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
No part of
this report may be reproduced in any manner without the expressed written
permission of Squared Concept Partners, LLC.
Any information presented in this report is for informational purposes
only. All opinions expressed in this
report are subject to change without notice.
Squared Concept Partners, LLC is an independent asset management and
consulting company. These entities may have had in the past or may have in the
present or future long or short positions, or own options on the companies discussed. In some cases, these positions may have been
established prior to the writing of the particular report.
The above
information should not be construed as a solicitation to buy or sell the
securities discussed herein. The
publisher of this report cannot verify the accuracy of this information. The owners of Squared Concept Partners, LLC
and its affiliated companies may also be conducting trades based on the firm’s
research ideas. They also may hold
positions contrary to the ideas presented in the research as market conditions
may warrant.
This analysis
should not be considered investment advice and may not be suitable for the readers’
portfolio. This analysis has been written without consideration to the readers’
risk and return profile nor has the readers’ liquidity needs, time horizon, tax
circumstances or unique preferences been taken into account. Any purchase or
sale activity in any securities or other instrument should be based upon the
readers’ own analysis and conclusions. Past performance is not indicative of
future results.
