Asset Allocation Update - October 2019

Updated: Dec 4, 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% invested in stocks, 19% in cash and short-term treasuries, and 0% in long-term Treasuries.

Model allocations are currently 85% stocks, 15% cash and short-term US treasuries and 0% long-term US Treasuries (as at 31/10/2019).

This is a higher target weight to stocks (15+% 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 31/10, 30/9 and 31/8.

Clients may notice that most of the change in the overall asset allocation score over the last few months has been 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. We check each indicator daily and update the model as new evidence emerges. Lately the indicators have been shifting between uptrend and downtrend and extremes of pessimism and optimism more quickly. This has resulted in more frequent updates to the framework score.

The overall score ended September at +3. It increased to +5 early in October fished the month at +4 and is now (7/11) +3.

Sentiment was downbeat early in the month (positive) but it ended the month in optimistic territory (negative). Investors are now showing signs of euphoria. The current (7/11) sentiment score has moved to -2. Investor over-optimism increases the chances that stocks will pause or experience a short-term pull back.

The Fed cut rates and is effectively providing QE through its market interventions(the Fed’s balance sheet has started expanding again). The S&P 500 is in an uptrend and is trading at all-time-highs. Equity markets around the world have also started to move positively. This is a change from recent rallies and is a positive confirmation of the positive trend in US stocks.

The US economy is late-cycle, but it seems to be doing OK. A few indicators (such as the ISM survey and CEO confidence) are pointing at slower earnings growth. That said, the stock market usually does OK when earnings are slow (unless the slowdown is severe or due to a recession).

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.

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.

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

a. Valuation

There’s been little change to valuations based on trailing earnings in October. 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 chart below 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 51.25% The P/E ratio has fallen (-9.29%) while GAAP earnings have increased by 55.63%. 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.

What has changed is valuation based on expected future (or forward) earnings.The S&P 500 now trades on a forward P/E ratio greater than 17x.

The chart above shows the S&P 500 (red) in comparison to where the S&P 500 would be 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.

Stocks are cheap relative to bonds. Buying a US 10-year Treasury bond with a yield of 1.69% is equivalent to purchasing a stock with no future earnings growth at a P/E ratio of 59.17x!

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 +0.01% 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 it remains positive.

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

Manufacturing activity is contracting (blue line) and non-manufacturing activity is growing albeit at a slower rate (green line). Overall the purchasing activity is expanding (red line above 50) although the rate of expansion has slowed all year. Activity has ticked up in October.

It will be interesting to see if this is analogous to the 2015/2016 slowdown. The S&P 500 fell by close to 20% only to zoom higher from mid-2016 through to early-2018 as growth fears subsided and tax cuts were implemented. It’s too early to tell, but its something that we’re watching.

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.

Most of the economic indicators that we track are lagging.In other words, they describe what has happened, not what will happen. This is why our 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.

There hasn’t been much change across the economic indicators since our September 2019 update.

That is, with the exception of the yield curve (3-month minus 10-year US Treasury); which is no longer inverted. The 3-month interest rate now sits 0.15% below the 10-year interest rate.

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 a higher low in October. 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 October. It has just reached euphoric levels at the time of writing (7/11). We currently see signs of optimism everywhere we look.

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 to over 88% by the end of October. The last two times they were this high (April-May and July-August), the market experienced a pull-back not long afterwards.

Another well-regarded measure of advisor sentiment is the Investor’s Intelligence Investor’s Intelligence still shows signs of excessive optimism, with bulls outnumbering bears by almost 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.Retail investors were knocking on the door of over-optimism (i.e. almost one standard deviation above the trailing 100-day average score) at the end of October.

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, there was a quick move to extremely bearish positioning in early October, followed by an equally large reversal. Evidently someone invested a big bet that the market would fall and then changed their mind in a hurry! This has taken this indicator back to a neutral score.

Market volatility has fallen to low levels in October. The VIX has fallen from over 20 at the beginning of the month to just over 13 at the end of the month.The 10-day moving average (blue) is well below the 60-day moving average (red).

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) falling throughout October. Some of the individual daily reeding have been very low. This is another indicator or investor over-optimism.

Investor sentiment can also be gauged by comparing the performance of lower volatility (i.e. defensive) companies. Investors buy low volatility stocks when they’re feeling nervous about economic growth. Low volatility stocks have done well since the December 2018 bear market, although their dominance appears to be ending as investors increasingly embrace riskier stocks.

As the chart above shows, the out-performance of low-volatility versus the stocks seems to have peaked back in early-September.

f. Trend

Trend was mostly positive in October. 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.

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

Breadth was also positive. The number of stocks trading above their 50-day moving average (65.93%) is just above the 200-day moving average (approximately 65.93%). It also hasn’t crossed above and reversed below75%; a level where the indicator is signalling that the S&P 500 might be overbought.

The number of stocks currently trading above their 200-day moving average (69.74%) was comfortably above the 200-day moving average (approximately 63.28%) 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.

This indicator looked as if it might fall below the 70% threshold, but it has since rebounded to 74.50% (7/11).

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 recently broke out of an almost 2-year downtrend (blue lines). 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 outperformance of stocks versus bonds is a positive.

g. Gold

Gold continues to look a little less shiny in October. The gold price currently tracking its 50-day moving average. Is this “a pause that refreshes” or the beginning of a down trend? I’m not sure.

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 +.0.26 % in September. All returns are in USD.

Best Ideas Market Timing at times invests in TLH – the iShares Long-Term Treasury ETF. The price return for TLH was -0.79% in October. All returns are in USD.

The price return for TLH has been 18.85% over the last 12 months (middle chart). The relative strength of long-term US treasuries vs the S&P 500 is shown in the bottom chart. All returns are in USD.

i. AUD

The AUD rose from 0.6718 at the end of September to 0.6893 at the end of October.

The –2.04% fall in the AUD USD exchange rate over the month was a headwind that negatively impacted absolute performance.

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