Sunday, 19 April 2015

Should You Hold On To Your Wallet Now?

September 15, 2013 

As I am writing this article, the S&P 500 has advanced 3.37% so far in September, bringing total year-to-date price return to 18.36% and year-to-date total return to 20.18%. It seems like investors are having a good year with the index is only a little more than 1% away from all time high. The question is, where are we going next?

We have seemingly compelling arguments from both the bulls and the bears. I'll not waste the readers' time in listing out the arguments out there. Instead of picking a side based upon what various market experts masterfully opined on CNBC, I'd rather follow the wisdom of one of my favorite investors-Howard Marks:

"We may never know where we're going, but we'd better have a good idea where we are."

The Most Important Thing Is... Having a Sense for Where We Stand

Although this is not a macro forecast, it is by no means easy to figure out where we stand in terms of the cycle and act accordingly. Fortunately, Howard provides us with "The Poor Man's Guide to Market Assessment", which I shall use in an attempt to take the temperature of the market. The purpose of the assessment is to come to an objective conclusion with regards to the position of the pendulum. This assessment include a list that can be found in Chapter 15 of Howard's book "The Most Important Thing." Essentially this list contains pairs of market characteristics and for each pair, we will check the one that we think is applicable to today's market. At the end of this exercise, we should be able to have a sense of where we stand. Below is a brief summary of my analysis of the list:

  • Economy: The U.S economy is still "muddling through" with unemployment still at 7.3% (August) and estimated growth of GDP at merely 1.6%. I think it is neither vibrant nor sluggish.
  • Outlook: This is a market characterized by plenty of uncertainty mingled with cautious optimism. Therefore, a neutral rating seems appropriate.
  • Lenders: If we use Thomson Reuters' PayNet Small Business Lending Index as a proxy, it looks like lenders are becoming more eager as the index is at a level just around 115, much higher what it was at the bottom of the recent crisis (65) and not far from what it was prior to the crisis (130).
  • Capital Market: Using the Total Credit Market Borrowing and Lending data available from the Federal Reserve as a proxy, I think we are neither tight nor loose. Credit market borrowing and lending has picked up considerably since 2009 (negative $539 billion) to about $1.5 trillion at the end of 2012 (last full year data available). However, compared to the pre-crisis level of $4.5 trillion, I think we are still at a neutral stage, but probably not for too long.
  • Terms: Here we can talk about the terms of mortgage, corporate long term debt and etc. In terms of mortgage, it is pretty clear that lenders are very selective when initiating mortgages. Banks have been very strict in the arrangement of corporate debt covenants. Therefore, it seems to me that the loan terms are closer to the restrictive side.
  • Interest rates and spreads: Low. Not much explanation needed.
  • Investors: American Association of Individual Investors publishes survey result of individual investors on a regular basis on its website ( The latest result shows that 45.5% of investors are bullish, 29.9% are neutral and 24.6 % are bearish. Overall, individual investors are bullish.
  • Equity Owners: The Fed has forced equity owners to hold their equity positions.
  • Equity Sellers: With no better places to go, I would argue that the number of equity sellers are relatively few.
  • Markets: Using the trading volume of the S&P 500 as a rough proxy, the market is neither too crowded nor starving for attention at August's average trading volume of 3,069,868,600. During panic months such as March 2009 and October 2008, average trading volume were above 7,000,000,000.
  • Funds: According to Hedge Fund Research, "total hedge fund launches in the trailing 4 quarters ending 2Q 2013 totaled 1144, the highest total since nearly 1200 funds launched in the trailing 4 quarters ending 1Q08."
  • Recent performance: Strong.
  • Assets prices, respective returns, and risk: Both the Shiller P/E and the total market capitalization as % of GDP imply a high equity price and low implied returns, and hence, relatively high risk. You can find the relevant information using gurufocus' market valuation tools.
  • Popular qualities: Consumer discretionary and financial sectors have been leading the way in the market advance so far this year. Although the technology sector (which usually is perceived to be a sector for aggressive investors) has been a laggard year to date, many investors (of course not value investors) are paying a lot attention to and a hefty premium for stocks with promising futures such as Salesforce,Tesla, Linkedin, Stratesys, and 3D Printing. This indicates aggressiveness.
Now that we have finished the market temperature exercise, I thought it might be useful to quantify this checklist. In doing so, I tweaked Howard's method a little by adding a neutral characteristic in between and assigned a score of 1, 3, 5 for each category. A score of 1 indicates characteristics of a potentially overvalued market; a score of 3 indicates characteristics of a fairly valued market; a score of 5 indicates characteristics of a potentially undervalued market. Below is the summary table based on the above analysis: 

Economy: Vibrant Neutral Sluggish

Outlook: Positive Neutral Negative

LendersEager Neutral Reticent

Capital markets: Loose Neutral Tight

Terms: Easy Neutral Restrictive 

Interest RatesLow Moderate High 

SpreadsNarrow Moderate Wide

InvestorsOptimistic Neutral Pessimistic

Equity OwnersHappy to hold Neutral Rushing for the exits

Equity SellersFew Moderate Many

Markets: Crowded Neutral Starved for attention

FundsNew Ones Daily Neutral Only the best can raise money

Recent Performance: Strong Moderate Weak

Equity Prices: High Moderate Low

Respective Returns: Low Moderate High

Risk: High Moderate Low

Popular Qualities: Aggressiveness Neutral Caution and discipline

Total Counts: Score of One: 12; Score of Three: 4; Score of Five: 1

Score: 12*1+4*3+1*5=29

Maximum Score: 85

Score %: 29/85= 34%

Obviously 34% is just an estimate, we can easily shift some categories from score 1 to 3. However, as value investors, we would rather err on the side of caution. Hence, for the items that I am not entirely sure of, I chose the more conservative characteristic. 

When interpreting the result, the lower the percentage score is, the more cautious a prudent investor should be. At the peak of the crisis, I think we are not too far from the maximum score. Things have improved dramatically since then. To me, 34% implies that this is a time for us to take a more defensive stand and this is consistent with Howard's recent observation that "the race to the bottom isn't on, but we are getting closer." Of course the future of the stock market is unknowable but there are many things that I think we can comfortably say knowable, just to name a few. 

(1). Interest rates are going to rise and we all know how it will impact the price of all assets classes. 

(2). Corporate profits as % of GDP is unlikely to stay above 10% for a sustained period of time. 

(3). Both the Schiller P/E and Total Market Cap as % of GDP indicate potential overvaluation and reduced implied returns for equity investors. 

(4). The U.S's debt problem is still looming and has not gotten any better. 

None of the above knowables bodes well for the equity market. However, that doesn't mean we will have a so-called correction. It means we need to apply a higher level of prudence when managing our money, or other people's money given what we know. 

I want to end this discussion with the last paragraph of Chapter 15 of "The Most Important Thing." Here, Howard shrewdly observes:

"Markets move cyclically, rising and falling. The pendulum oscillates, rarely pausing at the "happy medium," the midpoint of its arc. Is this a source of danger or of opportunity? And what are investors to do about if? My response is simple: Try to figure out what's going on around us, and use that to guide our actions.

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