Sunday, November 30, 2014

Trust (the bull), but verify (the trend)

Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

In the words of Ronald Reagan...
The US Thanksgiving long weekend isn`t supposed to be like this. Hitler had a habit of attacking over a long weekend, when his opponents`leadership had gone away early, and I suppose it sort of felt like this in Hawaii on the morning of December 7, 1941 when the Japanese fleet bombed Pearl Harbor. But the OPEC decision was telegraphed well in advance and the degree of volatility it induced in the energy and other markets was highly surprising. As  Friday drew to a close in a volatility-induced thinly traded market, I am somewhat unclear about the meaning of the Trend Model's readings.

Here is where we stand. The Trend Model remains at a bullish risk-on reading, both for my inner investor and inner trader. However, the emotionally laden panic sell-off in oil prices created enormous implications for the future path of earnings. In addition, the SP 500 violated a short-term uptrend in the form of its 5-day moving average, which has been closely watched by market technicians. Josh Brown remarked that the most recent streak, which has broken all records of days above the 5 dma, may represent momentum-driven buying that can lead to a crowded long:
What’s happening here is classic herding behavior and the market isn’t letting you back in if you’ve sold.

The danger here is clear – mass complacency and a moment at which anyone who could buy, would buy or needed to buy throws everything they have at the tape just to end the pain.
Whenever the bull trend reverses itself, it could have nasty negative implications (emphasis added in bold):
The market has been a wall for the dip-buyers. Impenetrable. They cannot get in unless they’re willing to pay the all-time high. It’s a high barrier of entry psychologically, especially if they’d been counseling caution all this time to their clients. The about-face could be career-wrecking, especially if it happens at a major top.
The recent market action in oil prices, as well as a number of events next week, could lead to a turning point in the markets. While the Trend Model indicates that US equity prices will continue to slowly grind upwards, current conditions lead me to paraphrase the words of Ronald Reagan:
Trust the bull, but verify the trend.
At the end of the week, there are plenty of reasons to be bullish and bearish. Let`s go through the bull and bear cases, one at a time.

The bull case
The bull case consists of:
  • Positive seasonality for stocks;
  • The US expansion is continuing with no recession in sight;
  • Earnings boost from lower oil prices, not just in the US, but globally; and
  • Friendly central bankers worldwide.

Bullish reason 1: Positive seasonality
First of all, December has been seasonally positive for stocks. Tim Edwards of S+P Dow Jones Indices found the following seasonal effect on global stock prices:
At least in the past few years, December has borne gifts for equity investors. But does the market’s good or bad behavior earlier in year have any influence? Exhibit 2 shows the average performance during December for each of these markets, split into those times when the previous 11 months had generated positive (“nice”) or negative (“naughty”) returns.

Since the equity markets have generally been “nice”, Edwards postulated that Santa Claus will come in December for equity investors.

Bullish reason 2: Continued US expansion 
One of the key fundamental drivers of the stock market is the earnings outlook, whose upward progress has mainly been interrupted by recessions. As this chart from Factset shows, stock prices have been highly correlated with consensus forward 12 month EPS estimates. Further to the hiccup in estimates seen in the October correction, forward EPS has steadied and started to rise slightly. 

If we were to step back for a moment, the US economic expansion is continuing and there is no sign of a recession in sight. New Deal democrat summed up the current economic conditions well in his weekly review:
There was a little change in tone this week, as indicators were more sharply mixed...

For the moment, oil prices are collapsing, a strong positive. Temp hiring made an all time high. On the other hand, there were a few significant, if slight, new negatives. I don't think Q4 is going to match the strong growth of Q2 and Q3 - although that's not saying much. Barring a sharp reversal in gas prices, however, the first part of 2015 in particular looks like it will feature an increase in growth.
Until we see definitive signs of slowing growth, the bulls have little to worry about.

Bullish reason 3: Higher EPS momentum from falling energy prices
Another tailwind for the bulls will be the positive effects on earnings from a drop in oil prices. The aforementioned forward EPS figures from Factset were compiled before their sudden fall. If oil prices were to remain at these lower levels, I would expect that EPS estimates to start rising in the next few weeks. 

Indeed, Ambrose Evans-Pritchard highlighted analysis showing that falling oil prices are bullish for equities:
Tumbling oil prices are a bonanza for global stock markets, provided the chief cause is a surge in crude supply rather than a collapse in economic demand.

HSCB says the index of world equities rose 25pc on average over the twelve months following a 30pc drop in oil prices, comparable to the latest slide. Equities rose 19pc in real terms.

Data stretching back to 1876 is less emphatic but broadly tells the same tale. The SP 500 index of Wall Street stocks rose by 11pc on average. The equity rally of 1901 was a corker.

Click to enlarge
Further analysis from Citi shows the oil price sensitivity of the equity markets of different countries to a drop in oil. The biggest winners in relative performance are the US and Japan, in that order, and the biggest losers are Norway, Russia, Canada and Brazil.

The fall in oil prices should be bullish for eurozone equities as well, largely because eurozone countries are mainly net consumers of energy. I had already pointed out that European equities represent a value play that is seeing the benefit of positive momentum (see Two contrarian plays that will make you queasy), I would expect that the Street will further raise EPS estimates in Europe in the days to come. Such a development should be another bullish development for eurozone equities.

Indeed, Morgan Stanley had put out a bullish note on Europe, even before the OPEC news hit the tape (via Value Walk):
The analysts believe now is the wrong time to trim exposure to Europe for various reasons. The analysts point out that despite European ETF and mutual fund outflows at historically significant levels, Europe’s 6 month underperformance and de-rating to global stocks is close to prior lows: 

Bullish reason 4: Dovish central bankers
Last but not least, the bulls have the support of accommodative central bank policy around the world (see my comment last week Don`t fight the tape (or central bankers)):
In effect, the Chinese saw the party at the BoJ`s place and decided to throw one of their own. Party now, pay later.
The BoJ party wasn`t enough. The PBOC party wasn`t enough. The ECB has decided that it wants in on the party action too. So we now have a Central Bankers street party.

