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

The two things investors must do now, according to the Nobel laureate.

Shiller's back, and he has more depressing news

CNBC
By Alex Rosenberg
Feb 14, 2015 2:08 PM

The two things investors must do now, according to the Nobel laureate.

Nobel Prize-winning economist Robert Shiller has a grim message for investors: Save up, because in the years ahead, assets aren't going to give you the type of returns that you've become accustomed to. In his third edition of "Irrational Exuberance," which will drop later this month, the Yale professor of economics warns about high prices for stocks and bonds alike. "Don't use your usual assumptions about returns going forward." Shiller recommended to investors in a Thursday interview on CNBC's " Futures Now ." He says that stock valuations look rich. In fact, Shiller's favorite valuation measure, the cyclically adjusted price-earnings ratio (which compares current prices to the prior 10 years' worth of earnings) is "higher than ever before except for the times around 1929, 2000, and 2008, all major market peaks," he writes in his new preface to the third edition. "It's very hard to predict turning points in markets," Shiller said on Thursday. His CAPE measure of the S&P 500 (CME:Index and Options Market: .INX) "could keep going up. ... But it's definitely high. By historical standards, it's up there." Meanwhile, Shiller said that bond yields, which move inversely to prices, "can't keep trending down" and "could [reach] a major turning point in coming years." It's no surprise, then, that Shiller expects little in the way of asset returns-meaning Americans will have to rely more heavily on the piggy bank.

Shiller warns bond investors: Beware of 'crash'! Given the current state of the stock and bond markets, "you might want to save more. A lot of people aren't saving enough. And incidentally, people are living longer now and health care is improving, you might end up retired for 30 years-people are not really preparing for that," he said. The other pillar of his advice is a classic tenant of responsible investing, with a global twist. "Diversify, because that helps reduce risk," Shiller said. "And you can diversify outside the United States. Some people would never invest in Europe-I think that's a mistake." Shiller adds that emerging markets can also provide attractive values. And indeed, valuations in much of the world are far lower than in the United States, given that investors are more optimistic about economic prospects in America than in nearly any other country. But perhaps people shouldn't base their investing decisions quite so heavily on predictions. "The future is always coming up with surprises for us, and the best way to insulate yourself from these surprises is to diversify," Shiller said.

Price-Earnings Ratios as a Predictor of Twenty-Year Returns (Shiller Data)

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,^[1] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Indexas computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot"confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."^[1]

Robert Shiller's plot of the S&P Composite Real Price-Earnings Ratio and Interest Rates (1871–2008), from Irrational Exuberance, 2d ed.^[1] In the preface to this edition, Shiller warns that "[t]he stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

http://en.wikipedia.org/wiki/P/E_ratio

SHILLER’S PE RATIO

The noted Yale economist, Robert Shiller, calculates a very interesting cyclically-adjusted price-to-earnings ratio. Instead of using 12-month earnings (which can be very volatile, especially recently), he uses a 10-year average of earnings. He has compiled an incredible data set, with the data going back to 1881, so you get a true sense of history.

For October, the Shiller P/E is just over 20x (the 125-year plus historical average is about 16x). It’s true that this metric is not as overvalued as in past peaks (in the dotcom era, it went over 40x), but it’s interesting to know that when we usually see 20x, it’s not at the end of a recession but five years into an economic expansion. Shiller is skeptical on the recent boom in the stock market (and housing as well for that matter). On stocks, he said recently “you have to go back to the Great Depression to see such a turnaround in the stock market” and that the current booms (both stocks and housing) “…can’t be trusted to continue.”

http://pragcap.com/shillers-pe-ratio-signals-stocks-are-overvalued