US Equities, Month-End July 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 73.2% invested in stocks, 22.1% in cash and short-term treasuries, and 4.7% in long-term treasuries.

Model allocations are currently 80% stocks, 10% cash and short-term US treasuries and 10% long-term US treasuries. This is a higher weight to stocks (+10% vs benchmark), offset by an allocation to quality/defensive stocks and an allocation to long-duration bonds.

Current positioning reflects a short-to-medium-term positive view on US stocks. That said, the framework’s score has dropped from +5 to +2 during July. There are a few signs that the score may continue to fall. Further moderation of the score will result in a reduced allocation to stocks.

Here’s a summary of my asset allocation framework as at the 31/7, 30/6 and 31/5.

a. Valuation

Some clients have expressed concerns about the market’s valuation. 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 the S&P 500 (top chart), the change trailing 12-month P/E ratio for the S&P 500 (second from the top), the change in GAAP earnings for the S&P 500 (third from the top) and the total return (including dividends) the S&P 500 (bottom chart).

Over the last three years, the S&P 500 has returned 52.33%. The P/E ratio has been flat (+1.23%) while GAAP earnings have increased by 41.60%.

What’s the point of this chart? 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 risk (i.e. how much prices can change if investor preferences shift) and long-term returns (over a horizon of at least five years); not an indicator that can be used to 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!

Stocks are cheap relative to bonds. Buying a US 10-year Treasury bond with a yield of less than 2% is equivalent to purchasing a stock with no future earnings growth at a P/E ratio of over 50x!

b. Fundamentals

As at 2/8, the Q2 2019 reporting season results were:

  • 77% of S&P 500 companies reported

  • 59% positive revenue surprise (above the five-year average)

  • Revenues have beaten estimates by 1%

  • 76% positive earnings per share surprise (above the five-year average)

  • Earnings have beaten estimates by 6%

This isn’t cause to get too excited. Revenue and earnings estimates for Q2 2019 were lowered, making consensus expectations easier to beat.

As discussed in last month’s client letter, the equity market tends to do OK when earnings growth is weak to moderate (unless there’s a recession).

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. Several late cycle indicators with a reliable history of predicting recessions are flashing caution. An escalating trade war and the 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.

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 happy. Consumer sentiment is very optimistic, which is a long-term contrarian signal. But over-optimism can continue for a while, which is why the time to worry is when confidence starts to deteriorate from a high-level. No sign of that yet.

US House Prices remain in an uptrend. Again, bad news if the trend breakdown. No sign of that yet.

Industrial production has slowed, but remains in an uptrend. a sustained break of the 12-month moving average (i.e. falling industrial production) is a negative indicator. No sign of that currently.

Now for the negatives. The yield curve (3-month minus 10-year US Treasury) remains inverted. An inverted yield curve has been a reliable indicator of past recessions.

Banks borrow short (from depositors) to lend long (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 can 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.

Here’s the yield curve over the last twelve months.

Here’s the yield curve over the last twenty years.

The output gap is another important indicator of a late-cycle economy. The measure compares actual gross domestic product (GDP) with estimated potential GDP.

The output gap 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

· Recession

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.

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. Long-term interest rates are in a downward trend.

Short-term interest rates are also in a downward trend for the first time in over two years.

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.

In summary, Fed policy is accommodative but, tensions between the Fed and the White House are a risk.

e. Sentiment

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

Sentiment continues to yo-yo between over-confidence and outright pessimism. Sentiment was extremely pessimistic in May. The stock market fell by approximately 6% in May, a relatively minor correction, and yet sentiment reached pessimistic extremes across a range of different measures.

The market rallied and by the end of July investors were showing signs of extreme optimism (a contrarian indicator) across a range of measures.

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 weight from 90% to 55% in May along after only a 7% move. They are now advising their clients to be over 90% invested in stocks.

Rydex (Guggenheim) offer a suite of geared long (bull) and short (bear) mutual funds. This chart 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, the bears are hibernating.

Market volatility was really low leading into the end-of-the-month. This is a sign of investor complacency. It has ticked up over the last few days on the back of confusing comments by the US Federal Reserve Chairman Jay Powell and escalating trade war rhetoric by President Trump.

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 (i.e. below 1) suggests investors are complacent.

f. Trend

The S&P 500 remains in an uptrend. The current price is above both the 50-day and 200-day moving averages. Both averages are also sloping upwards (i.e. positive).

That said, there are some signs that the trend may be weakening. For example, the number of stocks in an uptrend (relative to their 50-day moving average) has fallen below its long-term average.

The number of stocks in an uptrend (relative to their 200-day moving average) is also starting to show some weakness.

Breadth is also an issue. The broader US market hasn’t done nearly as well as the S&P 500. For example small cap stocks (the Russell 2000 Index in blue) has underperformed the S&P 500 (black) by appoximately 10%.

g. Gold

Gold has recently broken through a seven-year price resistance level. The prospect of lower interest rates and heightened political uncertainty has see the price of Gold rally significantly in recent months.

The positive move in the gold price really gained momentum in early June when the US Fed started hinting that it may begin cutting interest rates.

Gold is also useful as a portfolio diversifier as it has a low correlation to both stocks and bonds. Historically, the stock of gold mining companies has typically out-performed physical gold during periods when the price of gold is rallying.

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