The bear case
Despite the bullish backdrop, there are plenty of reasons to be cautious as well:
  • Valuations are elevated;
  • Technical conditions point to a pause or pullback; 
  • Potential trouble from the HY market, sparked by energy; and
  • Possible central bank easing headwinds, mainly from falling energy prices.

Bearish reason 1: Equities are expensive
The most longer term problem for the bull case is the elevated equity valuation levels. In a recent post, I showed that US equities are expensive from both a value and growth perspective (see How cheap are stocks? (growth investor edition)).

Moreover, we are seeing signs of froth in Silicon Valley, which is the high-beta part of the stock market (via Wolf Street):

Elevated valuations should not be a problem as long as positive momentum, otherwise known as the Greater Fool Theory, is dominant. But Todd Schneider pointed out that confidence is starting to roll over among Silicon Valley VCs, as measured by startup announcements:

And by funding value:

Now consider that the latest BoAML Fund Manager Survey shows managers to be highly overweight Technology, both at a global and US sector level. The combination of deteriorating momentum and a crowded long position can be ingredients for a nasty sell-off.

Bearish reason 2: Vulnerable technical conditions
Another reason to be short-term cautious on stocks are red flags from technical and sentiment models. I already pointed out that the time that the SPX had been above its 5 dma is at a record/ The index finally broke down below its 5 dma level in the last hour of trading on Friday. As the break was neither convincing nor definitive, especially on a holiday-shortened day, we need to look for technical confirmation during Monday`s trading hours. A break below the 5 dma may be the signal for either a sideways consolidation or pullback in the market.

As well, some sentiment models are flashing red, or at least amber. The chart below of Rydex sentiment tells the story. The top panel is the SPX going all the back to 1998, when Rydex data was first available. The middle panel shows the ratio of Rydex bear to bull assets and the bottom panel shows the ratio of flow to bearish Rydex and money market assets to bullish assets.

From this chart, I can make a number of observations. First of all, the long-term trend of Rydex investors are generally correct. They were bullish and poured money into bull funds during the Tech Bubble. When the market turned, they were sellers until the market bottomed in 2003, when they turned into marginal buyers. When the market bottomed in 2009, Rydex investors correctly turned bullish and poured money into bull funds. Strictly from a bear/bull asset ratio viewpoint, I would therefore not be overly bothered by the all-time lows of bear/bull assets shown on the middle panel chart.

However, I can make a case that traders can find useful signals when the bear/bull asset ratio (middle panel) reaches a near-term extreme and the bear/bull flow ratio (bottom panel) reaches an extreme as well. I have marked with dotted vertical lines when conditions indicating excessive bullishness have occurred since the 2007 market peak. The red lines indicate episodes when the market has either stalled or retreated, while the blue lines indicate when the market has continued to rally. Despite the low number of signals, this indicator has been more right than wrong in the past.

This week, this Rydex indicator flashed a cautionary signal. When I combine this condition with the break in the 5 dma, it may signal some near-term weakness for stock prices.

Longer term, I am also concerned about the latest picture from margin debt data (via Doug Short). As the chart below shows, the stock market has shown a tendency to peak when margin debt peaked out from an all-time high and rolled over. These market peaks could be explained by excessive stock market speculation, as measured by margin debt, combined with a stalling out of momentum, as shown by the retreat from all-time margin debt highs.

Historically, margin debt rollover has generally led the market peak by several months. The current episode is slightly unusual because margin debt peaked out in February 2014, started to decline and rose again. However we did see similar patterns in past market peaks as well. Nevertheless, this pattern in margin debt is a concern and something to keep an eye on.

Last but not least in the froth department, I present the Business Insider's 20 under 20: Meet the teen traders trying to take over the finance world. Not only are these kids trading plain vanilla stocks, they are into derivatives and exotics like *shudder* CFDs, butterfly option spreadsiron condors and so on.

Bearish reason 3: The HY canary in the coalmine
A further reason for concern are the signs of brewing trouble in the high-yield (HY), or junk bond market. The HY market is important barometer of risk appetite. What I find troubling is that are HY spreads are blowing out, indicating reduced risk appetite:

HY analyst Martin Fridson had been forecasting a junk bond Apocalypse as early as last November, with a wave default to start in 2016 (via Bloomberg):
Almost $1.6 trillion of junk bonds globally will default between 2016 and 2020, according to Martin Fridson, chief executive officer of New York-based FridsonVision LLC, a research firm specializing in speculative-grade debt.

With historical evidence indicating default rates will surge between 2014 and 2016 and persist, implying a rate of more than 30 percent cumulative during four years, Fridson estimated in a report for Standard and Poor’s Capital IQ Leveraged Commentary and Data that the face value of total defaults will be $1.576 trillion. That’s a market value of $752 billion, according to Fridson, who started his career as a corporate debt trader in 1976.

“When the default tidal wave eventually hits, it will be very big,” Fridson said in an e-mail. “No one realizes how much distressed debt is going to be available for investment when it finally hits.”
Now that oil prices have tanked and energy companies having a progressively higher weight in the HY market, defaults in energy have the potential to push this market over the edge.

A meltdown in HY could get ugly and spread beyond the credit market (via CNBC, emphasis added):
"This is the one thing I've seen over and over again," said Larry McDonald, head of U.S strategy at Newedge USA's macro group. "When high yield underperforms equity, a major credit event occurs. It's the canary in the coal mine."

Since the turn of the last century, there have been 12 times when the value of high-yield debt dropped at least 10 percent in 60 days, according to Kensho, a quantitative analytics tool used by hedge funds. (The Credit Suisse High Yield Bond Fund was the benchmark.)

