Updated: Oct 8, 2019
Best Ideas Market Timing uses an asset allocation framework to vary the allocation to stocks around a 70% S&P 500, 30% US Short-Term Treasury benchmark.
The portfolio ended the month with 81.5% invested in stocks, 18.5% in cash and short-term treasuries, and 0% in long-term Treasuries.
Model allocations are currently 75% stocks, 20% cash and short-term US treasuries and 5% long-term US Treasuries (as at 30/9/2019).
This is a higher weight to stocks (5+% vs benchmark), offset by an allocation to quality/defensive stocks and long-term US Treasuries.
Current positioning reflects a neutral view on US stocks.
Here’s a summary of my asset allocation framework as at the 30/9, 31/8 and 31/7.
Clients may notice that most of the change in the overall asset allocation score is due to changes in the Sentiment and Trend scores. These indicators are short-to-medium term in nature. Fundamentals, Economy and Central Bank and Government Policy are medium-term indicators. Valuation is a long-term indicator. In other words, the asset allocation framework is diversified by using multiple indicators AND multiple time horizons.
2019 has been a whipsaw market which has accelerated changes in Sentiment and Trend. I check each indicator daily and update the model as new evidence emerges. Lately the indicators have been shifting between the extremes of pessimism and optimism more quickly. This has resulted in more frequent updates to the framework score.
For example, in early September the framework score was +4 due to a strengthening uptrend. Sentiment then shifted to neutral, bringing the overall score back to +3 at the end of the month. At the time of writing (3/10) the trend score has now fallen to =, bringing the overall framework score to +2.
First-time readers looking for more information on how I use the Asset Allocation Framework score can find it HERE.
There’s been little change to absolute valuations during September. It’s true that stocks aren’t cheap by historical standards. But nor are they extremely over-valued given the current interest rate environment.
The following chart of the S&P 500 (top chart) shows (from top to bottom):
· The S&P 500 Index
· The total return (i.e. including dividends) of the S&P 500
· The trailing 12-month P/E ratio for the S&P 500
· The change in the trailing 12-month P/E ratio for the S&P 500.
· Trailing 12-m GAAP earnings for the S&P 500
· The change in trailing 12-m GAAP earnings for the S&P 500
Over the last three years, the S&P 500 has returned 45.60% The P/E ratio has fallen (-11.37%) while GAAP earnings have increased by 54.61%. All figures are in USD.
Valuation isn’t the only driver of long-term returns. Over the last three years, it has been earnings growth, not rising valuations, that have propelled the market higher.
Valuation is a measure of long-term sentiment (i.e. how much prices can change if investor preferences shift) and likely future returns (over a horizon of at least five years); not an indicator that can be used to successfully time the market.
A singular, myopic focus on any variable, be it valuation or any other variable is a bad way to invest. Focusing exclusively on valuation would have kept investors out of the market for the last three years. Frameworks keep the focus on the big picture!
One of the best considerations of both sides of the valuation debate can be found on Aswath Damodaran’s blog. Damodaran is a Professor teaching valuation and Security Analysis at NYU Stern. The post is entitled US Equities: Resilient Force or Case Study in Denial?
Stocks are cheap relative to bonds. Buying a US 10-year Treasury bond with a yield of 1.68% is equivalent to purchasing a stock with no future earnings growth at a P/E ratio of 59.52x!
Another way to look at relative valuation is to compare the spread between the dividend yield on stocks and the yield on bonds.
The dividend yield on the S&P 500 index is currently +0.17% higher than the yield on the US 10-year Treasury Bond. This is a big change. 12 months ago (Sep 2019) the spread was -1.3%.
Stocks look even more attractive when you factor in the impact of buybacks (another way that companies return cash to shareholders) and earnings growth. Buybacks boost shareholder earnings by reducing the number of shares in circulation. As a result, company earnings are divided between fewer shares. This increases earnings per share.
Corporate revenues (sales) and earnings continue to rise while corporate profit margins are steady.
Revenue growth has decelerated but it remains positive.
Most economic indicators are currently showing that the risk of recession is low. That said, the global economy is slowing. The US economy is late cycle. Several late cycle indicators with a reliable history of predicting recessions are flashing caution. An escalating trade war and the increasingly spiteful and vitriolic 2020 US election campaign also add some uncertainty to the mix.
The economy matters because bear markets are roughly twice as bad if they occur during a recession. A 10-20% fall outside of a recession has historically been a good long-term opportunity to invest. In contrast, a 10-20% fall during a recession usually means that things are likely to get worse.
All of the economic indicators considered below are lagging. In other words, they describe what has happened, not what will happen. This is why my analysis focuses primarily on the speed and direction of change. Comparing an indicator to a long-term moving average is an excellent way to do this.
Unemployment remains in a downtrend. As the chart shows, a sustained break of the 10-month moving average (i.e. rising unemployment) is a negative indicator. No sign of that currently.
