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 (http://www.aaii.com/sentimentsurvey). 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

Lenders: Eager Neutral Reticent

Capital markets: Loose Neutral Tight

Terms: Easy Neutral Restrictive 

Interest Rates: Low Moderate High 

Spreads: Narrow Moderate Wide

Investors: Optimistic Neutral Pessimistic

Equity Owners: Happy to hold Neutral Rushing for the exits

Equity Sellers: Few Moderate Many

Markets: Crowded Neutral Starved for attention

Funds: New 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. 


http://www.gurufocus.com/news/228957/should-you-hold-on-to-your-wallet-now

Market value, business value, Short-term & Long-term Market Returns and the effects of GDP Growth

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

• GDP growth of 3 to 5%
• Productivity growth of 1 to 2%
• Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year? 

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually. 

But for a particular stock? 

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever? 

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen. 


GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total book selling business in the previous decade.



Main point:  
Business value and market value of a company grow further through increases in productivity (better profit margins) and through growing its market share (higher revenues).

GDP Growth and Market Return

Economic Growth: Great for Everyone but Investors?

While it may be intuitive to presume strong economic growth translates into strong stock market performance, the evidence suggests otherwise.

By Alex Bryan | 12-19-12

By 2050 the world's population is projected to reach 9 billion, up from 7 billion today. Nearly all of that growth will come from emerging markets, where living standards are rapidly improving. Although these markets have experienced large capital inflows, they still have a long way to go to match developed countries' levels of capital and wages. Consequently, emerging markets will likely continue to grow faster than developed markets for the foreseeable future. While this growth may lift hundreds of millions out of poverty and spur investment and innovation, evidence suggests investors may be left behind.

About the Author

Alex Bryan is a fund analyst with Morningstar.

Contact Author | Meet other investing specialists

Jay Ritter, a professor at the University of Florida, documented a negative relationship between economic growth and stock market returns in his seminal research paper, "Economic Growth and Equity Returns," published in 2005. Ritter's findings are no fluke. Using real gross domestic product data from the Penn World Tables and stock market returns, as proxied by the total return version of each market's MSCI country index, I found a weak negative correlation between GDP growth and stock market returns for 41 countries from 1988 to 2010. This relationship is plotted in the chart below. However, excluding China (the outlier at the bottom right of the chart) brings the correlation close to zero.

While the strength of these relationships is sensitive to the start and end dates of the sample period, the general findings are fairly robust over long time horizons. It's clear that higher economic growth does not necessarily translate into superior stock market returns over the long run.

Reasonable Assumptions?

This result should not be surprising given the strong assumptions that would be required to make the jump from GDP growth to stock market returns. In order for this relationship to hold, corporate profits as a share of GDP and valuation ratios would need to remain stable over time. Second, current shareholders' ownership stake of total corporate profits would also need to remain constant. In other words, there should be no dilution from new share issuance, private and public companies would need to grow at the same rate, and there could be no new enterprises or initial public offerings. All existing publicly listed companies would also need to generate substantially all of their revenue and profits from the domestic economy.

The Link Between Economic Growth and Profitability

In a closed economy, it would be reasonable to expect that total corporate profits would grow at a similar rate as the economy in the long run. Although the share of corporate profits relative to GDP fluctuates over time, it tends to revert to the mean. Profits cannot persistently grow faster than the economy because they would crowd out all other economic activity and attract new competitors. Similarly, total corporate profits should not grow slower than the economy in the long run, as firms exit unprofitable businesses, allowing those remaining to preserve margins. Of course, it is inappropriate to assume that any country United States investors have access to is closed. The largest companies listed in most countries tend to be multinational firms that generate a large portion of revenue and income outside their host country. For instance, the constituents of the S&P 500 generate close to 40% of their profits outside the U.S. This international exposure means that profits can grow at a different rate than the domestic economy, even in the long run.