Sixty days after those credit events, shares of Citigroup had a median return of negative 8 percent. Bank of America's stock had a median return of negative 6 percent. JP Morgan took a 5 percent hit.

This may not seem that bad, but those are just "median" returns, and including times when high yield falls just 10 percent. The decline in these stocks and prices of high-yield bonds can get much worse.

Isabella Kaminska of FT Alphaville also pointed to liquidity risk in thin markets like HY. Thus risk were the subject of a paper by "the Committee on the Global Financial System (CGFS) published on the same day, focusing on similar themes, rubber-stamped by William Dudley of the New York Fed." Kaminska observed that many banks have withdrawn from their market making business because of higher capital requirements:
A key observation is that many market-making businesses have shifted towards a more order-driven or brokerage model, meaning the execution of large trades is taking more time, with many market-makers being more reluctant to absorb large positions.

The consequence of this is that market liquidity is now becoming more dependent on the portfolio allocation decisions of only a few large institutions.
The cited paper noted:
Furthermore, even though reliable data are often unavailable, trading appears to remain highly concentrated in just a few liquid issues in most corporate bond markets, with signs of further concentration evident in some markets. One example is US corporate bond markets, where the share of securities with a 12-month turnover ratio of at least 50% (i.e. the sum of traded volumes accounting for at least half of the securities’ outstanding amount) has declined from 20% to less than 5% (Graph 5, right-hand panel)

Even worse, perceived liquidity rests with ETF providers, who promise real-time liquidity but may not have the sufficient capital to back up those promises should the markets become disorderly (I`m looking at you, JNK and HYG):
Bond ETFs improve price discovery in illiquid markets by providing a market price on a portfolio whose underlying holdings are often thinly traded. ETFs allow market-makers to hedge inventory risks when liquidity in the underlying bond and related derivatives markets is insufficient and ETFs are also commonly used for rebalancing flows by investors with passive or index-linked strategies. The liquidity of ETF bond funds, however, builds on the willingness and capacity of authorised participants – typically the same dealers that provide immediacy services in bond markets – to make markets for ETF shares.

Liquidity shocks may thus spread across different segments of the bond market via their impact on the risk-taking capacity of key market-makers. At the current juncture, with mutual funds and ETFs having attracted significant inflows from both institutional and retail investors, a reversal in global bond markets could trigger redemptions that, as funds sell assets to meet cash demands, could amplify the decline in bond valuations. Notably, bond mutual funds have managed significant outflows in the past (eg during previous episodes of monetary policy tightening) that have generally not disrupted financial markets. Yet, past episodes of large redemptions occurred at times when fund holdings were much smaller, both in absolute terms and relative to trading volumes and dealer inventories. Current market-making trends, however, suggest that redemptions could have a larger impact on bond market liquidity than in the past.
The combination of over-levered energy companies dependent on the HY market for funding, a collapsing oil price, an illiquid bond market and diminishing risk appetite are the ingredients for a bond market meltdown. Such an event may not be contained within the credit markets and see contagion effects spread throughout the financial system. In other words, a HY market sell-off could get very ugly - and fast.

Wait! There's more. James Farro (via Josh Brown) reminded us how intricately linked share buybacks are to junk bond financings. If backbacks start to dry up, it will start to hinder EPS growth as the "S" in EPS stop shrinking:
With the ongoing massacre in crude oil my thought has been that the highly leveraged players would have debt issues which would just facilitate industry consolidation. But with the state of the credit market excluding sovereigns, we could have something else entirely. The energy sector makes up a large segment of the HY bond market and it’s about to take a big hit.. Sooner or later it’s coming. If the high-yield market in it’s fragile state is given a push we could see a real rout in the markets. It’s starting to look like energy debt could go bidless for a time and take HY with it if action isn’t taken soon. And that action, in part should be for the orgy of debt issuance that is being used for buy-backs to stop asap.

But wait.. The stock buy-backs have been a major enabler of higher equity prices.


Why is no one talking about potential consequences from this ocean of unproductive debt issuance that’s not used for expansion/capex but merely multiple expansion?

Bearish reason 4: How will central bankers and oil mix?
So far, we have seen global central bankers tilt dovishly in their policies. The PBOC and BoJ have announced stimulative policies. The ECB may finally be ready to join the party. I see a number of potential problems cropping up in the weeks to come.

First, Gavyn Davies highlighted some deep philosophical differences at the ECB. Simply put, Draghi is a New Keynesian while Weidman and his allies are Austrian economists:
The dispute is fundamental and longstanding. Mr Draghi has adopted the New Keynesian approach that dominates US academia and central banking. There is really no difference between the philosophy that underpins his latest speech and that of Ben Bernanke, vintage 2011-13. In contrast, recent remarks by representative hawks such as Mr Weidmann and ECB executive board member Yves Mersch stem directly from the Austrian school of European economics. It is no wonder that these differences are so difficult to bridge.
As a result of this dispute, Draghi's initiatives get watered down to goals and suggestions instead of actual policies. As the ECB will be meeting next week and the markets appear to be expecting further announcements about QE, all eyes will be on Frankfurt as to how these kinds of differences get resolved. In addition, falling energy prices will give a boost for the eurozone economy and will provide an excuse for ECB hawks to delay QE policies.

Already, we are seeing signs of opposition to further stimulus from Weidman ally Lautenschlaeger (via Bloomberg, emphasis added):
European Central Bank Executive Board member Sabine Lautenschlaeger said quantitative easing isn’t the right policy choice for the euro area currently, hardening a split among officials over the right response to slowing inflation.

“A consideration of the costs and benefits, and the opportunities and risks, of a broad purchase program of government bonds does not give a positive outcome,” Lautenschlaeger, a former Bundesbank vice president, said at an event in Berlin today. “There are very few shared competencies in fiscal policy. As long as this is the case, the ECB’s purchase of government securities is inevitably linked to a serious incentive problem.”

