Another man's vivid image of markets which resonates with me. Bull markets die hard! It takes time for one to form a top. Bear markets, on the other hand, generally end with what I have called a waterfall decline, a "puking" phase, or a selling climax. (See my posts during 2008 and 2009.) This asymmetry of stock market phases has dictated my asymmetric money management approach. During the bull phase, I rebalance my equity exposure back to my core 30% position as the Standard and Poor's 500 Index (the "Index") becomes more and more overvalued according to Shiller's CAPE ratio*. On the other hand, during the bear phase, I rely only on technicals --trading volume, market breadth, and price -- to confirm a market bottom. At that point, time is of the essence; and my adjusted CAPE ratio determines how much I add to my equity risk exposure.
At 2578 today, the Index became close to 89% overvalued according to Shiller. In previous posts, I have mentioned that 90% would be a call to action. To me, the tax decreases likely to be passed have already been discounted by the market. And any meaningful tax code overhaul will be a long slog. Today I rebalanced my equity exposure back to my core 30% of financial assets. Next stop: Shiller's 100% overvaluation.
The "Search For Yield" Trap
As you know, I believe in mean reversion in both stock P/Es and bond yields. I also feel that Shiller's CAPE ratio is helpful in determining how far stock P/Es have strayed from their mean. As stocks and bonds both become more overvalued, I reduce risk in both of these asset classes. In certain circumstances, like now, cash becomes a legitimate asset class.
A good example of this is how I have managed my two daughters' financial assets. Their core equity exposure over the last several decades has been an aggressive 100% of their financial assets. Originally, the money was invested equally in four no-load equity mutual funds--a Standard and Poor's 500 Index fund, and three T. Rowe Price funds with a higher risk: New Horizons, Small Cap Value, and New Asia. So 75% of the accounts were then in funds with a higher risk than in the Index.
As the Index became more overvalued, I have been reducing the equity risk exposure in these accounts, with the proceeds invested in cash equivalents because bonds are overvalued as well. Now the equity exposure is 55% of financial assets, with 45% in cash. Furthermore, the composition of the equity exposure has changed. Now 50% of the accounts are in the Index fund, with only 50% in the higher risk funds.
As stocks and bonds become more overvalued, many money managers are compelled to do the opposite: they are increasing risk in their clients' accounts. This is due to managers' abhorrence of
cash. In fixed income, their search for higher yield takes them from U.S. government bonds to investment-grade U.S. corporates to high-yield U.S. corporates to emerging market corporates. In equities, as the Index becomes more overvalued, they go farther out on the risk spectrum by investing in, for example, emerging market funds.
This makes no sense to me; for their clients, this will end badly!
* An arcane point--in calculating his CAPE ratio, Shiller uses the average earnings (adjusted for inflation) over the last ten years. During the Great Recession which began in late 2007, Index annual operating earnings fell from 91 to 40 in eight quarters. During the next eight quarters these depressed earnings (adjusted for inflation) will be dropped and the expected strong current earnings will replace them. Absent a recession during this period, the result will be an additional significant temporary jump in Shiller's earnings in each of the next two years -- thus putting downward pressure on the CAPE ratio. However, during the next recession, this positive impact on Shiller's earnings will ultimately be reversed. Nevertheless, short term, this will be grist for the bulls' mill.
Monday, October 23, 2017
Tuesday, May 23, 2017
EXPECTED STANDARD AND POOR'S 500 INDEX TOTAL RETURNS
I was recently asked to write an article on observations gleaned over a half century of investing. Following is one observation.
MOST OF THE TIME STOCKS ARE THE PREFERRED ASSET—BUT NOT ALWAYS.
When the Standard and Poor's 500 Index ("the Index") is selling at its mean CAPE ratio, its expected compound annual return is 8% to 9%—6% to 7% from earnings growth and two percentage points from reinvested dividends. The 10-year U.S. Treasury note yield has averaged 6.4%, albeit with less risk than the Index. Treasury bills yield even less, but with almost no risk. Almost always, the Index outperforms U.S. Treasury fixed income.
However, in late December, 1999, a rarity occurred. The Index was more than 100% overvalued; and zero-coupon Treasury securities, from 5 to 25 year maturities, were yielding 6% to 7%. According to my analysis at that time*, if the Index’s P/E ratio reverted to its mean at any time before each of those 5 year intervals, the Treasury notes and bonds would outperform the Index! At that time the Index was 1435. Following are the results of my study.
Index Index
Mean Reversion Expected Compound Zero Treasuries'
by Year-End Annual Return** Yield to Maturity
2004 -3.3% 6.2%
2009 2,5% 6.5%
2014 4.4% 6.7%
2019 5.4% 6.5%
2024 5.9% 6.4%
**Including reinvested dividends
This year, in early March, the Index reached 2400. Since my study 17 years ago, the Index has compounded at 3.1% annually. Add 2 percentage points for reinvested dividends, and the total compound annual return has been a mere 5.1%—in line with my expectation shown in the table. The bond with that maturity yielded 6.6% at the time of my study—a 29% higher return with LESS RISK.
