Market internals continue to deteriorate and leaves this
humble investor wondering if a stock market correction looms on the near-term
horizon. Our strategy thus far has been to raise cash through the collection of
interest and dividends without automatically reinvesting the proceeds in the
hopes of a better entry point. This coming week our investment committee will
meet to have a serious discussion about putting portfolio insurance in place
should this prove to be the start of a soft patch.
Sector Strength
Over the past six months or so the sectors leading the
market have been Consumer Discretionary, Health Care, Technology and
Financials.
One measure we like to track is the strength within the
strongest sectors by comparing the sector performance (which is a market
capitalization weighted measure) versus an equal weighted measure of the same
sector constituents. There has been noticeable deterioration in sector
leadership within three of the top four performing sectors mentioned above. We
commented on lack of leadership in a blog entitled Size
Matters as it related to the overall markets and we are finding
disturbing evidence that the sector leaders are breaking down internally. It
would appear that fewer and fewer of the largest companies are supporting the
stock market. This isn’t a bullish signal.
One can see the battle between the bulls and the bears over
the past several months as the S&P 500 waffles in a tight trading range.
Once the market makes up its mind as to the new trend, the movement will be
sudden and sharp in my opinion. I came across a great article from Lance
Roberts from the Street
Talk blog. He references analysis by Charles Hugh Smith in the blog and
shows the indecision of the markets of late. I agree with their analysis that
the risks at this point are weighed to the downside. He writes, “While we do NOT know for sure which way the
market will break, there is mounting evidence that such a break will likely be
to the downside. As my friend Charles Hugh Smith penned recently:”
“"What's
"saved" the market seven times in seven months? The usual burps of
hot air: the Federal Reserve issued more mewlings (zero rates forever), Greece
was "saved" again, China's crumbling stock bubble was
"saved" again, and so on."”
“"The problem for
bulls is they keep hitting their head on the ceiling after every
"save": instead of running to new highs in an extension of the
six-year uptrend, the S&P 500 reverses once it reaches the narrow band of
recent highs. As soon as the SPX hits this range, somebody starts selling. It's
called distribution: the smart money sells to whomever is buying--bot, trader,
hedge fund, it doesn't matter, as long as someone takes the shares off their
hands. This raises the question: how many more "saves" can there be?
How many more times can Greece be "saved" so global markets rally?
How many more times can China's imploding stock market be "saved,"
bailing out global markets again? How many more times can the Fed talk up zero
interest rates and put off an eventual click up in rates? History isn't
especially kind to the faith that the market can be "saved" every
month for years on end. China's authorities and stock market punters are
learning this the hard way: when the sentiment has turned, every
"save" gets sold by the smart money, and then by the "dumb"
(i.e. margined) money as their hopes of new highs are shredded once again. Can
markets be saved an eighth time, a ninth time, a tenth time this year? How
about next year? Another 12 months, another 12 saves? If the "saves"
are going to run out, why wait to be the last sucker holding the bag when the
Fed's fetid hot air fails to work its magic?"”
Further Evidence of
Coming Market Weakness
Cam Hui, author of Humble
Student of the Markets pointed out problem spots within the IPO market as a
potential sign of trouble. He writes, “There are trouble signs ahead. Conor
Sen recently warned that the market action looked "heavy" and the
market is not prepared to accommodate the companies in the IPO pipeline:
Good companies like
LinkedIn and Tableau are trading down heavily on good earnings reports. Same to
a lesser extent for Facebook – multiples are coming down as valuations shift
from revenue multiples to EBITDA and earnings multiples. If 80 unicorns all
wanted to go public now, it’s not clear if there are enough I-bankers and
underwriters to work the roadshows and make the deals all happen in a short
period of time (the whole liquidity problem), to say nothing about prospective
investor demand in the public markets.
Most of the tech IPO’s
of this cycle have ranged between disasters and underwhelming. And yet there
are 80+ unicorns in the pipeline, all of whom are dreaming of IPO riches to
afford a middle class life in the Bay Area. Companies that…are trying to avoid
going public as long as possible. While I’m always impressed by the talents of
my friends in I-banking, it strains credulity to think that public investors
will continue to line up at the trough for IPO’s when so few of them are
winners. Watch out for the Square S-1. Box took 6 weeks to go from confidential
filing to S-1. If Square takes the same amount of time that’ll be
mid-September. Tech market leadership has been thin, with a handful of
companies accounting for all of the YTD index gains. If it looks like Square
will be a busted IPO that could create a race to the IPO exits for unicorns.
