March 10th, 2015
X-factor Report 09 March 2015
by Lance Roberts, StreetTalk Live
This past week, I penned a piece entitled "You Think Like A Bear But Invest Like A Bull?" that discussed the disconnect between my writings and the "Bullish" posture of the portfolio.
However, when that reversion process occurs is anyone's guess.
Therefore, while the analysis suggests that portfolios should be heavily underweighted 'risk,' having done so would have led to substantial underperformance and subsequent career risk.
This is why a good portion of my investment management philosophy is focused on the control of 'risk' in portfolio allocation models through the lens of relative strength and momentum analysis.
The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as 'greed' and 'fear' overtake logical analysis.
I have discussed the effect of 'full market cycles previously' as shown in the chart below."
"By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated to rising markets while managing the inherent risk of behavioral dynamics.
This is why, despite the fact that I write like a "bear," the portfolio model has remained allocated like a "bull" during the markets advance. The point is simple, our job as investors is to make money when markets are rising. We can debate the valuation metrics and argue with each other why markets should not be rising, and eventually those arguments will be correct. However, for now markets are rising, and we need to participate until the trends change to the negative. Of course, if your current portfolio management philosophy does not have a method to understand when "trends" have changed, how will you know when it is time to step away from the poker table?"
With this in mind let's take a look at the current trend of the market.
S&P 500 Bull Trend Remains
Currently, there is little evidence that the current bullish trend in equities is over. As shown in the chart below, the current trend is still directionally higher, and the longer-term moving averages are still providing substantial levels of resistance against dramatic declines.
However, the weekly short-term buy/sell indication is close to registering a "sell signal" that suggests that the current correction in the market may have further to go. A retest of support at 2016 is very possible currently which would provide investors an opportunity to rebalance equity exposures in portfolios.
- Will this eventually change? Yes.
- Will a bearish trend eventually emerge that devastates a large portion of investor wealth? Absolutely.
- Is that now? No.
In a momentum driven market things like fundamental valuation metrics, macro-economic analysis, and other data-driven quantitative and qualitative measures give way to "psychology."
Dr. Hussman's analysis will eventually be proven extremely correct; however, in the short-term Dr. Momentum holds all the "aces" in this poker-game. Therefore, for now, we must remain allocated to the markets.
Warning Sign 1: Margin Debt
It is not the "rise" in margin debt that is worrisome. As long as margin debt is rising it is providing support to rising asset prices. However, as Norman Fosback, former President of the Institute for Econometric Research, pointed out in his book "Stock Market Logic", it is the fall:
"If the current level of margin debt is above the 12-month average, the series is deemed to be in an uptrend, margin traders are buying, and stock prices should continue upwards. By the same line of reasoning, sell signals are rendered when the current monthly reading is below the 12-month average. This is evidence of stock liquidation by margin traders, a phenomenon that usually spurs prices downward."
As shown in the chart below, only for the 4th time since 1995 have margin debt levels fallen below their 12-month moving average. (There was a small tick below the 12-month average in 1998 during the Asian-Contagion/LTCM crisis)
Each decline below the 12-month average in the past has coincided with fairly large market corrections. While the current decline in margin debt does NOT mean that we are about to enter into the next major market reversion, it does suggest that the current bull market trend could be at substantial risk.
Lastly, we can take a look at the Relative Strength of margin debt as compared to the S&P 500 going back to 1959. While declining levels of relative strength are not ALWAYS indicative of a decline in asset prices, there is a fairly high correlation when the RSI begins to fall from 80 or above to 60 or below. Currently, RSI for margin debt is at 58.06.
As I summed up previously:
"What the data does not tell us is whether it [the next correction] will be a 'buy the dip' opportunity or something much more significant. Given the length of current economic expansion and cyclical bull market, the fact that the Fed is extracting liquidity from the markets, and the current extension of the markets above their long-term moving averages, there is cause for real concern."
Warning Sign 2: Stock Buy Backs
One of the biggest drivers of the stock market over the last couple of years has been the rush by companies to repurchase shares of their stock. This is NOT a sign of "bullishness" by corporate executives of the company's future prospects as it is a sign of stock price and earnings manipulation.
Let's take a look at Apple (AAPL) as an example.
In 2014, EPS for Apple grew from $5.72 per share to $6.49 per share which was an annual increase of 13.4%. Top line sales grew from $170.91 to $182.80 billion or an annualized gain of just 6.96%.
So, how does a company like AAPL effectively DOUBLE a topline sales gain of 6.96% for a bottom line earnings increase of 13.4% per share? Simple, reduce the number of shares.
In 2014, APPL reduced the number of shares outstanding, via stock repurchases, from 6.48 to 6.09 billion. Had the number of shares remained the same as in 2013, APPL would have only earned $6.10 per share instead of $6.49.
In other words, instead of EPS exploding in 2014 by 13.4%, it would have just been 6.64% growth that would have been in line with top-line sales growth. This is what you would expect from a mature company like AAPL.
Such an announcement by AAPL would have substantially missed Wall Street estimates and would have likely resulted in a much lower stock price. Such an event is not good for Wall Street, or the corporate executives, whose compensation is heavily weighted to stock price performance.
Currently, stock repurchases are surging as the late stage bull market, combined with a weak economic backdrop, leaves little opportunity for companies to deploy capital for organic growth effectively. Furthermore, the need to turn substantially weak earnings growth into an earnings "growth positive" also need to support stock prices. As Dr. Ed Yardeni recently pointed out:
"Share repurchases by the S&P 500 corporations totaled a staggering $2.1 trillion from Q1-2009 through the latest available data, for Q3-2014. Over the same period through Q4-2014, these companies paid dividends of $1.6 trillion. Many investors tend to reinvest dividends in the stock market. The S&P 500 has been highly correlated with the sum of these two cash flows."
"S&P 500 corporations have had an incentive to buy back their shares ever since 2004, when corporate bond yields consistently fell below the forward earnings yield of the composite. Today, Moody's Seasoned Aaa Corporate Bond yield is down to a historical low of 3.8% while the forward earnings yield is at 5.8%. In other words, the Fed's Stock Valuation Model has been more relevant to corporate finance behavior than investor behavior in the equity market. My friend Lazlo Birinyi reports that buyback authorizations for February 2015--of $118.32 billion--were the strongest for any February on record as well as for any month ever, in dollar terms. While analysts expect H1-2015 earnings growth to be negative y/y for the S&P 500, I think buybacks could help to turn S&P 500 earnings growth positive."
Watch for a change in the trend of stock repurchases. It will be a clear "exit" sign.
Warning Sign 3: Extreme Complacency/Bullishness
The levels of "bullishness" and "complacency" remain at extreme levels currently. However, like margin debt, it is not the rise in these indicators that are important, but rather the decline. Currently, we are beginning to see those signs of deterioration from extreme levels.
Investor bullishness, a composite of both individuals and professionals, remains at historically high levels. However, importantly, the index is coming off a reading of more than three which has only happened four times since 2005, and they have all been in the last two years.
Secondly, complacency or lack of fear of a correction, has also remained at near historically low levels. However, that indicator, when smoothed with a six-month average, has also begun to deteriorate.
Both of these indicators suggest that some of the "froth" is coming out of the market. Currently, these indicators suggest nothing more than a normalized correction process within the current bullish trend. However, an acceleration of these two indicators will provide a clear warning that something else is afoot.
As Dr. Hussman points out in his recent missive - we currently exist in what has historically been witness to some of the most "awful times to invest."
It will be worth paying attention to the warning signs.
Have a great week ahead, I will be back with you after Spring Break.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.