Every month, Steve reviews several market valuation metrics in an effort to provide visibility into forward 7- and 10-year returns. In this week’s On My Radar, Steve looks at Median P/E and Warren Buffett’s favorite measure, Total Stock Market Cap to Gross Domestic Product. Additionally, Steve shares GMO’s 7-Year Asset Class Real Return Forecasts. It’s a must-read!READ MORE
My favorite trend following indicator is something we co-created with Ned Davis Research. It looks at the underlying trends in 22 industry sectors and scores the weight of evidence on a 0 to 100 scale. Here is the chart if you haven’t seen it before (note: I post it every Wednesday afternoon in Trade Signals). The trend for equities is currently bullish.
What about bond exposure? We monitor the Zweig Bond Model.
Please refer to the March 10, 2017 post of On My Radar for an explanation of how it works.
Finally, I believe the key to investing and perhaps the most important lesson to learn is how money compounds over time. To that end, I wrote a piece called the “Merciless Mathematics of Loss.” Next is the chart and you can find the full piece here.
The number one rule many of us were taught is “Don’t Fight the Fed.” I like to add “trend” into that equation and, as you’ll see in the next chart, the math is compelling.
When the Fed raises rates (don’t fight them) and the trend turns negative, equities underperform. Focus on the red arrows. Two different time periods are measured, however, the message is the same. The big corrections come when both the Fed and trend turn negative. I wrote some time ago in On My Radar to “watch out for minus 2.” We currently sit at -1. I’ll share this chart from time to time – especially if -2 is triggered.
Here is how you read the chart:
- The top section plots the S&P 500 Index but focus on the middle section.
- NDR has a Multi-Cap Tape Composite Model to measure the technical health of the broad equity market. That model aggregates the signals of over 100 component indicators and generates a signal based on the percentage of the component indicators that are giving a bullish signal for the S&P 500. It measures momentum and trend.
- The Fed component is really an interest rate component, which measures the trend in rates by looking at the yield on the 10-year Treasury note. When the 10-week trend in yields are lower than their 70-week trend in yields, the S&P 500 has produced larger gains. When it is higher, the S&P 500 has performed poorly. It’s that simple.
- The combined indicator can produce a score of -2 (both indicators are bearish) to +2 (both bullish) and overall have done a good job historically as a risk-on/risk-off indicator.
- The current reading is -1 (data shows we need to watch out for -2): refer to the red arrows.
Source: Ned Davis Research
Last week, the investment staff of CalPERS — the $300 billion California pension fund — announced that they want to reduce its target of 7.5 percent annual returns. According to Chief Investment Officer Ted Eliopoulos, achieving a 7.5 percent annual return is no longer realistic. Holy cow!
The implications of this proposal, if adopted, are significant and “would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.”
Can you imagine how many people are going to be affected? Here’s the bottom line. The pension system, across our great nation, is underfunded and in trouble.READ MORE
Interesting chart from Ned Davis Research. Most people believe that Republican control is pro-business and thus good for stocks.
Early each month, we look at market valuations to see where we are. It’s also important to consider what valuations may indicate with respect to probable (7- and 10-year) forward returns. We believe risk is most when we feel it least and the risk is least when we feel it most. Today, we feel it least.
In Friday’s On My Radar, we presented several valuation charts, including median price-to-earnings (P/E) and Warren Buffett’s favorite.
Bottom line: the market remains overvalued. Trend following strategies can help you participate and protect.
Nasdaq looks to have made an important bottom. This may set up a year-end rally.
Several things to note on the following chart. The most important is that the Nasdaq held support line marked by the November low (green arrow), the September high (red arrow) and the July low (green arrow). Also, volume expanded on yesterday’s large turnaround. Further, the stochastic lines are turning higher from an oversold reading below 20. In short, this is a nice set up for a year-end rally.
“Many equity investors are feeling okay right now. Yes, the 2008 financial crisis was downright scary, with exploding credit spreads, disappearing financial institutions, and sharply declining stock market. However, if investors have stayed in equities since then, their wounds have healed.
The market had a Tepper Tantrum last week. We all know what a taper tantrum is after the Fed backtracked on tapering its bond buying program last year. But what is a Tepper Tantrum?
David Tepper, aside from being a fellow Carnegie Mellon alumnus, is one of the most well-known money managers in the world. His firm, Appaloosa Management, manages more than $20 billion. More importantly, Mr. Tepper has been right about equity markets.
Since the financial crisis, few investors have matched Tepper’s track record. His ability to read the tea leaves of Fed policy has made him a market sage. So when David Tepper speaks, the market listens. It didn’t like what it heard last week, namely, that it’s time to take some chips off the table. Mr. Tepper didn’t really say anything new; many market observers (ourselves included) have been highlighting the elevated risk at these equity market levels, but investors like winners, and Tepper’s winning calls have made him the highest paid hedge fund manager over the last two years.
Advisors are wondering: What percentage of equity should I hold in my client portfolios? How frothy is this market? Is it time to get more defensive?
The short answers: this market is expensive – stay cautious. Hedge long-term equity exposure.
How do we realize this? On the chart below, the table shows stock market performance six-months to five years after over- or under-valuation is reached.
In the bottom clip, note the S&P’s current price to its Normal Valuation Line (dotted red middle line) and the zones that identify valuations to be “overvalued” or “undervalued”. The yellow circle identifies current valuation. The idea is to get a sense of a market that is above or below its normal valuation. When the S&P 500 is 20% above its normal valuation, we consider it overvalued; at 20% below normal we consider it undervalued.