Fundamentally the Market should be Heading Lower...So Buy More Stocks!!!

I’m reading more and more about the concerns surrounding equity valuation in the U.S. Based on several valuation methodologies the case can certainly be made that equities are overvalued. Those investors that are anticipating the market to act in a rational way during irrational times are certainly getting frustrated. Albert Edwards from Societe Generale was quoted (via Business Insider) saying, "With equity markets galore hitting record highs clearly I must be missing something big! We are at that stage in the cycle where I begin to doubt my own sanity. I’ve been here before though and know full well how this story ends and it doesn’t involve me being detained in a mental health establishment (usually)."

Frustrating Indeed.

It is true that the corporate earnings picture has been deteriorating of late and P/E multiples are at elevated levels through a combination of rising stock prices and declining forward earnings projections. The chart below from FactSet provides a breakdown of current valuation by S&P sector and one can clearly see most sectors (with the exception of telecommunications) are trading at a premium to their five and ten year averages. Clearly not the best justification for piling into the market.

 

John Mauldin at Mauldin Economics also writes about stretched valuations in saying, “Even so, valuations are stretched. Doug Short combines four different ways to compute valuations (basically, derivatives of the price-to-earnings ratio) into one average. In the graph below you will note that there was only one previous time (during the tech bubble that popped in 2000) when valuations were higher than they are now. Bear markets and recessions can start from much lower valuations.”

Bank of America was also quick to point out that the global earnings outlook is deteriorating making it difficult to justify current market levels.

 

 

With the Fed still expected to raise rates this year while almost every other country is maintaining easy monetary policy, one would anticipate continued strength in the U.S. dollar against a basket of other currencies. In that same FactSet report, they provided a brief summary on the impact of the stronger dollar on earnings and revenue projections for the companies most exposed to currency fluctuation. As the chart below shows, the folks at FactSet divided the S&P 500 into two categories…those companies getting greater than 50% of their revenues overseas and companies that book greater than 50% of their revenues domestically.

The results are clear, those companies with greater exposure to the stronger dollar are expecting year-over-year 1Q15 revenues and earnings to decline 10.2% and 11.9%, respectively.  This compares to those companies with less dollar exposure showing year-over-year 1Q15 revenues growing 0.6% and earnings remaining flat. Given the rate of deterioration in corporate earnings as a whole, there is little doubt that revenues and earnings for the first half of the year will produce negative year-over-year comparisons.

David Bianco from Deutsche Bank further analyzed the dollars impact on corporate earnings stating, “A third of S&P 500 sales and 40% of its profits are from abroad, but only ~25% of its profits are earned in foreign currencies. Thus, every 10% appreciation in the dollar vs. major currencies hits S&P EPS by 2.5% or $3.”

Given the less than stellar corporate earnings outlook one would expect these concerns to be reflected in the current stock prices but that is just not the case. In this investor’s humble opinion, the market action today is still very much dictated by Fed action and monetary policy. The chart below shows the S&P 500 (orange line) against the dollar (black line). What should historically equate to an inverse relationship, it’s stunning to see the miraculous ascent of the dollar with little notice from equity participants. We believe the Fed is at least partially responsible for both. Having the possibility of even tighter monetary policy in the near term while most other countries are practicing looser policy is fuel for the U.S. dollar. The complacency that has been instilled on U.S. investors by the Fed supporting equity prices for so long has in my opinion introduced an unhealthy variable that skews traditional fundamental analysis.

 

 

There has been tough criticism of the Fed recently. The following clip (via ZeroHedge) has Ed Yardeni calling the market “rigged” through central banking intervention. Even retired Dallas Fed chief Richard Fisher acknowledged that there is a dangerous dependence on the Fed to support the markets. This is a striking interview (via ZeroHedge) where he called equity participants “lazy”.

So one may conclude that the market correction is right around the corner, but it’s certainly not that easy. In contrast to the efficient market hypothesis that states all relevant information is fully reflected in current market prices this investor believes there is an inherent behavioral component to the market and cannot accept that all investors are rational all the time. Periods of irrationality can and will exists and many times this irrationality can be in place for quite some time.

Looking at several sentiment indicators tell me that investors are not all that concerned about the market overvaluation at this time. The VIX is sitting near its lows (under 15) and the AAII investor sentiment survey is indicating market participants are “neutral” in their opinion of the market for the most part. The chart below shows the percent of investors that call themselves “bullish” and the second chart are those that are “bearish”. On the bullish side, 27% of the respondents said they were bullish (39% is the average) and 31% said they were bearish (30% is the average). The rest are neutral. This is the kind of “sleepy” sentiment indicators of late. Investors are not all that concerned about market valuations. They have become comfortable - or as Richard Fischer said - lazy.

 

I use a proprietary sentiment indicator that I created many years ago. This attempts to capture market sentiment through pricing and volume metrics. Up days are compared to down days and volume is added to the equation to over-weight those up days that come about on greater volume and over-weight high volume down days. As with other sentiment indicators, it is largely benign.

 

It appears to me that investor sentiment is not at levels deemed excessive (although this can change very quickly). This commentary would have a much different conclusion if this investor were taking a purely fundamental approach. Valuations, fundamentals, monetary policy and the U.S dollar are all providing significant head winds against high stock process – yet we believe the market will continue it move higher in the near-term. Please read “The bulls are alright” by The Humble Student of the Markets and see why the market appears to be going higher based on excellent technical analysis.

So if one will accept market direction as a function of fundamental underpinning and investor behavior then there is a clear dichotomy at play that is the conundrum of all money manager alike, preparing for the inevitable while remaining competitive in the near term. Lance Roberts summarized it brilliantly when writing, “In a market where fundamentals are no longer cheap by any measure (on a 50-year basis), has now simply become a momentum push as the “fear” of “missing out” overwhelms more logical investment analysis.

However, this is also an interesting dichotomy for financial advisors. Here’s why:

•An individual hires a financial advisor to manage their investment portfolio.

•Markets rise to levels of extreme valuation

•Advisor sells assets and raises cash (sell high so they can buy low later.)

•Market moves higher due to “irrational exuberance.”

•Client moves money from cautious advisor to another advisor chasing the market.

•Market eventually crashes wiping client out.

•Client seeks out conservative advisor, so that does not happen again.

•Wash, Rinse, Repeat Until Broke”

Bottom Line: We remain invested in our allocated asset classes but continue to build our cash position by collecting dividends, interest and premiums from covered call strategies. By keeping our market exposure in place but increasing our cash reserves over time, we will capitalize on continued market momentum and allow the room within the portfolio to deploy our collected excess cash when the appropriate entry level presents itself. 

Joseph S. Kalinowski, CFA

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