Even if aggregate corporate profits grow in sync with GDP, dilution can prevent shareholders from enjoying the benefits of growth. Creative destruction is essential to economic growth. In aggregate all companies that are publicly listed today will grow slower than the economy because new entrants drive much of that growth. Between the time these new companies are launched and publicly listed, their growth dilutes most investors' ownership interest in the economy. Flagrant dilution of corporate earnings through employee stock grants and seasoned offerings is also a very real risk, particularly in developing countries with a tradition of poor corporate governance. Additionally, earnings growth can only create value if it allows firms to generate returns that exceed their cost of capital. High reinvestment rates may enhance both corporate and domestic economic growth but destroy shareholders' wealth through inefficient capital allocation.

Is Growth Already Priced In?

Growth expectations influence stock market valuations. Valuations are rich when investors expect strong growth. However, as developing economies mature, their growth rates slow and valuations tend to decline. Consequently, even when countries realize their expected growth rates, their stock markets may not keep pace.

The impact of lofty growth expectations on valuations can create a treadmill effect, whereby fast-growing economies must realize high growth in order to generate a competitive rate of return. For example, in the mid-1980s the so-called Asian tigers had experienced two decades of rapid growth and investors had high expectations for future growth. In contrast, several countries in Latin America were facing severe inflation, a debt crisis, and low expectations for future growth. As a result, according to research published by Peter Blair Henry and Prakash Kannan in "Growth and Returns in Emerging Markets," in 1986 Latin American stock markets were trading at 3.5 times earnings, while the Asian markets were trading at 18.3 times earnings. Over the next two decades, Latin American stock markets posted more than twice the annualized returns as the Asian markets, despite experiencing lower GDP growth over that horizon. This was because Latin American countries implemented economic reforms that allowed them to exceed investors' low expectations. Conversely, the Asian markets performed in line with investors' high expectations, which were already priced in.

What's an Investor to Do?

In order to benefit from economic growth, investors must identify markets that have the potential to exceed expectations. Russia may fit the bill. The Russian equity market, as proxied by  Market Vectors Russia ETF (RSX), is trading at a paltry 5.6 times forward earnings, making it the cheapest of any major emerging market. Corruption and a taxing regulatory environment have stunted the country's growth and depressed valuations. However, if (and this is a big if) Russia adopts structural reforms similar to those undertaken in Latin America over the past two decades, it could offer investors rich rewards--albeit with high risk.

Even if fast-growing emerging markets do not offer superior risk-adjusted stock market returns, they can provide significant diversification benefits. Over the past 20 years, the MSCI Emerging Markets Index and S&P 500 were only 0.73 correlated. Emerging-markets equities may also offer a long-term hedge against a weakening U.S. dollar.

http://news.morningstar.com/articlenet/article.aspx?id=578607

Buffett's Ratio Says Stocks Are Getting Interesting

17 August 2011
The art of cheap.

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."

There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."

He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."

Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.

Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.

^{Source: Dow Jones, St. Louis Fed, author's calculations.}

Understand what this does not mean:

• It does not mean stocks are bound to go up in the short run. No metric can predict that.
• It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.

And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.

But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:

U.S. Stocks as % of GNP	Average Subsequent 2-Year Return
< 60%	21%
60%-80%	24%
80%-100%	13%
> 100%	(4%)

^{Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.}

There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favour. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. 

"The lower things go, the more I buy," Buffett said last week. How about you?

http://www.fool.co.uk/news/investing/2011/08/17/buffetts-ratio-says-stocks-are-getting-interesting.aspx

The Ultimate Signal to Load Up on Stocks?

The Ultimate Signal to Load Up on Stocks?
By Brian Richards and Tim Hanson April 20, 2009 Comments (22)

Legendary fund manager Peter Lynch famously said that if investors spend 13 minutes thinking about the economy, they've wasted 10 minutes.

Granted, Lynch wasn't managing money during a mega-macroeconomic crisis of the sort we're facing today. Plus, Lynch was likely being funny and hyperbolic -- surely some thought to macroeconomic events is useful for investors. (Anyone thought about buying a bank stock lately?)

So when we read the other day that lipstick sales rose more than 4% in 2008, we nodded our heads. Here it was again: the leading lipstick indicator.

How lipstick explains the economy

The ... what?

