US Equities Month-End August 2019

Best Ideas – Market Timing

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 81.1% invested in stocks, 8.9% in cash and short-term treasuries, and 9.9% 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 stock weight (+10% vs benchmark), offset by an allocation to quality/defensive stocks and an allocation to long-duration bonds (TLH).

Current positioning reflects a short-to-medium-term positive view on US stocks. That said, the framework’s current score is neutral. 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 31/8, 31/7 and 30/6.

The continued fall in bond yields has seen the relative valuation score improve.

Medium term indicators of sentiment are no longer over-optimistic. Several short-term indicators are showing signs of extreme pessimism. Asset classes and strategies that do well in a risk-off environment continue to outperform; suggesting that investor psychology is in risk-off mode.

Trend is sending mixed messages. The S&P 500 is below its 50-day moving average (short term trend) and above its 200-day moving average (medium term trend). Breadth is weak and there is a lack confirmation from other markets.

a. Valuation

There’s been no change to absolute valuations during August. 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 in the 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 50.78% The P/E ratio has been flat (-1.72%) while GAAP earnings have increased by 41.60%.

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 1.5% is equivalent to purchasing a stock with no future earnings growth at a P/E ratio of 66.67x!

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 +0.42% 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 companies return cash to shareholders) and earnings growth.

b. Fundamentals

Corporate revenues (sales) and earnings continue to rise while corporate profit margins are steady.

Revenue growth has decelerated but it remains positive.

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 OK. Consumer sentiment ticked lower in August. 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.

Industrial production has fallen through its 200-day moving average. As the chart shows, the short-term falls below the trend line followed by quick reversals 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 adjust our views as the evidence changes.

Now for the negatives. The yield curve (3-month minus 10-year US Treasury) has inverted further. The 3-month interest rate now sits almost half a percent 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 banks 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.

We covered the output gap in last month’s asset allocation update. It remains positive and indicates that the US economy is currently late in the economic cycle.

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 (for the first time in two years).

Long-term interest rates are also in a pronounced downward trend

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.

Powell 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 over August to further lambaste Powell describing him variously as a golfer who can’t putt and a bigger enemy to the American people than Chinese Premier Xi.

In the end I think it’s the market that will win his argument. Further inversion of the yield curve is a clear sign that market’s believe short-term interest rates are too high.

Currently the market is pricing in a 97% chance of a 0.25% rate cut when the Fed next meets on the 18/9 (CME Fed Watch).

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.

The over-optimism present at the end of July is now gone. Medium-term indicators of sentiment have yet to reach levels of extreme pessimism (they aren’t far off). Short-term measures of sentiment have reached pessimistic extremes. Historically, short-term pessimism is associated with higher equity returns over the next few months (on average).

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 after only a 7% change. They were over 90% invested in stocks at the end of July, more than 20% above their long-term average allocation.

They cut their equity allocations in August to 58% (approximately 12% underweight) only to increase their allocations back to the long-term average range of 70-75%.

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 below 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. The score has since recovered but it remains in bearish territory. This is a positive for the stock market.

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 woke up from their hibernation in early-August. Money invested in bear funds has continued to increase over the month.

It’s a positive sign that the investor complacency seen at the end of July has evaporated during August.

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 has since begun to moderate. That said, it remains high at approximately 19.

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 high ratio (i.e. above 1) suggests investors are fearful. The chart below shows that the 10-day moving average Put/Call ratio is high.

Another way to get an insight into investor psychology is to compare the performance of risky vs defensive assets and investment strategies.

For example, the chart below compares the performance of the S&P 500 Low Volatility index versus the S&P 500. Low volatility stocks have out-performed the broader market by 13.20% over the last few months.

The next chart compares the performance of the S&P Dividend Aristocrats (high quality companies with stable and growing dividends) versus the S&P 500. The S&P Dividend Aristocrats have outperformed the S&P 500 by 3.61% over the last 12 months.

The out-performance of low volatility, high-quality and high dividend stocks suggests that investors are still concerned about the sustainability of the current bull market.

f. Trend

Trend is sending mixed messages. The S&P 500 is below its 50-day moving average (short term trend) and above its 200-day moving average (medium term trend). The slope (or rate of change) of the 50-day moving average is negative, while the slope of 200-day average remains positive. Short-term trend is down, while the medium-term trend remains up.

Breadth is weak. The number of stocks currently trading above their 50-day moving average (43%) is below the 200-day moving average (approximately 60%).

The number of stocks currently trading above their 20-day moving average (59.6%%) is worryingly close to the 200-day moving average (approximately 56%) 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 -2.66%. In other words, the S&P 500’s performance has been driven by a subset of stocks.

Market trends are also more likely to persist if they’re confirmed by other markets. The chart below shows that US small caps (Russell 2000 index) have under-performed the S&P 500 by -14.26% over the last 12 months. All returns are in USD. No confirmation from small cap stocks.

Also, no confirmation from global stocks. The chart below shows that global stocks (MSCI All Country World Index) have under-performed the S&P 500 by -24.25% over the last 12 months. All returns are in USD. It’s less likely that the US can sustain its upward trajectory if the rest of the world is in the doldrums.

We can also compare the performance of stocks vs bonds. US 10-year Treasury bonds have beaten the S&P 500 by 9.18% over the last 12-months.

The High Low Logic Index is flashing a warning signal. This index is calculated using the number of stocks making new highs and lows. I won't bore you with the calculations but the idea is simple. A high index value (above 4) = lots of stocks making new highs and lows at the same time. In other words, there's a lot of churn and no clear direction up or down. This usually happens at an inflection point in a trend. The High Low Logic Index is now over 7 and well above its October 2018 level.

I’d like to end this section on a positive note. Unusual changes in volume often accompany changes in trend. The chart below shows up volume (i.e. the traded volume of stocks increasing in price) as a percentage of total traded volume.

In late-December 2018 and early-January 2019 the New York Stock Exchange (NYSE) there were two days where the traded volume in advancing stocks was more than 90% of the total traded volume. Historically, extreme upside volume has accompanied the beginning of an uptrend. This occurred around the time of the reversal of the bear market starting on the 26/12.

The NYSE had a 90% up day on 16/8 and two 80% up days on 28/8 and 29/8. Studies have shown that two 80% up days in close succession also indicate the beginning of an uptrend.

g. Gold

Gold has continued its breakout of a seven-year price resistance level. The prospect of lower interest rates and heightened political uncertainty has seen 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.

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 +0.0.23 % in August.

Best Ideas Market Timing also invests in TLH – the iShares Long-Term Treasury ETF. The price return for TLH was +6.65% in August.

The price return for TLH has been 19.26% 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.

i. AUD

The AUD fell from 0.6894 on 31/7 and finished the month at 0.6718.

The -2.6% fall in the AUD USD exchange rate over the month was a tailwind that helped absolute performance.

The chart below shows the 12-month performance of the AUD, which has fallen -6.7%.






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