Lautenschlaeger’s comments signal she’s become ECB President Mario Draghi’s highest-ranking opponent in the debate over introducing QE to the euro area. They echo the position of Bundesbank President Jens Weidmann, who has said QE diverts attention from the need for governments to make structural adjustments to their economies.
How German Austrian of you, Sabine!

As well, we have the US Employment Report being released this coming Friday. How will the Fed and market react to the report in light of lower oil price? Will good news (beat) be good news or bad news for stocks? The current environment just creates more volatility and uncertainty.

In addition, Izabella Kamanska at FT Alphaville pointed to a Citi report on the negative effects of fewer petrodollars on bond yields and central bank balance sheets. One part of the Citi report reads:
The pace of petrodollar accumulation is highly correlated to the price of oil. When Brent and WTI were trading at $110 and $90 respectively, as they were for much of the last three years, sovereign wealth funds were rapidly growing assets. Indeed, we find a strong empirical relationship between the price of oil and sovereign wealth fund AUM (see figure). WTI above $100 has corresponded to AUM growth of +10%, while WTI at current levels suggests a more modest 5% growth rate.
Kamanska commented:
The key implication, they note, is that with WTI trading below $80 and Brent right at that level, one should not expect another $500bn of assets to be bought by petrodollar investors in 2015. They add that the longer crude prices persist at current levels, the more likely it is that these investors stop seeing inflows, which could see the drop in oil prices effectively offsetting further balance-sheet expansion from the BoJ and ECB.
In other words, petrodollar recycling involves oil exporting SWFs buying US Treasury assets, largely because SWFs are conservative by nature. Fewer petrodollars will mean a lessened demand for Treasury and other sovereign paper, which would drive up interest rates.

What about the stimulative effects of a lower oil price on the economy? The Citi report stated that the nature of petrodollar SWF demand is very different from consumer demand and they would affect the demand for interest rate instruments differently (emphasis added):
While that’s certainly the case, what matters is how the savings from lower crude oil prices end up getting invested relative to the investments made by sovereign wealth funds and FX reserve managers. And on that score, we suspect that petrodollar investors generally make conservative investments that are inherently fixed income-friendly, while the savings from lower gasoline prices tend to grow the top line revenue of consumer-oriented companies and the margins of those companies with significant transportation costs. As such, forsaken petrodollars rarely find their way back into fixed income markets.

Time to call an audible
Regular readers know that I have been managing an account based on the signals of the Trend Model. In the last monthly report card for that account, I wrote:
As a proof of concept, I started to manage a small account that traded long, inverse and leveraged ETFs on the major US market averages and, on occasion, sector and industry ETFs. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators.
My Trend Model remains bullish and so does my inner investor. However, the "short-term sentiment indicators" that I mentioned indicate that uncertainty is rising and therefore so are risk levels. We have several key events to watch for in the week to come that will that must be answered:

  1. What will happen to oil prices and how will the stock and bond markets react to them?
  2. What will the ECB do, because it affects the near-term outlook for the sputtering growth in the eurozone?
  3. Unemployment claims have missed forecasts for two consecutive weeks, what will the Non-Farm Payroll release on Friday tell us about the pace of US expansion? How will the market react?
Even though the trend remains at a risk-on reading and bullish, my inner trader recognizes that near-term risks have risen considerably. Under such circumstances, he is inclined to call an audible at the line of scrimmage and move to a neutral position in his portfolio. He wants to wait and watch how the market reacts to all of the events next week before committing to either a bullish or bearish position.

In effect, my inner investor is telling me to "trust the bull" as the medium term outlook remains positive, but my inner trader is telling me to "verify the trend" as the market may be nearing an inflection point.

Saturday, November 29, 2014

Humble Student turns seven

Seven years ago today, Humble Student of the Markets began. My first blog post was about how hedge fund returns are correlated to the stock market (see What exactly are hedge funds hedging?).

It seem some things never change, hedge funds returns are, in aggregate, still correlated to the equity market.

Friday, November 28, 2014

Calling all contrarians: What would Warren do?

About three weeks ago, I wrote about possible contrarian plays in the oil patch (see Do you have what it takes to be a contrarian investor?). I had pointed out that Warren Buffett had taken large stakes in Suncor (SU) and ExxonMobil (XOM) in Q2 2013 and the closing price of those stocks are approaching the top of the zone where Buffett made his purchases. For contrarian value investors, this could be a rare opportunity to step up and buy at depressed prices. Here is the chart of SU

Here is XOM:

$80 oil?
On the bottom panel of each chart, I have shown the ratio of each stock to the WTI oil price. Given how oil prices have cratered in the last couple of days, the SU/oil and XOM/oil are at considerably higher valuations than the Buffett buy zone, which indicates that the price of these two stocks are nowhere near valuation levels where Buffett would buy again.

As the oil market is in turmoil, the price of crude is likely to be volatile and current prices is unlikely to be the long-term equilibrium price. One sensible comment that I saw today came from Neil Irwin, who tweeted that the futures curve was discounting a 5-year price of roughly $80:

$80 is certainly a better level than the closing price Friday and about $10 below where Buffett made his SU and XOM purchases.

A near-term bottom for oil?
Indeed, the market psychology may be getting close to a temporary bottom, when I saw Ian Bremmer, who is a political analyst, tweet the following comment on a topic outside his area of specialization:

These kinds of sarcastic comments are closely related to the magazine covers effect, where the general public seizes on a market condition when it`s very late in the game - and they mark a market turning point. Most recently, well-known investment professional and blogger Josh Brown tweeted this irreverent comment

...right before the market open on October 15, the day of the most recent market bottom.

It is said that value-oriented contrarians buy when blood is running in the streets. Is there enough blood in the streets yet?

What would Warren Buffett do?