Callum
Thomas of AMP Capital also highlighted similar concerns about the health of
the IPOs:
IPO (initial public
offering) activity can provide clues to a top in the market and the cycle more
broadly – but it’s not a perfect indicator. As I was trawling through various
datasets and trying to think up new things I thought it worthwhile comparing
IPO stats to the SP 500 index to see if it provides any clues. There are some
tentative clues but before we discuss the data and charts it’s worth thinking
about the logic or intuition. More IPOs mean more supply of stock (all else
equal – although it’s not quite equal because strictly speaking you should look
at *net* supply - IPOs and capital raisings less buybacks). IPOs also happen in
greater frequency in boom times because usually in boom times the economy is
going well and it’s much easier for new companies to be successful and thus go
on to do IPOs. Also, the pricing is better and the greater market enthusiasm
increases the likelihood that the IPO will be successful. So we can therefore
say that there will be more IPOs when the market and economy are booming, and
if the economy or market stops booming it will be harder to sustain IPO
activity. So, we have a supply argument and a cycle argument that says there
should be information in IPO activity. In terms of the charts there is a loose
link: IPO proceeds (amount of capital raised) moves in line with the market as
you would expect. When it rolls over it can mean a change in trend or rolling
over of the cycle – however, it is more or less a coincident indicator. The
monthly pace of IPO filings is also a potentially useful indicator where a surge
in filings can flag a short-term top in the market. Looking at the longer-term
data for the number of IPOs, it’s a little tricky because in the past there
were many more IPOs than in recent times. So in terms of its efficacy it is
‘mixed’ but it is another information point worth considering. There is a
potential red flag in that there was a surge in filings and the volume and
proceeds seem to have rolled over.”
VIX Reading
I like to track the relative correlated volatility between
the VIX and the S&P 500. Similar to a beta reading, it is a measure of the
sensitivity of the VIX returns to market returns. The formula can be found
below.
I then track the dispersion of readings to find certain
outlier activity. This model will move inversely to the market so it has been
in a down trend since the market bottomed in 2009. When this model showed
larger movements to the downside, market weakness soon reared its ugly head and
a few of the moves have been sudden and sharp, albeit short lived.
Fundamentals are
stretched
We have written several times in this blog that it is our
opinion that the market appears to be overvalued currently. That said, we
understand that stretched valuations are not a precursor to a market
correction. Clearly market sentiment has taken over and thus we are attempting
to track market psychology in an effort to mitigate our portfolio downside
should the next correction take hold. We have found some interesting
fundamental points that confirm our belief that the market is overvalued currently.
3 charts that show the stock market is almost in a bubble –
Commonwealth Financial Network (via Business
Insider) – “Let’s start with the
Shiller price/earnings ratio, which uses current prices and 10-year average
earnings. This metric has leveled off since February and remains around where
it was in 2006–2007, though well below the levels of 2000. The question going
forward is whether valuation levels will continue to increase, which, with
earnings growth, would allow higher market returns; remain stable, which would
limit market returns to earnings growth levels; or start to pull back, in which
case earnings growth still might not drive the market higher. In any case,
future strong market returns now require valuations to move above 2007 levels
and closer to the levels of 2000.”
“Any P/E analysis
relies on interest rates. Lower rates make a given stream of earnings worth
more, and lower rates can justify higher P/Es. In many respects, the high
valuation levels of the past couple of decades may have been due to declining
rates, and the leveling off of valuations recently may reflect the possibility
that rates will start increasing again. One market valuation metric that isn’t
dependent on interest rates is the level of margin debt. Historically, high
debt levels have often preceded market trouble in many asset classes—not only
stocks but also real estate and, most recently, housing. We can look at the
ratio of debt to market capitalization as a reasonable risk measure.
This chart tells us
several things:
Since 1994, margin
debt has been higher than it was in 1987. Arguably, this represents a new
normal, but it might also be a force that has allowed the market to continue to
climb higher.
After a decline
earlier this year to below 2007 levels, the ratio has climbed again to heights
above those of 2000. Note that, despite the absolute levels, local peaks (in
1973, 1987, 2000, and 2007) all led in reasonably short order to market
pullbacks. The fact that this ratio has jumped to a new peak is a concerning
data point.”
“A final way to
evaluate market valuations is to compare them to the economy overall. This is
often known as the Warren Buffett indicator, as he is said to favor it. A
benefit of this metric is that it's based neither on interest rates nor on
debt, but on the country as a whole. Once again, valuations are at levels above
those of any point prior to the late 1990s but have recently leveled off
slightly below the 2007 peak and somewhat below the 2000 peak. The conclusions
here are similar to those for the Shiller P/E: growth may come, but it will
require a move back above 2007 levels and closer to the 2000 high.”