The leading lipstick indicator, is a scientific measure of the sale of, well, lipstick. The theory goes as follows: When times are tough, women will purchase lipstick rather than purchasing new threads or splurging for a new necklace. During the Great Depression, lipstick sales reportedly rose 25%!

The term was introduced by Estee Lauder (NYSE: EL) Chairman Leonard Lauder, who created it with nothing more than years on the job and astute observation.

Of course, lipstick sales are a comically unreliable economic indicator and lipstick alone can't save Estee Lauder investors from a downturn in consumer discretionary spending. But the obvious absurdity of judging the state of the U.S. economy by sales of this single product should at least suggest that other market "indicators" that judge our economy by a single metric are equally dubious.

New home sales? New home starts? Jobless claims? Non-farm payroll numbers? Durable goods report? They all make for interesting morning segments on CNBC, but they're unreliable, subject to revision, and not worth much without loads and loads of context. That means they're nothing but obnoxious noise to the ears of long-term-focused investors.

Turning to Buffett -- who else?

So imagine our surprise when we read a Fortune piece a few weeks back with the following headline: "Buffett's Metric Says It's Time to Buy."

Would Warren Buffett -- the patron saint of fundamental-focused value investing -- really suggest broad market indicators are relevant to a buy decision?

As it turns out, it can be.

His signal looks at total stock market value compared to gross domestic product. In 2001, when the percentage was over 130%, Buffett said that "if the percentage falls to the 70% or 80% area, buying stocks is likely to work very well for you."

At the end of January, Fortune reported, the ratio was at 75%.

The ultimate signal to load up on stocks?

Not so fast. This is, after all, the same Warren Buffett who told Berkshire Hathaway shareholders that "We try to price, rather than time, purchases."

He went on to say:

In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess? ... We have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

In other words, it's foolish to abstain from buying because stocks in general appear "overheated," just as it's foolish to buy willy-nilly because stocks appear "cheap." Investing the Buffett way (which seems to have worked out pretty well for him) is about bottoms-up fundamental analysis with a focus on long-term competitive advantages.

Which brings us to an analogy

But look, it'd be daft to ignore the fact that it's better to go fishing at some times of the day than others and that that optimal time of day is determined by the weather and moon. If you go out at the wrong time with the best bait, your chances of hooking a fish are diminished; if you go out at the right time with nothing more than hook and a string, your chances are improved.

Similarly, in investing, you're more likely to earn great returns if you buy when stocks across the board are cheap than if you try to find the one or two bargains at a time when stocks across the board are expensive. And that's why some macroeconomic analysis can be useful: It tells you the best times to go fishing.

And today is one of those times. As we mentioned earlier, the market is broadly trading for just 75% of GDP, and on an individual level, many of the market's most impressive companies are trading at enormous discounts relative to their norms:

Company
Current P/E ..... 5-Year Average P/E

Google (Nasdaq: GOOG)
29.5 ..... 67.1
Johnson & Johnson (NYSE: JNJ)
11.6 ..... 17.8
Boeing (NYSE: BA)
10.5 ..... 20.9
Intuitive Surgical (Nasdaq: ISRG)
25.4 ..... 53.8
IBM (NYSE: IBM)
11.3 ..... 15.5
Disney (NYSE: DIS)
9.7 ..... 17.3
Data from Morningstar.

So, I buy those six stocks? Now, this doesn't mean that all of these stocks will beat the market from here on out, but it does mean that now is a great time to go fishing for top stocks in your portfolio.


Brian Richards does not own shares of any companies mentioned. Tim Hanson owns shares of Berkshire Hathaway. Google and Intuitive Surgical are Motley Fool Rule Breakers picks. Berkshire and Disney are Stock Advisor and Inside Value recommendations. Johnson & Johnson is an Income Investor selection. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy says that if you're looking for fishing advice, try arkansasstripers.com -- but be careful when typing in the URL -- it learned the hard way and ended up having a talk with our IT department.

http://www.fool.com/investing/general/2009/04/20/the-ultimate-signal-to-load-up-on-stocks.aspx