Thursday, November 27, 2014

How cheap are stocks? (growth investor edition)

It's that time of year again, when Wall Street strategists and other pundits give their forecasts for 2015. This is not an unusual year in that we have seen some bullish, bearish and middle-of-the-road forecasts for the stock market. For me, it leaves the perennial question unanswered, "How cheap are stocks?"

On one hand, you have the likes of Henry Blodgett of Business Insider, who points to the Shiller CAPE and say that the market is overvalued. Though he is not selling his equity positions, Blodgett says that the degree of over-valuation suggests that investors should lower their long-term expectations for equity returns.

On the other hand, you have the likes of former bear David Rosenberg who believe that US equities are fairly valued to cheap when compared to other asset classes like 10-year Treasuries and cash (see interview here).

Who is right? What's the real story?

A value investor`s perspective
Rather than get into a debate about the validity of the Shiller CAPE ratio, one way of getting some perspective is to simply consider the EPS and EBITDA multiples of the SPX (via the excellent work done at Philosophical Economics). From those perspectives, US equities don't look very expensive at all:

Here is the P/B ratio, the conclusion is the same:

It could be argued, however, that the time horizon for these valuation multiples were too short as the above charts only goes back to the mid-1990's. Here is a very long term chart of the SPX P/E ratio. A very different conclusion can be drawn from this chart: Stock prices appear to be elevated on a P/E basis on a 100-year+ time horizon:

One problem with the P/E ratio is the "E" in the P/E can be noisy as earnings will fluctuate depending on the cyclical effects of the economic cycle. One alternative way to address some of the cyclical noise is to study the P/B ratio, because book value tends to be a more stable figure. While this chart is also a little dated and not directly comparable because it shows the Dow`s P/B ratio (and the current ratio is slightly higher at 3.1), the conclusion is roughly the same as the long-term P/E analysis. Current stock market valuations are above average, though they cannot be characterized as crazy nosebleed levels.

A growth investor's viewpoint
The aforementioned valuation metrics suggest that US equities are overvalued, but a growth investor would scoff at the discussion and asks, "Forget valuations, does the market have earnings visibility?" In the short run, valuations do not matter very much for growth investors, but it is earnings momentum that matters to growth investors. Indeed, as this chart from Factset shows, the SPX has been highly correlated with consensus forward 12 month EPS estimates.

Instead of focusing on pure earnings momentum of the growth-at-any-price approach, I prefer the a growth-at-a-reasonable-price (GARP) framework of, "How much am I willing to pay for a certain level of growth?"

To answer that question, we turn to the PB-ROE model, where:
If we were to decompose the elements of ROE and analyzing their past trends and future projections, we have a better understanding whether the market P/B multiple is likely to rise or fall. Here, we turn to the Dupont formula, where:
ROE = (net income / sales) * (sales / assets) * (assets / equity)
         = Net margins * Asset turnover * Financial leverage
Thus, the three elements of the Dupont formula are:
  1. Net margin, which is a function of operating margin, tax rate and interest expense;
  2. Asset turnover; and
  3. Financial leverage.
The analysis at Philosophical Economics showed many of Dupont formula components of ROE for the SP 500 for the last 20 years: First. we start our analysis by focusing on the ROE chart on the bottom left hand corner, where ROE has moved up and down with past cycles. Nevertheless, ROE will have to rise in order to see P/B multiple expansion. The question then becomes, how possible is that in the near future?

Now consider the Dupont formula components of ROE. The top left chart shows the net margin history of the SP 500. As the chart shows, net margins have been rising since 1996, though with cyclical hiccups. The top middle chart, however, shows a history of the operating, or EBITDA. margin. It indicates that EBITDA margins have been largely flat over this period. As I have pointed out before on this blog, the rise in net margins has largely been attributable to lower interest expense and lower effective tax rates. The top right chart shows ITDA, which is a measure of interest expense and tax retention rates, as a percentage of EBITDA for the last 20 years and it indicates that the tailwind from these factors have been steadily dissipating.

If we were to assume that the US is roughly in the mid-cycle of its economic expansion and, based on that assumption, EBITDA margins could rise for cyclical reasons over the next year as they have in the past at similar points of the cycle. However, that positive cyclical effects could be offset by the negative effects of rising interest rate and net tax rates. If I were to project the likely growth outlook for net margins for the next year, I would rank it as roughly neutral.

Another Dupont formula component of ROE is financial leverage. As the bottom right hand chart shows, financial leverage has been steadily falling this expansion cycle. Rank the growth outlook for financial leverage as neutral to negative.

The analysis from Philosophical Economics does not directly show history of the third component of the Dupont formula, but we can more or less back out the direction of change from the other two components. When I eyeball the progress in ROE (bottom left chart) and compare it to net margins (top left) and financial leverage (bottom right), I deduce that asset turnover has been roughly flat to down this expansion cycle.

Flat to falling asset turnover is not surprising, given the dismal record of capital expenditures during this recovery. This analysis is suggests that the world is suffering from a lack of demand, which is restraining the level of CapEx among companies, though the results are not necessarily conclusive.

Unfortunately, the stated level of CapEx may actually be exaggerated. Analysis from Francisco Blanch of BoAML shows that most of the CapEx seen this cycle has come from energy sector. Given the recent fall in oil prices, the outlook for CapEx acceleration is bleak (via Business Insider).

Large vs. small cap valuation
The mediocre outlook for the major components of ROE suggests that large cap stocks are no bargains for growth investors. Another way of thinking about the SP 500 is to look at the profitability and valuation metrics of the small cap Russell 2000.

This analysis from Principal Global shows that the P/B ratio for the large cap Russell 1000 and Russell 2000 have tracked each other relatively closely, except for the Tech Bubble of the late 1990`s. Viewed in that context, P/B ratio of the Russell 2000 is elevated and it is near the cycle peaks of the last bull market. However, the market remained at those P/B valuation levels for about three years before the bear market began in 2007. I conclude that while these valuation levels might be cause for concern, this level of P/B ratio for small caps does not represent a sell signal. even if we were to use the Russell 2000 P/B as a large cap valuation proxy.