The Tide has Turned and These Charts Predict the Next Stop –
David
Stockman’s Contra Corner – Thad Beversdorf. “I’ve been writing for almost a year now about the economic cannibalism
that has been feeding earnings growth. I
have discussed this concept with a dire warning that feeding earnings expansion
through operational contraction is a short lived meal. And well we are now seeing the indications
that the growth through contraction has now hit its inevitable end. Have a look at the following chart which is
really the only chart one needs to study at this point. The chart depicts S&P 500 adjusted
earnings per share (blue line), S&P Price level (green line), S&P 500
Revs per share (red line) and US Productivity of Total Industry (olive line).”
“The initial
observation is that the past 25 years has been a series of large bubbles and
subsequent busts, at least in both the price level and adjusted eps of the
S&P. Focusing on the price level we
see the normalized index having two similar peaks and now into a third peak
quite substantially higher than the previous two. The first two peaks top out around 400 on the
index and each subsequent reset price was down around 220. Now one might expect that the sources of
these two very similar bubbles were thus the same. But one would be wrong.
Notice in the first
bubble that adjusted EPS topped out around 275 whereas in the second bubble
they reached 450. We often hear that
because of this phenomenon equities were far more overvalued in the tech bubble
than in the credit bubble. While the
conclusion is correct it creates a strawman analogy for this third and current
bubble. Specifically, that because
current price to earnings is similar to that of the credit bubble that equities
are fairly priced or at least relative to the tech bubble. But this argument is a strawman fallacy.
The tech bubble was a
bubble of massive direct capital allocation stupidity. The credit bubble was a
bubble of massive indirect capital allocation stupidity. What I mean by that is the tech bubble was
created by absurd capital injections directly into the secondary market
(bypassing earnings), driving stock valuations to the moon. The credit bubble was done via flooding
consumers with debt which was used to prop up personal consumption which led to
growth in revenues, earnings and thus stock valuations. You can see a large increase of revenues per
share between 2001 and 2007. Now revenue
growth is supposed to lead earnings growth which in turn pushes up stock
valuations. However, when revenue growth
is driven by debt consumption it is temporary.
And we all learned that cold, hard fact in 2008.
But so the argument
that EPS is the figure one needs to pay attention to really misses the actual
driving force which is revenue based earnings growth. The above chart depicts that while EPS has
been rising significantly for the past 7 years, revenues have been absolutely
flat. And so what we have is earnings
growth pushing stock valuations massively higher but without the consumer
onboard. Very different from the credit
bubble. How does this happen?
Well again, stock
valuations are being pushed higher
through another temporary effect. EPS
growth is coming by way of operational contraction and financial engineering –
meaning dividend payouts and share buybacks. This is evident in the following
chart of just this latest bubble that depicts growth in stock valuations
relative to growth in revenue per share, which have (notably) declined since
Aug 08 (the base period).”
“Now EPS growth from
anything other than earned consumption, meaning consumption from income rather
than debt can only be temporary. (One
arguable exception would be if EPS growth came from productivity, however, we see
in this first chart that productivity is flat and so not the driver of EPS
growth.) And if the EPS growth is
temporary it follows that the stock valuations that have grown on the back of
EPS growth too is temporary. What we are
about to find and already are seeing the signs of with major technical supports
breaking down is that stock valuations will reset to match each firm’s
operational propensity for earnings growth (i.e. each firm’s expected
sustainable future free cash flow). We
saw this inevitable result in each of the last two major bubbles.”
Mr. Beversdorf goes on to further his point that the market
is susceptible to a significant drop from here and the article is very
interesting. I would suggest going to the link provided and read the article in
its entirety.
Final Thoughts
We understand that fundamentally the market appears
overvalued but we were tracking market sentiment as a gauge for us to stay
invested in the stock market. We are currently seeing cracks in sentiment as
market internals are starting to deteriorate. We have written in the past that
we use the long term MACD for the S&P 500 as one of the final decision
points in our analysis to add portfolio protection. Recently the long term
model that we track has indeed started lower confirming our fears that momentum
is quickly fading and could result in a sudden reversal to the downside for the
general markets.
Bottom Line: Market
fundamentals are signaling over-valuation and market sentiment/momentum appears
to be weakening. This along with less accommodative monetary policy on the
horizon increases the risk of a market correction, in our view. We will
maintain our existing portfolio but will start introducing “portfolio insurance”
in the coming weeks and months as the market dictates. It is impossible to
predict market tops and bottoms but it is prudent to alter the risk profile of
the portfolio with changes in market data. We’d rather risk a portion of future
upside if we are wrong in our analysis than risk previous gains if we’re right.
Joseph S. Kalinowski, CFA
Further Reading:
This is great stuff…
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