Supply And Demand Is More Important Than Sentiment Or Valuation, But. . .
In last month’s update just prior to Christmas, we put forth the evidence that market breadth was confirming the new highs in stock prices and that based on history, this portended higher prices in coming months. Nothing has taken place to change that view, as it continues to be reinforced.
Since December 22, the S&P 500 has gained 1.62%. That may not seem like much, but on an annualized basis, it is nearly 18% per annum. Global equities have been even stronger, with the Vanguard Total International Stock Fund gaining 5.27% during the same period. Could this be the beginning of a change in fortunes for international stocks, in comparison to U.S. equities?
That’s possible, but we wouldn’t go about guessing. In this area, we are guided by our relative strength rankings, and international equities continue to be at the bottom, while small and mid-cap stocks remain at the top.
Sentiment indicators remain optimistic (which is a contrary indicator) and valuations are among the most expensive in history (see below), but investors (and money managers for that matter) will be best served by ignoring these external indicators and concentrate their focus on the performance of supply and demand.
A Healthier Technical Background Today Than May 2015
In that respect, the stock market is in a better place today than at its previous peak in May 2015, which eventually led to a 14% decline, which terminated in February 2016. To better illustrate this, Doug Ramsey, the Chief Investment Strategist at Leuthold Weeden Capital Management, created a table which compared the S&P 500 to seven different indicators at prior market tops going back to 1990. That table is reproduced below, courtesy of the Leuthold Group.
Ramsey calls this process his Red Flag Indicator. The thinking behind it is that at the vast majority of stock market peaks, there are divergences in the various indicators (as I had mentioned last month). You can see that in the five prior cases since 1990, there has been an average of 6.3 warnings (out of a possible 7). That sends a message that markets are out of sync, and it normally leads to a significant decline.
As the charts below show, which compare the various indicators/indexes from 2014-2015 to 2016-17, we are in a much different situation at present. As of last week, only one of the 7 indicators, the Dow Jones Utilities Average, was not confirming the new highs in stock indexes.
Bottom line, this has bullish implications for the next three to six months, at a minimum. This doesn’t preclude a correction of about 5% beginning at any time. Even if that takes place, though, higher prices are still likely before the end of this bull market.
An Expansion in Psychology
We’ve mentioned several times in the past 24 months (maybe longer) that stock prices were expensive relative to history, using several different metrics, from dividend yields, price to earnings, capitalization to GDP (gross domestic product) and price to sales, to name a few. The chart below, courtesy of Ned Davis Research, is a great illustration of what has taken place the past few years. It depicts the price/sales ratio of the S&P 500, using quarterly data going back to 1954.
The current ratio of 1.90 has only been exceeded one time in the past 60 years, and that was at the market peak of 1999-2000. But, let’s take a look at what has happened to sales in comparison to prices. Sales, as shown in the table in the upper right portion of the chart, have only increased since 2012 by 6.4%, yet the S&P 500 Index during that same period has gained 74%.
So, sales growth is not supporting the expansion in prices, nor is earnings growth. What’s taken place is that investors have been willing to pay a higher price for the same amount of sales. This is all driven by psychology, and certainly some would argue that it has been facilitated by the zero interest rate policy that the Federal Reserve has pursued for the past 7 to 8 years.
In looking at this chart, it might be easy to conclude that something has changed since around 1997. Prior to 1997, the ratio vacillated from about 1.24 to as low as about 0.40. But since 1997, it has only been below 1.24 for a few years, mostly because of the collapse in stocks during the 2007-2009 bear market.
It might be tempting to conclude that “this time it’s different,” and that we’re in a new era of elevated valuations that will go on for many years. Anything is possible, which is why we favor technicals over fundamentals, but I would be quite cautious about assuming that conclusion. Rather, I agree with the comments from Howard Marks of Oaktree Capital, in his book, “The Most Important Thing.”
Marks said, “Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true.
“The next time you’re approached with a deal predicated on cycles having ceased to occur, remember that invariably that’s a losing bet.”
Fidelity Tax Documents
Yes, it’s that time of year again. We just wanted to remind you that the first mailing of 1099 forms was mailed (and posted online) on January 28. They will do a second mailing on February 18 that will include information that was not available at the first deadline. There is a final mailing on March 4 for situations where information was not available at the earlier deadlines.
Our recommendation would be to make any tax appointments with your CPA after February 18, so you’re not having to come back to them with additional data. As always, if you need something in this area and don’t have it, don’t hesitate to call our office and speak with Mary or Sylvia. Sometimes, we have access to this information before you do.
Investment Allocations Update
With the weekly data ending December 30, our risk model for high yield bond funds turned positive, so on the first trading day of 2017, our accounts moved to an approximate 80/20 over-weight position in high yield, in comparison to short duration bond funds. Prices are up about 1.25% since then, so there has been decent follow-through thus far, but we’re not expecting a repeat of the February 2016 BUY signal, which led to an approximate gain of over 12%.
In many ways, bonds are just as expensive as stocks, but our process and trend-following model demands that we be heavily invested. In stocks, most of our risk models are positive, and exposure is at about 63%, which we consider to be moderately positive. We are looking to get to 70% on some weakness.
I also wanted to announce that for now, we’ve suspended our allocations to real estate, where we’ve either used a real estate mutual fund or a real estate ETF, such as the Dow Jones Real Estate Index (IYR). We’ve been studying some research in this area, along with on-going research we’ve maintained on sector investing. At present, we’re not convinced that our model for this area is adding enough value above and beyond buy and hold for the diversification benefits.
As a result, we’ve just shifted the real estate allocation within portfolios to our broad-based equity exposure. Real estate represented 3% in Conservative accounts, 5% in Moderate accounts and 7% in Aggressive accounts. A lot of times, simple is better. Though this was not part of our decision process, I might add that in real estate, cap rates are extremely low, which means real estate is quite expensive, both on the commercial side and residential side.
Material of A Less Serious Nature
An older couple recently learned how to send text messages on their mobile phones. One afternoon, the wife went out to meet a friend for coffee. The two ladies got to talking about their husbands and decided to up the romance levels in their relationships.
Capitalizing on her new skill, the wife decided to send her husband a romantic text message: “If you are sleeping, send me your dreams. If you are laughing, send me your smile. If you are eating, send me a bite. If you are drinking, send me a sip. If you are crying, send me your tears. I love you.”
After a few minutes, the husband texted her back:
“I’m on the toilet. Please advise.”
As always, thanks for your continued trust and confidence in all of us at TABR. As the Chinese proverb states, we are certainly living in interesting times.
Bob Kargenian, CMT
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