The US Consumer is OK. Consumer sentiment ticked lower in September. That said, it remains positive. Consumer sentiment is worth paying attention to. High-levels of consumer sentiment typically indicate lower future stock market returns. Conversely, there’s no better time to buy stocks than when the consumer is down in the dumps.
Over-optimism (or pessimism) can continue for a while, which is why the time to pay attention is when confidence starts to deteriorate (improve) from a high (low) level. A further fall in consumer confidence would trigger such a signal.
US House Prices remain in an uptrend. Again, its bad news if house prices fall below their medium-term trend. No sign of that yet. Lower interest rates should support house prices.
Industrial production had fallen through its 200-day moving average. As the chart shows, short-term falls below the trend line that subsequently reverse are reasonably common. A sustained break of the 12-month moving average (i.e. falling industrial production) is a negative indicator. We’ll keep monitoring the indicator and we’ll adjust our views as the evidence changes.
Now for the negatives. The yield curve (3-month minus 10-year US Treasury) remains inverted. The 3-month interest rate now sits almost 0.2% higher than the 10-year interest rate. An inverted yield curve has been a reliable indicator of past recessions.
Banks borrow over the short-term (from depositors) to lend over the long-term (to businesses and households). An inverted yield curve means that it costs a bank more to source funds from depositors than it makes from lending to borrowers. Eventually, if this persists, banks will reduce the amount that they lend. It is this reduction in credit that helps trigger a recession.
Some nuance is required when interpreting the yield curve. For example, the yield curve has to remain inverted for at least a quarter to be considered a reliable signal. Also, the amount of time between inversion and recession varies widely. Historically, it has been as much as a couple of years.
An inverted yield curve shouldn’t be considered in isolation, but rather as part of a wider set of economic indicators.
The output gap remains positive and indicates that the US economy is currently late in its economic cycle.
The output gap compares actual gross domestic product (GDP) with estimated potential GDP. It is usually negative, that is actual production is less than potential production. The gap becomes positive when the economy is producing above its long-term capacity. A positive gap is resolved in one of three ways.
· The estimate of theoretical long-term output is revised
· Potential output increases due to increased productivity
An economy growing above potential draws more and more workers into workforce (i.e. low unemployment) until there’s literally nobody left to hire. The current rate of production becomes increasingly difficult to sustain.
Also, a positive out-put gap is also a sign that the economy may be overheating. The demand driving increased consumption may also result in inflation. Central banks may then raise interest rates to control inflation.
I’m not sure that inflation is much of a concern at the moment. Sustaining the current expansion with unemployment at or near all-time lows is of some concern. So far there has been little evidence of wage driven inflation.
Recently the Institute of Supply Management (ISM) manufacturing index dropped below 50, signalling contraction. Its current reading of 47.8 is the lowest in ten years. Non-manufacturing (i.e. services) indices are all above 50 (i.e. signalling expansion). Investor’s Business Daily sums up the significance of the fall to 47.8 as follows:
Bad News for U.S. Economy
While manufacturing makes up just over a tenth of gross domestic product, slowing in the sector combined with cooler business investment and economic growth puts the longest-ever American expansion in a more precarious position. Greater weakness may threaten President Donald Trump's re-election prospects in 2020.Supplier deliveries was the only sub-index above 50, which for that gauge indicates slower deliveries. A Fed measure of production already signalled U.S. manufacturing is in a recession when it contracted in the first half of this year.
The pullback in the employment gauge, to 46.3 from 47.4, comes amid economist projections that the main monthly Labour Department report Friday will show limited manufacturing payroll growth. Economists forecast a 3,000 gain in factory employment for a second month.
d. Central Bank and Government Policy
There’s a Wall St saying: Don’t fight the tape (market trend) and the Fed. Both are currently positive. Short-term interest rates are in a downward trend in 2019 (for the first time in two years).
Long-term interest rates are also in a pronounced downward trend. That said, they did rise sharply during the first two weeks in September, only to resume their downward trend soon after.
My score for Central Bank and Government Policy was +2 in June but I downgraded it to +1 in July. The Fed has done a poor job in communicating its views on future interest rates. Financial markets have reacted badly to this uncertainty.
Fed Chairman Jay Powell seems to be trying to a) respond to market and economic data as it evolves and b) demonstrate the Fed’s independence from President Trump. The problem is that the market and economic data is aligning with Trump’s view, particularly if the US is going to keep fighting a trade war with China.
Powel tried to give investors what they wanted (a rate cut) without giving Trump what he wanted (a 0.5% cut). The result (so far) this has backfired.
Trump has taken to Twitter to repeatedly to further lambast Powell describing him variously as a golfer who can’t putt and a bigger enemy to the American people than Chinese Premier Xi. His latest insult was that the Federal Reserve is “pathetic”.