*This analysis was part of an article published in the December 27, 1999 issue of Barron's.
FUTURE RETURNS FROM HERE
In the same vein, I thought it might be interesting to calculate future total Index returns using the same methodology from 17 years ago. With that in mind, I have calculated what Index returns can be expected if mean reversion occurred immediately, within five years , or ten years. For the Index's mean CAPE ratio, I use my adjusted 19.8. The Index is currently again at 2400.
Index
Expected
Index Compound
Mean reversion Annual Return***
Immediately -33.0%
Within Five Years 0.7%
Within Ten Years 4,8%
***Including reinvested dividends
Were a cataclysmic event to occur, causing immediate mean reversion, the Index would drop 33.0%, to 1600. I would take an out-sized Index position at that price. Mean reversion within five years would result in an expected compound annual total return of a mere 0.7%; and within ten years 4.8%. This compares with a normal 8% to 9% total compound annual return for the Index. $100,000 invested at 4.8% a year reaches $160,000 in ten years; at 8.5%, it reaches $226,000—the beauty of compound growth, the “eighth wonder of the world!”
Saturday, March 4, 2017
"ANIMAL SPIRITS", the SNAP IPO, and CalPERS
The Standard and Poor's 500 Index ("the Index") flirted with 2400 last Wednesday. At that level, the Index became 80% overvalued according to Shiller's CAPE Index. He uses a mean P/E multiple of 16.7 to determine fair value. That is the mean over 145 years. I use a mean P/E of 19.6, the mean over the last 50 years. According to my approach, the Index is 50% overvalued. No matter how you slice it, the Index is way overvalued. If the Index reverted to fair value immediately, according to my valuation approach, it would decline by a third to roughly 1600.
As I have written in previous posts, whenever the CAPE becomes ten percentage points more overvalued, it triggers an automatic rebalancing of my equity exposure back to 30% of my financial assets. Accordingly, yesterday I rebalanced.
Recently, the phrase "animal spirits" has appeared frequently in investment news letters. "The animal spirits are behind the stock market melt up since the Trump victory." "This is only the beginning of the last phase of the bull market that began eight years ago this month."
This week's SNAP IPO is evidence of this phenomenon. It is the first large tech company to go public in quite some time. The offering was priced at what I would euphemistically describe as "full" and then appreciated 50%! Shades of 2000 when the dot.com bubble burst--when Professor Shiller published his book "Irrational Exuberance" almost exactly at the top of that bull market. (That effort won him the Nobel Prize for Economics.)
Furthermore, the percentage bulls at Investors Intelligence reached its highest level since 1987!
Another example of a pricey stock market is that CalPERS, the California public employees retirement fund, one of our country's largest institutional investors. recently reduced its long-term expected return on its assets from 7.5% to 7.0% and announced this week that it would reduce it again! (According to my calculation, a conventional 60% stock/40% bond portfolio would, at best, return 2% during the next five years if a reversion to stock and bond market means occurred during that period.)
Unfortunately, the "animals" are the retail investors, many of whom have missed the entire move in the Index from 666 in March, 2009 to roughly 2400 last Wednesday. It is a shame that, historically, the retail investor tends to buy at the tops of bull markets and sell at the bottoms in bear markets. (This is borne out by mutual fund inflows and outflows.) This behavior wreaks havoc with baby boomers' retirement funds.
Yes, the animal spirits could propel the Index higher from here. I look upon such a happening as an opportunity to rebalance again. This raises the question "How overvalued must the market be to warrant your selling your entire equity position?"
If the Index soon reached 3200 (up a third from here) and the U.S. Treasury note yield reached 4% (it is now at 2.5%), I would liquidate the entire equity position and buy the Treasury note. While such an overvaluation did occur in 2000 when the Index reached its most overvalued in at least a century, I attach a de minimis probability to that event, (See my recent post entitled "WAITING FOR GODOT" for why I think so.) Meanwhile, for financial planning purposes, I assume that the Index valuation reverts to its mean P/E of 19.6; and I take a "haircut" of one-third off the current equity valuation for a more accurate view of reality. I find this especially useful for long duration accounts such as my grandchildren's Section 529 college savings plans.
As I have written in previous posts, whenever the CAPE becomes ten percentage points more overvalued, it triggers an automatic rebalancing of my equity exposure back to 30% of my financial assets. Accordingly, yesterday I rebalanced.
Recently, the phrase "animal spirits" has appeared frequently in investment news letters. "The animal spirits are behind the stock market melt up since the Trump victory." "This is only the beginning of the last phase of the bull market that began eight years ago this month."
This week's SNAP IPO is evidence of this phenomenon. It is the first large tech company to go public in quite some time. The offering was priced at what I would euphemistically describe as "full" and then appreciated 50%! Shades of 2000 when the dot.com bubble burst--when Professor Shiller published his book "Irrational Exuberance" almost exactly at the top of that bull market. (That effort won him the Nobel Prize for Economics.)
