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
In their May market review, Arthur Grizzle, CFA and Charles Culver of Martello Investments wrote an article called “Markets in a Post-Volatility World.”
We wanted to share the following selected bullet points from the piece:
- Market Volatility: Global equity markets, and especially the US stock market, have shown remarkable resilience despite elevated valuations and an onslaught of negative news.
- The last few months have seen increased dysfunction in Washington, rising geopolitical tension particularly saber-rattling from North Korea and increased terrorism in Europe, weak economic growth, and the prospect of the Fed unwinding nearly a decade of stimulative monetary policy.
- Nevertheless, market volatility sits near historic lows on both an implied and realized basis.
- Structurally, investors can analyze market volatility in two distinct ways: realized volatility (how volatile something has been historically) and implied volatility (expectations for future volatility based on the price of derivatives).
- In both cases, US stocks have shown dramatically low levels of volatility in recent years. Implied volatility is easiest tracked using the CBOE Market Volatility Index (VIX), which derives its price from the implied volatility of options on the S&P 500 Index.
- In May, VIX broke under 10 for the first time since 2007. Indeed, there have been only two other periods since 1990 that the VIX reached a 9-handle; one was in late 1993 through early 1994, and the other in late 2006 through early 2007.
- In each case, the index ultimately re-rated to higher levels, though in only the more recent example of 2006-2007 was this eventually accompanied by lower equity prices.
In Friday’s On My Radar, Steve posted his “Charts of the Week.” Be sure to click below to view charts regarding market volatility and the VIX, fund flows between passive and active managers, stocks of companies involved in robotics and artificial intelligence, probability of further interest rate increases and currency valuations.
Stay informed!READ MORE
At a conference in Chicago last week, following up on a recent On My Radar, Keep Dancing but with a Sharp Eye on the Tea Leaves, an advisor client asked me what my favorite “tea leaf” might be. When one of the greatest investors of our time, Ray Dalio, tells us to keep an eye on the exit door we should take note. But how? And when? There is no perfect indicator, but there are a few very good ones and it’s been my experience that simple is best and trend following works well.
Since we were talking about the economy and the stock market and since all the bad stuff in the stock market happens during recessions, my answer was to watch the trend in the high yield bond market. The players have a keen eye toward the economy and potential default risks in the bonds they own. Thus, in my view, high yield tends to be a pretty good “tea leaf.”
Watching the trends every day since the early 1990s has taught me that the high yield market generally leads the equity market by six months or so. It’s not exact, but in my 25 years of trading high yield, it’s been my observation (with real money on the line) that high yield is sensitive to the economy and tends to lead equities lower. I believe it is because high yield bond managers are razor-focused on changes in their underlying bond credits (default risks) and react just a bit faster than equity investors. More sellers than buyers drive prices lower.
So how can you keep your eye on this? Following is a weekly chart of the PIMCO High Yield Fund going back 19 years to 1998. The chart shows weekly price data. The orange line is a simple 13-week smoothed moving average price trend line. When the current price drops below the smoothed trend line, a sell signal is triggered.
I remember taking a lot of heat from clients in 1999. High yield rolled over in 1998 while the tech bubble bubbled on. Then it broke. Avoided were the recessions in 1991, 2000-02 and 2008-09.
Here is the chart and how to read it:
- The data is weekly price data for the PIMCO High Yield Fund (PHIYX).
- The orange line is the 13-week moving average line. Think of it as a smoothed moving average of the trend in price over the preceding 13 weeks.
- When the price drops below its trend line, that’s a warning signal (red arrows).
- When the price moves above the trend line, it is a buy signal (green arrows).
- Note – arrows show only a few of the signals to give you a sense of how it works. More attention should be paid late in a business cycle (like today).
It’s important for me to say that we use a trend following process that triggers more quickly than the above for our high yield trading, but the point is that trend following can help you gauge turning points in the economy and the stock market. High yield is a leading indicator for both the economy and for equities. Experience has taught me it is a tea leaf worth watching. Of course, past performance does not predict, indicate or guarantee future results.
In recent years, there has been a proliferation of academic research that evidences the positive benefits of trend following. I’m a trend follower and have been since I founded my business in 1992. Maybe I was just optimistic when I started, but many years and a track record I’m proud of tells me it works. The reason is tied to our human behavioral tendencies. I’m not sure why but we humans seem to wash, rinse and repeat and in that is your and my opportunity.
AQR’s Brian Hurst, Yao Hua Ooi and Lasse Heje Pedersen authored a white paper in 2014, “A Century of Evidence on Trend-Following Investing.”
Trend-following investing has performed well in each decade over more than a century as far back as we can get reliable return data for several markets. Our analysis provides significant out-of-sample evidence across markets and asset classes beyond the substantial evidence already in literature. Further, we find that a trend-following strategy has performed relatively similarly across a variety of economic environments, and provided significant diversification benefits to a traditional allocation. This consistent long-term evidence suggests that trends are pervasive features of global markets.
