Asset Allocation Update: November 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 89.9% invested in stocks, 10.1% in cash and short-term treasuries, and 0% in long-term Treasuries.

Model allocations are currently 80% stocks, 20% cash and short-term US treasuries and 0% long-term US Treasuries (as at 30/11/2019).

This is a higher target weight to stocks (10+% vs benchmark), offset by an allocation to quality/defensive stocks.

Current positioning reflects a neutral-to-positive view on US stocks. Here’s a summary of our asset allocation framework as at the 30/11, 31/10 and 30/9.

The overall score ended October at +4. It has now been downgraded to +2.

The economy score has fallen to -1 due to the slowdown in industrial activity and the escalation in trade war rhetoric between the USA and China.

This week saw the fourth consecutive decline in the ISM survey of industrial production. We haven't had four consecutive decreases since 2016. To make matters worse, the market was expecting an increase; so, the survey results were a negative surprised. Also noteworthy was the weakness in the new orders (i.e. the forward-looking component) section of the survey.

The sentiment score was also downgraded from -1 to -2. There were multiple signs of investor over-optimism at the end of October. That said, over-optimism can persist for a while. For example, we saw this in November with volatility reaching increasingly lower levels as the month went on.

Consequently, we’ve been hesitant to further downgrade the score until there were signs that sentiment had peaked (i.e. started to become more pessimistic). Sentiment started turning negative in the survey data last week and it is showing up this week in measures of volatility.

All other things being equal, a trend is stronger and more likely to be sustained if the majority of stocks are participating in that trend. This is why breadth indicators are often used in conjunction with trend indicators.

Early in November we started to see a divergence between breadth and trend indicators. That is, the market kept rallying, but fewer and fewer stocks were participating. This warning sign was reversed later in the month as breadth indicators started to improve.

The early-December sell-off has seen several breadth measures begin to deteriorate. We will be watching these indicators closely as they may signal a downgrade to our trend score.

The Fed cut rates and is effectively providing QE through its market interventions (the Fed’s balance sheet has started expanding again).

Valuation (absolute) is starting to look expensive. The S&P 500 trading above 17x on a forward P/E basis. Consequently, our valuation score has dropped to -1. Valuation is a poor market timing tool (especially in the short term) but it has a big impact on long-term risk/reward.

In summary, our October conclusions still hold:

Taken together, it seems more likely that the S&P 500 goes higher in the medium-term. That said, we wouldn’t be surprised to see an increase in short-term volatility given the euphoria that’s currently in the market.

It’s too early to say for sure, but it looks like we might now be experiencing a short-term pull back with higher volatility in early-December.

We’ve implemented this view in two ways:

  • Reducing Best Ideas Market Timing’s asset allocation to stocks from almost 90% to less than 80%

  • Tightening stops across all holdings.

First-time readers looking for more information on how we use the Asset Allocation Framework score can find it HERE.

a. Valuation

November’s rally in the S&P 500 was driven largely by an increase in stock prices rather than an increase in future earnings. The S&P 500 trades on a forward P/E ratio greater than 17x.

The chart below shows the S&P 500 (red) in comparison to where the S&P 500 would trade if a different multiple was used to value forward earnings (blue). The forward earnings multiple briefly touched 10x in early-2009 and has trended upwards ever since. It has only been above 17x on three occasions since the global financial crisis.

The price to earnings growth (PEG) ratio compares the P/E ratio to the earnings growth rate. The top panel in the chart below shows the P/E ratio (red) has risen while the long-term earnings growth rate (blue) has fallen. This has resulted in a PEG ratio of 1.6×, which is expensive by historical standards.

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.

Stocks are cheap relative to bonds. Buying a US 10-year Treasury bond with a yield of 1.78% is equivalent to purchasing a stock with no future earnings growth at a P/E ratio of 56.2×!

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 +0.07% higher than the yield on the US 10-year Treasury Bond. The yield spread has fallen due to a combination of stocks rallying and bonds selling off. That said, it still points to equities being better relative value than bonds.

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. The S&P 500 shareholder yield (i.e. dividends + buybacks) is 5.18%.

b. Fundamentals

Corporate revenues (sales) and earnings and profit margins are holding steady.

Revenue growth has decelerated but so far it has remained positive.

Companies sell goods and services to consumers and also to other businesses. The Institute of Supply Management Purchasing Managers index (PMI) is a survey that measures business-to-business activity. It is one of several important indicators of future corporate earnings.

c. Economy

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. 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.

Perhaps the biggest economic news was the fall in the US PMI fell for the fourth consecutive month.

Here’s a summary of the November PMI results by Investor’s Business Daily:

The Institute for Supply Management data on Monday showed the factory purchasing managers' index unexpectedly declined to 48.1, near the expansion's low point, from 48.3. The median forecast in a Bloomberg survey of economists called for an improvement to 49.2. Readings below 50 indicate activity is shrinking.

The figures show the manufacturing sector, while no longer in free-fall, lacks upward momentum in an environment of corporate investment cutbacks, subdued global demand and a still-simmering China trade war. At the same time, factory gauges in China and Germany suggested the worst may be over for the sector.

Consumer spending continues to keep the U.S. expansion going, and other reports indicate American factory activity is gradually firming. A similar PMI issued Monday by IHS Markit rose to a seven-month high of 52.6 in November, after the government reported last week that business-equipment demand climbed in October by the most in nine months.

Still, the ISM's measure of factory orders declined in November after consecutive gains and, at 47.2, matches the lowest readings of the expansion. That figure signals that the surprise jump in the government's October reading for capital goods orders and shipments may not be sustained.