In the end I think it’s the market that will win his argument. Continues inversion of the yield curve is a clear sign that market’s believe short-term interest rates are too high. The Fed was also forced to provide liquidity to the repo market, another sign that they may have gone too far in trying to shrink their balance sheet.
If you squint you can see that the Fed’s balance sheet has started expanding again (due to their intervention in the repo market). It will be interesting to see if this trend will continue.
In summary, Fed policy is accommodative but, tensions between the Fed and the White House are a risk.
Sentiment is a contrarian indicator. Strong returns usually follow periods where sentiment is currently poor and beginning to improve.
Sentiment is currently neutral. That said, several shorter-term measures are showing signs of pessimism, but nothing to get too excited about just yet. Sentiment was negative an improving in August – a great combination. But it didn’t reach levels of over-optimism and it has since changed direction. As always, I’ll update my views as new information becomes available.
The National Association of Active Investment Managers surveys approximately 200 Registered Investment Advisors in the USA. The survey measures the amount of equity exposure that these advisors currently recommend to their clients.
Advisors cut their equity allocations at the end of August to 58% (approximately 12% underweight) only to increase their allocations back above the long-term average of 70-75% in mid-September. In late-September they started cutting their allocations again. Ideally, I’d like to see signs of greater pessimism – e.g. allocations to stocks in the 40-50% range.
Another well-regarded measure of advisor sentiment is the Investor’s Intelligence Survey. In contrast to the NAAIM survey, Investor’s Intelligence still shows signs of excessive optimism, with bulls outnumbering bears 3:1.
The American Association of Individual Investors (AAII) surveys its members each week. Members are asked if they’re bearish, bullish or neutral on the market. The chart above compares the percentage of respondents that are bullish and bearish (i.e. it ignores neutral responses).
Individual investors were extremely bearish in early August. The net-bears score reached levels last seen during the December 2018 bear market. There were signs of optimism in early-September but these quickly reversed. This indicator is currently giving a neutral signal.
Rydex (Guggenheim) offer a suite of geared long (bull) and short (bear) mutual funds. The chart below shows the ratio of assets invested in bear market funds vs bull market funds. A low ratio means that the bulls dominate bears. As you can see form this chart, investment in bear funds has been decreasing but it has yet to reach “hibernation” levels (i.e. not a bear to be seen) last seen in May and July. Unsurprisingly, this indicator has a neutral score.
Market volatility spiked during late July/early-August. The VIX more than doubled in a matter of days as investors were shaken from their complacency. Volatility moderated in September. That said, it remains elevated (i.e. above its 10-day and 60-day trend). Investors are clearly nervous, but their anxiety has yet to reach panic levels.
The Put/Call ratio is another measure of investor sentiment. When investors are optimistic, they buy calls to leverage their upside. Conversely when they are pessimistic, they but puts to protect their portfolios. A low ratio suggests investors are complacent. The chart below shows that the 10-day moving average of the Put/Call ratio (blue) is rising. This is another indicator or investor caution.
Investor sentiment can also be gauged by comparing the performance of cyclical and defensive companies. Investors buy cyclicals when they’re feeling bullish about economic growth. Conversely, they typically purchase defensive stocks when they’re concerned about the future prospects of the economy and/or the stock market.
Cyclical sectors such as Energy (blue), Industrials (red), and Materials (green) continue to trail the S&P 500 by a wide margin.
On the flip side, defensive sectors such as Consumer Staples (red) Real Estate (blue), Utilities (green) continue to out-perform the S&P 500.
Trend was positive through most of September. The chart on the following page shows, from top to bottom:
· S&P 500 is in an uptrend and currently trading above both it’s 50-day and 200-day moving averages.
· Slope of the 50-day moving average is positive and steepening.
· Slope of the 200-day moving average is positive.
· S&P 500 total return is positive.
All of these indicators finished the month on a positive note. Several of them have deteriorated in October (as of the 3/10).
Breadth was also positive. The number of stocks currently trading above their 50-day moving average (68.14%) is above the 200-day moving average (approximately 60%).
The number of stocks currently trading above their 200-day moving average (70.74%) was comfortably above the 200-day moving average (approximately 58.5%) and the 50% level. It’s hard for the S&P 500 to advance further if less than 50% of the stocks that comprise the index are in a medium-term uptrend.
Another way to examine breadth (i.e. whether or not a trend is board-based and therefore more likely to persist or vice versa) is to compare the performance of the S&P 500 index versus its equally weighted equivalent.
Over the last 12 months, the equally-weighted S&P 500 index has under-performed the S&P 500 by -0.75%. All returns are in USD. In other words, the S&P 500’s performance has been driven by a subset of stocks.
There was a sharp reversal in the performance of the equally-weighted index in early-September. This is covered in detail in my post on Style Rotation.