Furthermore, the percentage bulls at Investors Intelligence reached its highest level since 1987!
Another example of a pricey stock market is that CalPERS, the California public employees retirement fund, one of our country's largest institutional investors. recently reduced its long-term expected return on its assets from 7.5% to 7.0% and announced this week that it would reduce it again! (According to my calculation, a conventional 60% stock/40% bond portfolio would, at best, return 2% during the next five years if a reversion to stock and bond market means occurred during that period.)
Unfortunately, the "animals" are the retail investors, many of whom have missed the entire move in the Index from 666 in March, 2009 to roughly 2400 last Wednesday. It is a shame that, historically, the retail investor tends to buy at the tops of bull markets and sell at the bottoms in bear markets. (This is borne out by mutual fund inflows and outflows.) This behavior wreaks havoc with baby boomers' retirement funds.
If the Index soon reached 3200 (up a third from here) and the U.S. Treasury note yield reached 4% (it is now at 2.5%), I would liquidate the entire equity position and buy the Treasury note. While such an overvaluation did occur in 2000 when the Index reached its most overvalued in at least a century, I attach a de minimis probability to that event, (See my recent post entitled "WAITING FOR GODOT" for why I think so.) Meanwhile, for financial planning purposes, I assume that the Index valuation reverts to its mean P/E of 19.6; and I take a "haircut" of one-third off the current equity valuation for a more accurate view of reality. I find this especially useful for long duration accounts such as my grandchildren's Section 529 college savings plans.
Saturday, January 7, 2017
Sentiment Indicator Flashes RED!
I wrote a post December 26, 2013 whose title was a famous Mark Twain quote, "History doesn't repeat itself, but it does rhyme!" I discussed how, as a contrarian investor, I find extremes in investors' bullishness and bearishness to be calls to action--selling when a bullish extreme occurs and buying when a bearish one is reached. In short, I view sentiment as a contrary indicator.
The sentiment indicator I have followed for decades is the weekly Investors Intelligence Sentiment Index Survey ("II"). If the percentage of bullish investors reaches 60% or more and the percentage of bearish investors 20% or less, that's a call to reduce my risk exposure to equities.
In that post I discussed how this call to action occurred five times during the last 25 years, and the average change in the Standard and Poor's 500 Index ("the Index") one year later was a MINUS 2.6% compared to average appreciation per year of 6% to 7% during that period. On the surface, this relative performance is outstanding! However, it is due primarily to having nailed the 2007 top in that bull market, from which there occurred a 39% drop in the Index during the ensuing year. The other four observations were false positives, albeit three led to subpar appreciations during the following year, but one was a glaring error with an above average appreciation of 12.4%.
At that time, I reduced my exposure to equities from 42% of financial assets to my core level of 30% due to that extreme in bullishness. In hindsight, that was a mistake! The Index appreciated 14% during the following year! So that was another glaring false positive. Still the average appreciation for the six observations during the last 28 years is still only a plus 0.2% a year. One might argue that we could experience another half dozen consecutive false positives and still the overall performance would be good.
The latest II reading is 60.2% bulls and 18.4% bears. Despite evidence that this sentiment indicator seems to be losing its predictive value, I did rebalance again back to my 30% core equity exposure. This is in addition to my rebalancing a few weeks ago when the Shiller CAPE ratio reached 28. So now both valuation and sentiment indicators are flashing RED!
The sentiment indicator I have followed for decades is the weekly Investors Intelligence Sentiment Index Survey ("II"). If the percentage of bullish investors reaches 60% or more and the percentage of bearish investors 20% or less, that's a call to reduce my risk exposure to equities.
In that post I discussed how this call to action occurred five times during the last 25 years, and the average change in the Standard and Poor's 500 Index ("the Index") one year later was a MINUS 2.6% compared to average appreciation per year of 6% to 7% during that period. On the surface, this relative performance is outstanding! However, it is due primarily to having nailed the 2007 top in that bull market, from which there occurred a 39% drop in the Index during the ensuing year. The other four observations were false positives, albeit three led to subpar appreciations during the following year, but one was a glaring error with an above average appreciation of 12.4%.
At that time, I reduced my exposure to equities from 42% of financial assets to my core level of 30% due to that extreme in bullishness. In hindsight, that was a mistake! The Index appreciated 14% during the following year! So that was another glaring false positive. Still the average appreciation for the six observations during the last 28 years is still only a plus 0.2% a year. One might argue that we could experience another half dozen consecutive false positives and still the overall performance would be good.
The latest II reading is 60.2% bulls and 18.4% bears. Despite evidence that this sentiment indicator seems to be losing its predictive value, I did rebalance again back to my 30% core equity exposure. This is in addition to my rebalancing a few weeks ago when the Shiller CAPE ratio reached 28. So now both valuation and sentiment indicators are flashing RED!
Subscribe to:
Posts (Atom)