Of particular concern was the drop in new orders, the forward-looking component of the PMI survey. Manufacturing new orders are contracting. Non-manufacturing orders are still expanding. This is likely to be because the USA vs China trade war primarily impacts manufacturing companies.

There hasn’t been much change across other areas of the economy such as housing, unemployment and consumer sentiment since our October update.

The continued deterioration in the PMI, together with escalating trade war rhetoric by the USA and China, resulted in a downgraded to our score for the economy.

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 continue their downward trend for 2019.

Long-term interest rates are also in a downward trend. That said, interest rates have made higher lows in October and November. Is this a sign that we’re near a bottom in long-term interest rates? This is something that we’ll be monitoring closely.

Our score for Central Bank and Government policy has been upgraded to +2 for three reasons.

Firstly, the Fed has improved in communicating its views on future interest rates. The market took this rate announcement in its stride We didn’t see markets through a tantrum following a disappointing press conference in October.

Second, Powell has made it clear that the only reason the Fed would raise rates is if there were signs of inflation.

Third, the Fed has resumed quantitative easing (despite protesting that it’s not quantitative easing)

The Fed’s balance sheet has now expanded to over US $4 trillion, up from US $3.76 trillion in August.

e. Sentiment

Sentiment is a contrarian indicator. Strong returns usually follow periods where sentiment is currently poor and beginning to improve.

Sentiment was optimistic in early-November. Survey-based measures of sentiment (NAAIM, AAII and Investors Intelligence) showed signed of euphoria which moderated as the month progressed. Market-based measures (VIX and Put/Call ratio) showed increasing optimism throughout the month.

We downgraded the sentiment score from -1 to -2. November started with multiple signs of over optimism. Over-optimism can persist for a while. That’s why we try to avoid becoming too bearish about sentiment until it starts to look like it may have peaked.

As the month progressed, we started to see a few indications that sentiment had peaked (i.e. started to become more pessimistic). Sentiment started turning negative in the survey data last week and it is showing up this week in measures of volatility.

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 increased their equity allocations at the beginning of November to over 90% (approximately 20% overweight relative to the 6-month average allocation). They reduced their allocations over November to end the month slightly over-weight equities.

Another well-regarded measure of advisor sentiment is the Investor’s Intelligence survey. Investor’s Intelligence still shows signs of excessive optimism, with bulls outnumbering bears by more 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 bullish in early November. Their optimism moderated and ended the month at an optimistic (but not euphoric level).

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.

Investors in Rydex funds are optimistic on-balance but their optimism isn’t yet at an extreme level.

Market volatility fell to its lowest level in over a year. The VIX spent several days below 12 towards the end of the month. The 10-day moving average (blue) is well below the 60-day moving average (red) and ended the month at a fifteen-month low.

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 buy puts to protect their portfolios. A low ratio suggests investors are complacent. The chart below shows the 10-day moving average of the Put/Call ratio (blue line) reached a seventeen-month low in mid-November. A clear sign of investor over-optimism.

Investor sentiment can also be gauged by comparing the performance of defensive stocks with lower levels of share price volatility with the broader market. Investors typically purchase defensive stocks when they’re concerned about the future prospects of the economy and/or the stock market.

The out-performance of low-volatility versus the S&P 500 peaked back in early-September and continued to fall during November.

f. Trend

Trend was mostly positive in October. The chart below 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.

  • The S&P 500 has powered through key technical levels

All of these indicators finished the month on a positive note.

The S&P 500 appears to have broken out of a consolidation phase (bounded by the green lines). It has also broken through a trend line joining the three prior market peaks (blue line).

Breadth was sending mixed signals. The number of stocks trading above their 50-day moving average (65.93%) held above its 200-day moving average (approximately 65%).

The number of S&P 500 stocks currently trading above their 200-day moving average (75.15%) was comfortably above the 200-day moving average (approximately 66.24%) 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.

Broader market measures of breath didn’t look as healthy. For example, the number of stocks making new 52-week highs minus new 52-week lows on the New York Stock Exchange peaked in early November (red arrow) and continued to fall as the S&P 500 rallied higher. In other words, progressively fewer and fewer stocks were participating in the rally.

The highs-minus-lows indicator did recover in late-November (green arrow).

It was a similar story with the ratio of advancing stocks vs declining stocks on the New York Stock Exchange. The number of advancing stocks declined as the market rallied (green arrows). This indicator also showed some improvement in late-November (blue arrow).

Divergences between the broader market and the behaviour of individual stocks are often a warning sign that an uptrend is running out of steam.

Market trends are also more likely to persist if they’re confirmed by the broader stock market and/or other markets. The chart below shows the Value Line Geometric Index which contains approximately 1,600 -1,700 stocks (i.e. large, mid and small caps).

The Value Line index broke out of a fifteen-month downtrend (blue line). In other words, the broader US stock market is now confirming the S&P 500’s advance.

It’s a similar story for global stocks. The chart below shows that global stocks (MSCI World ex US) has also breaking out of an almost 2-year downtrend. All returns are in USD. Global stocks are now confirming the strength of the S&P 500.

We can also compare the performance of stocks vs bonds. US 10-year Treasury bonds are now trailing the S&P 500 by approximately 5.5% over the last 12-months. All returns are in USD. The out-performance of stocks versus bonds is a positive.

g. Gold

Gold continues to look a little less shiny in October. The gold price currently below its 50-day moving average.

h. Cash and Fixed Income

Best Ideas uses SHV – the iShares Short-Term Treasury ETF as its proxy for cash. The price return for SHV was +.0.07 % in November. All returns are in USD.

i. AUD

The AUD fell from 0.6893 at the end of October to 0.675 at the end of October.

The –2.13% fall in the AUD USD exchange rate over the month was a tailwind that positively impacted absolute performance.

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