or impliedly, for any particular purpose and expressly disclaims any warranties of merchantability or fitness for a particular purpose. Streettalk Advisors, LLC will not be responsible for any loss or damage that could result from interception by third parties of any information made available to you via this site. Although the information provided to you on this site is obtained or compiled from sources we believe to be reliable, Streettalk Advisors, LLC cannot and does not guarantee the accuracy, validity, timeliness or completeness of any information or data made available to you for any particular purpose. Copyright or Other Notices If you download any information or software from this site, you agree that you will not copy it or remove or obscure any copyright or other notices or legends contained in any such information. All investments have risks so be sure to read all material provided before investing.
STREETTALK ADVISORS
Lance Roberts Director of Fundamental & Economic Analysis Michael Smith Director of Alternative Investments Luke Patterson Chief Investment Officer Hope Edick Compliance Officer Leah Miller Operations Manager Lynette Lalanne General Partner – Streettalk Insurance Office Location One CityCentre 800 Town & Country Blvd. Suite 410 Houston, TX 77024 Tel: 281-822-8800 Web Sites www.streettalkadvisors.com
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Mary McKelvy [email protected]
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