Here is the chart showing the relative performance of the Russell 1000 relative to the Russell 2000 showing the huge outperformance of the large caps during the Tech Bubble which prompted the divergence in P/B valuation shown in the above chart.

Given the P/E and P/S ratios of the markets, Principal Global also backed out the implied net margins of large and small cap stocks. This chart shows the outlook to be neutral to slightly negative. The implied net margin for large caps have been rising, but net margins for small caps have started to roll over. Given the earnings headwinds posed by a strong USD to large cap multi-national companies, large cap net margins are more likely to follow the path of small cap margins than the other way around.

Don't panic, stocks won't crash
In conclusion, US equities look expensive from both a value and growth investor`s perspective. Valuation multiples appear elevated historically based on a P/B and P/E basis. From a growth perspective, it`s hard to see how much earnings visibility and momentum the stock market can show on an aggregate basis in the absence of a positive surprise.

On the other hand, these market levels are no cause for panic. Sure, stocks prices are elevated, but they are not at danger levels that a crash is imminent.

Tuesday, November 25, 2014

Rebalancing your portfolio for fun and profit

This is part two of a two part post on portfolio rebalancing (see How to rebalance your portfolio (NAAIM maniac edition) for part one).

The standard practice among portfolio managers is to establish a rebalancing discipline for their portfolios. A typical process would involve the following steps:
  1. Determine the target asset mix, which could change depending on market conditions.
  2. Re-balance if:
    • The asset mix weights moves more than a certain percentage, e.g. 10%, from the target weight; or
    • Periodically, e.g. on an annual basis
These are all sensible rules that have long been practiced in the investment industry. In essence, the strategy involves taking profits on winning asset classes and averaging down on losers as a form of risk-control discipline.

Then I came upon an intriguing paper by Granger, Greenig, Harvey, Rattray and Zou entitled Rebalancing Risk. Here is the abstract:
While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.

Monthly rebalancing does the worst
You would think that, for example, given the massive losses seen during the Lehman Crisis episode, that a rebalanced portfolio where the investor bought all the way down would see superior returns. Interestingly, that was not the case.

In the paper, the authors compare and contrast a simple drift weight strategy, i.e. not rebalancing at all, with a fixed weight monthly rebalancing strategy. The chart below shows how that the monthly rebalanced portfolio actually showed a higher risk profile than the passive drift portfolio. (There were other examples in the paper, but I will focus on this period for the purpose of this post).

By contrast, they advocate a partial momentum strategy. In essence, this amounts to the application of of a trend following system to rebalancing. The idea is, as the stock market goes down and the bond market goes up, you keep overweighting your winners (bonds) and don't rebalance the portfolio until momentum starts to turn. As the chart below shows, the portfolio with the partial momentum overlay performed better than either the monthly rebalanced or passive drift weight portfolio.

Talking their book?
These are intriguing results and a demonstration of the positive effects of using trend following techniques for portfolio construction. However, I would add a couple of caveats in my read of this paper.

First, three of the five authors work for MAN Group, which is known for using trend following techniques in their investing. While this paper does show the value of these kinds of techniques, I am always mindful that researchers may be "talking their own book". As regular readers are aware, I extensively use trend following models in my own work, but I am cognizant of the weaknesses of these models.

In particular, these models perform poorly in sideways choppy markets with no trends. As an example, consider this chart of sugar prices for the period from 1891 to 1938. Unless the trend following system is properly calibrated, the drawdowns using this class of model are potentially horrendous.

As another example, try wheat prices for the 1872 to 1944 period:

A second critique of the approach used by the paper is the use of monthly rebalancing as one of the benchmarks. In practice, no one rebalances their portfolio back to benchmark weight on a monthly basis. A more realistic rebalancing technique might be a rule based rebalancing approach of rebalancing either annually or if the portfolio weights drift too far from the policy benchmark.

To be fair, however, the monthly rebalancing approach is an extreme one that does differentiate between a passive drift weight and a more frequently rebalanced portfolio.

Value vs. Momentum
In summary, this is an intriguing paper that compares and contrasts the use of price momentum, or trend following, techniques of chasing winners to a value-based rebalancing strategy of buying assets when they are down.

Before going out and blindly implementing a trend-following based re-balancing program, I urge portfolio managers to further study these approach and adopt it to their own circumstances. Your mileage will vary.

Monday, November 24, 2014

The Grinch comes early for retailers

About a year ago, I warned about getting overly excited about the Black Friday hype (see Is Black Friday the time to sell the Retailers?). I had identified a seasonally weak pattern for retailing stocks in December. Hype about Black Friday retailing results didn`t help investors in these stocks either.

Sure enough, retailing stocks exhibited a pattern of outperformance into late November and then dropping off in December last year, as shown by the chart of the relative performance of XRT to SPY:

A glance at the seasonal relative return pattern for retailing stocks showed that they tended to underperform the market in December.

This year, I reiterate my warning. If you want to go shopping this Black Friday, I suggest that you don`t buy retailing stocks.

Sunday, November 23, 2014

Don't fight the tape (or central bankers)

Trend Model signal summary
Trend Model signal: Risk-on (upgrade)
Trading model: Positive

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

No one ever expects the Central Banker street party!
In early November, when the BoJ unexpected announced another shock-and-awe QE program, I wrote (see Enjoy the party, but watch for the police raid):
While the BoJ party is just getting going, the partiers are spilling out onto the street and getting out of control. The neighbors are getting upset and they're about to call the cops. My inner trader remains wary of the time when the police show up and raid the party.
I identified two main risks to the "BoJ party". First, the latest round of Japanese QE will inevitably weaken the JPY against other major currencies and could invite a global currency war. In particular, it would make Japanese capital goods more competitive against eurozone (German) machinery exports and would weaken an already fragile European economy.