Trend following is integral to our investment approach at CMG. Click below to read more about trend following and the research that demonstrates the validity of the approach.READ MORE
The Fed raised rates last week and bond yields sank lower. Many expected the opposite reaction. If you missed last summer’s mortgage refi opportunity, I believe you are going to get another chance. Interest rates appear to be heading back down towards their July 2016 lows.
And what are the implications of Fed policy on the U.S. stock market? Ned Davis Research’s Ed Clissold pointed out in a tweet late yesterday, “Today’s #FOMC decision is a reminder that even slow tightening cycles eventually impact the stock market. #fed @NDR_Research.”
The chart Ed shared in his tweet follows. Here is how to read it:
- NDR compares market gains during slow tightening cycles (black line in chart) vs. fast tightening cycles (red line in chart) vs. non tightening cycles (green line in chart), and more.
- It looks at what happened historically to the stock market in periods when the Fed was quickly raising rates vs. slowly raising rates – like the current cycle.
- The purple line is the current Fed tightening cycle that began in December 2015.
- Note how NDR breaks out % Gain During 1st Year and % Gain During 2nd Year. We now find ourselves in year 2. Purple line (right-hand side of chart).
- Year 1 gains averaged 10.8%
- Year 2 gains averaged -1.8%
- The green line shows non-cycles… markets do better when the Fed is lowering (easing), not raising (tightening), interest rates. “Don’t fight the Fed” as they say.
In Friday’s On My Radar, Steve Blumenthal wrote, “Last Monday, the VIX broke below 10 to close at 9.77, the lowest level in more than a decade. There are only three other days the index has closed at lower levels, all of them in December 1993. Investors are complacent to risk. They shouldn’t be.”
Investment consulting firm 720Global also recently wrote about market volatility in The Unseen, “Volatility: A Misleading Measure of Risk.”
As investors, we are negligent if we follow the Fed’s lead into this complacent stupor. By prodding economic growth with unproductive debt and reigniting asset bubbles, the central banks have simply done more of what created the spasms of 2008 in the first place. Despite the markets calm façade and historically low perception of risk, the vast chasm that lies between perceived risk and reality is troublesome.READ MORE
In the May 5th issue of On My Radar, Steve Blumenthal provides his popular survey of current market valuation and 10-year forward returns forecast.
First, Steve offers a quick primer on valuation and price-to-earnings (P/E) in layman’s terms. Most investors (and even some financial advisors) don’t understand valuation methodologies and how median P/E works and what it tells us.
Steve presents a number of informative charts that advisors can use in their own valuation work and to discuss valuation and forward returns with their clients.
In sum, the broad market (i.e., S&P 500) remains very expensive and overvalued according to several metrics and 10-year forward returns are likely to be muted (0%-3% before inflation). Steve says, “We clearly find ourselves today in a high valuation and low potential forward return environment.” Click below to access the charts and Steve’s analysis!ON MY RADAR
Following a two-day meeting of the policy-making Federal Open Market Committee (FOMC), the Federal Reserve held current interest rates steady, but the central bank is likely to raise rates in the coming months (possibly in mid-June). Fed officials are not worried about the slow pace of growth during the first quarter of 2017. (U.S. GDP grew at an annualized rate of 0.7 percent.) The Fed said the slowdown was “likely to be transitory.”
“Inflation measured on a 12-month basis recently has been running close to the committee’s 2 percent longer-run objective,” the Fed said. Household spending rose “only modestly” but the fundamentals underpinning consumption growth “remained solid.”
Declines in the unemployment rate has been the primary driver behind the Fed’s recent rate increases. The unemployment rate fell to 4.5 percent in March, the lowest level since 2007. (The Labor Department will release the April jobs report on Friday.)
Credit Suisse recently published a research paper “The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer U.S. Equities.”
Following are the main findings:
- There has been a sharp fall in the number of listed stocks in the U.S. since 1996.
- While listings fell by roughly 50 percent in the U.S. from 1996 through 2016, they rose about 50 percent in other developed countries. As a result, the U.S. now has a listing gap of more than 5,800 companies.
- The propensity to list is now roughly one-half of what it was 20 years ago. The net benefit of listing has declined.
- Mergers and acquisitions (M&A) are the leading reason for delisting, and initial public offerings (IPOs) are the primary source of new listings. In the last decade, M&A has flourished while IPOs have floundered.
- Regulation has increased the cost of listing and facilitated meaningful M&A.
- As a consequence of this trend, industries are more concentrated and the average company that has a listed stock is bigger, older, more profitable, and has a higher propensity to disburse cash to shareholders.
- Exchange-traded funds have filled part of the list gap.
Click below for more on this important report and our take of the impact of fewer U.S. equities.ON MY RADAR