As well, I was concerned that China's economy was weakening rapidly and it was unclear how much more stress it could take. I asked:
How much stress can China take without taking action that reverberates around the world?
Up until recently, the PBOC`s modus operandi has been to launch either limited or covert stimulus if growth slowed too much for fear of sending the wrong message that Beijing was backsliding on its financial reform initiatives (via The Economist):
The central bank’s answer to this dilemma has been to loosen monetary policy, but in a covert fashion. It lent the state-owned China Development Bank one trillion yuan ($163 billion), according to rumours that dribbled into local media in June. Some likened it to Chinese-style quantitative easing (QE): the central bank had in effect printed cash to rev up growth. But whereas central banks in developed economies have explained every step of their QE schemes to markets, the PBOC did not even bother to announce its activity.

Then, in September and October, it launched a “medium-term lending facility”, injecting a further whack of cash—769.5 billion yuan, it turns out—into the economy via loans to commercial banks. Rumours spread for weeks before the central bank confirmed them on November 6th. As for the initial trillion-yuan loan, it eventually acknowledged the operation, though declined to say how much it had lent, at what rate or even to which bank.
Despite their size, these covert stimulus packages didn`t seem to be enough:
The combined amount of the infusions, if as big as reported, would be huge—equal to more than three months of America’s now-completed QE scheme when it was at its height, or to five months of Japan’s current programme. The impact of China’s easing, however, has been underwhelming. It has not reached the real economy. Short-term interest rates have fallen: a closely watched interbank rate is down by almost two percentage points this year, to 3.2%. But the rate at which banks lend to businesses, which matters more for growth, has remained stuck at about 7%.
The news about falling home prices in October may have been the last straw:

Finally, Beijing blinked and the PBOC unexpectedly announced an interest rate cut that is designed to effect a more broadly based stimulus program (via Bloomberg):
China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy, sending global shares, oil and metals prices higher.

The one-year lending rate was reduced by 0.4 percentage point to 5.6 percent, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, effective tomorrow, the People’s Bank of China said on its website today.

The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990. 
Even before the news of the latest round of PBOC stimulus, Diana Choyleva of Lombard Street Research presciently wrote the following in the SCMP. She believed that China was preparing to kick the can down the road, but the road is quite long (emphasis added):
Surprise, surprise - Beijing has set its eyes on debt-fuelled growth again, this time boosting lending to households. China's total debt is not excessive, so Beijing can try this trick. But its efforts will end in tears without genuine redistribution of income towards consumers.

Some people argue China already has too much debt and has little scope to raise it further. True, total debt has surged since the global financial crisis, but it is not extreme, as in some other countries. Gross private non-financial debt and gross government debt added up to 2.4 times China's gross domestic product last year compared with close to four times for Japan and Portugal and more than three times for Greece and Spain.

Yet there is no magic number above which debt in an economy becomes excessive. Moreover, different economic structures, cultural habits and market perceptions lead to different levels of sustainability for household, company and government debt.

Even so, a global comparison suggests Beijing can continue to play the debt game a bit longer. Also, like Japan, most of the debt is owned domestically so China would not be under the same international pressure as Greece and Argentina.
She concluded that it will not end well and cited the problems encountered by South Korea, but that`s a problem for another day:
The more output growth weakens, the more likely it is Beijing will spur household borrowing. Expanding the underdeveloped mortgage market is not bad news, but if China relies only on household credit to power economic growth and pulls back from needed financial reforms, the omens are not good.

South Korea went down this path in the 2000s after the fallout from the 1997 Asian crisis, but failed to rebalance its economy towards consumer spending. It was left with the mess from a burst household debt bubble and an economy even more dependent on exports. China must heed the lessons.
In effect, the Chinese saw the party at the BoJ`s place and decided to throw one of their own. Party now, pay later.

The ECB will  "do what it must"
If the surprise PBOC announcement wasn`t enough to light a fire under the markets, Mario Draghi stated that it will “do what it must“ to raise inflation and inflationary expectations (via Marketwatch, emphasis added):
In a speech to a banking conference, Draghi said the ECB was prepared, if needed, to expand its purchases of assets, which raises the amount of money flowing in the economy. That heightened hopes in financial markets that the ECB may soon buy large amounts of government bonds of eurozone members, a path other big central banks have taken but the ECB has largely resisted.

We will continue to meet our responsibility — we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,” Draghi said.

If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases,” Draghi added.
To emphasize its resolve, it tweeted that it had start to buy ABS as part of its effort to expand its balance sheet:

The BoJ party wasn`t enough. The PBOC party wasn`t enough. The ECB has decided that it wants in on the party action too. So we now have a Central Bankers street party.

The music`s fine, drinks are free
In response to these announcements, commodity prices spiked in reaction to the Chinese stimulus news. In Europe, the STOXX 600 staged an upside breakout from a minor resistance level.

I also highlighted a number of positive European catalysts in my last post (Two contrarian plays that will make you queasy):
  • Falling unit labor costs in Greece, Spain and Ireland that make them competitive with Germany
  • Positive earnings surprise from European companies
  • Forecasts of robust European company EPS growth
In addition, BCA Research also made its case that positive momentum will result in a turnaround in eurozone equities:

In the US, a San Francisco Fed paper indicating that inflation may not rise as much as expected could provide cover should the Yellen Fed decide to lean dovishly on the timing of raising interest rates (via WSJ, emphasis added):
New research from the Federal Reserve Bank of San Francisco warns the U.S. central bank’s inflation target may prove more elusive than many policymakers now think, in a fresh wrinkle for any move by officials to end their easy-money policy stance.

The report, written by bank economist Vasco Curdia and published Monday, says the Fed may not see its 2% inflation objective achieved until “after the end of 2016.” The finding generates fresh uncertainty around current Fed projections, which hold that the likely range of inflation in 2016 will be between 1.7% and 2%. For 2017, the likely range seen by officials is 1.9% to 2%.
Combine the SF Fed paper with this detail in the latest FOMC minutes and "many participants" on the FOMC could find justification for delaying raising rates (emphasis added):
There was widespread agreement that inflation moderately above the Committee's 2 percent goal and inflation the same amount below that level were equally costly--and many participants thought that that view was largely shared by the public.
Back on Wall Street, the SPX staged an upside breakout to all-time highs last Tuesday and I tweeted that I was buying the breakout:

The market friendly news from the PBOC and ECB helped propel the SPX to further highs:

Building towards a 1987 event?
Currently, both the intermediate term fundamental and technical underpinnings of the stock market are supportive of further highs. The latest earnings analysis from John Butters of Factset shows that consensus US forward EPS estimates have stopped falling and appears to have started to slowly grow again. Such a development has to be regarded as putting a floor on the stock prices.

Conditions may be setting up for a blow-off top in the stock market. I had highlighted the bullish views of former Value Line Research Director Sam Eisenstadt (see my previous post Global healing = Buy the dips) where he targeted a SPX level of 2,225 in six months (via Mark Hulbert at Marketwatch on November 5, 2014, emphasis added):
This incredible bull market, which has earned the right to go sideways for a while, is instead going to keep powering ahead.

That, at least, is the forecast of the market timer who has more successfully called stocks’ direction in recent years than anyone I can think of. His latest forecast: The SP 500 will rise to 2,225 in six months, 10.3% higher than where it stands today.

I’m referring to Sam Eisenstadt, the former research director at Value Line Inc. Though he retired in 2009 after 63 years at that firm, he continues in retirement to update and refine a complex econometric model that generates six-month forecasts for the benchmark stock market index.
Coincidentally, Jeremy Grantham postulated a bubble market where the SPX starts to get bubbly at 2,250 in the latest GMO quarterly letter. Eisenstadt's target is 2,225 and Grantham is thinking 2,250, which, as the saying goes, is close enough for government work:
My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the SP 500 on our data) before crashing as it always does. Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement – which seems inevitably to be led by U.S. markets – starts about now, entering the sweet spot of the Presidential Cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help.
Dana Lyons also observed that the SPX is well above its trend on an inflation-adjusted basis. The only other time it has been this far above trend was the March 1998 to July 2001 period, which was at the height of the Tech Bubble. I would note, however, that the last time these overbought conditions appeared, it took a full two years before the excesses began to correct themselves. Overbought markets can get more overbought:

As well, Byron Rich is projecting a SPX target of 2917 by the end of 2015 in a Forbes article:
If we applied the long-run annualized return for stocks (8%) to the pre-crisis highs of 1,576 on the SP 500, we get 2,917 by the end of next year, when the Fed is expected to start a slow process toward normalizing rates. That’s nearly 45% higher than current levels. Below you can see the table of the SP 500, projecting this “normal” growth rate to stocks.

Notwithstanding Rich`s *ahem* outlier forecast of a 45% SPX gain, consider this Twitter observation from Jesse Livermore, the blogger at Philosophical Economics, that puts some perspective on the current advance in US stocks from 2009:

I got to thinking. Eisenstadt is a well-respect market analyst who uses models that are tilted towards growth and momentum. Grantham is a well-respected value investor - and value investors tend to be conservative and early. If they are both thinking 2,225 to 2,250 on the SPX, might it overshoot to the 2,400 level, where the combination of over-valuation and some macro event, e.g. Fed tightening, cause the market to crash?

Let me make this very, very clear. I am not forecasting a market crash, but a scenario involving melt-up followed by a market crash is within the realm of possibility. These figures put forward by Eisenstadt, Grantham, Lyons and Livermore certainly puts some parameters of the upside potential in a bull run.

Under these circumstances, let`s enjoy the potential market melt-up first instead of worrying about a market meltdown, Party now, pay later.

The road ahead
In the short term, I am seeing signs of positive momentum everywhere. The latest BoAML Fund Manager Survey is seeing a renewal of optimism about global growth but the bullishness is not excessively high:

Fund managers have expressed a desire to pile into equities:

While their positions are above average, the BoAML comment is that readings are only 0.7 standard deviations above average and not stretched:

Technically, the SPX touched its weekly upper Bollinger Band on Friday but did not close above it. Episodes where the market has closed above the upper weekly BB are rare and has tended to signal impending weakness. However, as the market did not punch above its upper weekly BB, it may be poised for a multi-week ride on the upper BB, where the index rises along with the upper band:

In addition, BoAML has pointed out that Thanksgiving Week has been historically seasonally positive for equity returns (via ZH):

In the meantime, it`s a great party. Don`t be such a worrywart about what might happen next year. My inner trader tells me:
Don`t fight the tape (or central bankers, for that matter). It's a new era of financial hedonism.

A personal thought for Thanksgiving 
As my American friends look forward to their Thanksgiving celebrations, let me take this opportunity to launch my personal appeal for support of the Vancouver Youth Symphony Orchestra, to which I am a volunteer board member. I have kept my writing free since I started this blog. If you have found my work to be valuable, please show your appreciation by donating to this worthy cause by clicking here.

I have long believed that one of the ways to nurture youth is to give them a focus in their lives, whether it be music, sports or other pursuits. This is especially critical during their adolescent years as they start to form their own identities. It's one of the key reasons why I became involved with the Vancouver Youth Symphony Orchestra Society. Participation in a VYSO orchestra teaches young musicians to focus on both their individual musical and orchestral skills. The latter is particularly important as many people can learn to play music, but a different skill is required when the conductor points to a section and have them all play the same sound at the same time. It's much like the difference between learning to walk and learning to march in formation.

The Vancouver Youth Symphony Orchestra Society is a registered charity and tax receipts are available to contributors who are Canadian residents.

Thank you for your support.

Disclosure: Long SPXL