Night Moves

Woke last night to the sound of thunder
How far off I sat and wondered
Started humming a song from 1962
Ain’t it funny how the night moves
When you just don’t seem to have as much to lose
Strange how the night moves
With autumn closing in
Bob Seger

With the multi-year Summer of Love for stocks inexorably moving towards the early evenings of an Autumn of Discontent, it’s time to brush up on those rusty, bearish night moves. It’s easy to become dazzled by the stars at night, but this is no time to be pulling out the beer goggles for investments analyses, but rather the binoculars.  Careful scrutiny and selectivity are the names of the game in these late stages of bull markets.

With the S&P’s first close above 2000 after nearly tripling from its 2009 low, the talking heads are out in full force.

  • In a recent interview with the FT, Brian Belski at BMO, put a 4200 target on the S&P 500 by just compounding the current level of the S&P forward for a decade.  “Based on historical evidence, stocks typically enter a very long period of expansion after emerging from a period of negative 10-year returns. We found that, on average, these periods last for roughly 15 years and deliver average annual returns of about 16%. Given that 10-year holding period returns emerged from negative territory a little over a year ago and currently stand at 5.5%, it is not unreasonable to assume that there is about 10 years and 10% of average annual returns left to the current bull market. To get to an S&P 500 level of more than 4200, we have assumed that 2 percentage points of the return is dividend, and just compounded the current 1962 level of the S&P forward for a decade.”
  • Morgan Stanley reached a similar conclusion in a recently published report, titled 2020 Vision.  Rather than simply extrapolate annual stock returns forward, at least the US Equity Strategy Team at MS considered fundamentals.  There 3000 target on the S&P was based on extrapolating 6% annual earnings growth through 2020.  “The current expansion is more than five years old and there are no signs as yet that the global economy is overheating. The current US expansion has already lasted longer than the average expansion in the post-WWII period, but it isn’t unreasonable to expect that this expansion could be the longest on record. The US Equity Strategy team notes that EPS growth of 6% per year from 2015-2020 would drive S&P500 earnings to near $170. A 17x multiple would translate into a peak level for the S&P500 near 3000 under this scenario.”
  • To top it off, the WSJ ran a story this weekend titled, The Case for Sticking with Stocks – No Matter the Price.  “To be sure, many money managers insist that there is no way of knowing in advance whether the stock market is overvalued or undervalued. Investors, they say, should instead focus on issues like diversification, costs, their own risk tolerance, and their investment horizon—owning more stocks when they are young and fewer when they are older, for example.”

We agree that investors should always focus on “issues like diversification, cost, risk tolerance and time horizon,” but would suggest staying away from money managers that “don’t know” if the market is overvalued or undervalued.  It’s a pretty good bet that they are either lying (and have pretty good incentives to sell stocks and/or stock funds) or have simply not done their homework.  In either case, you are better served by moving on.

We’d also suggest that owning more stocks when they are cheaper and fewer when they are more expensive is a better strategy for generating long-term, sustainable returns while minimizing the risk of large draw-downs. Short term market timing gets a bad rap, but long-term, value-driven shifts in asset allocation remain an important tool at investors’ disposal.  Annual equity returns have averaged 21.6% when the Shiller P/E is at its lowest decile versus a meager 1.7% when valuation is at the highest decile, where it sits today.

Our friends at Emerald Asset Management, recently ran an analysis (chart below) comparing a hypothetical investment in a static balanced portfolio to a strategy rebalanced according to the Shiller P/E.  When valuation was in the highest 25% of historical observations they shifted a portion of the portfolio from stocks to bonds.  Conversely, when valuation was in the lowest 25%  of historical observations, they shifted a portion of funds from bonds to stocks.

A $100,000 investment in a balanced portfolio of half stocks and half bonds would have grown to more than $65 million from 1928 through 2013.  This sounds impressive.  At least until you realize that a value-driven allocation would have nearly doubled these results, growing to more than $123 million, over the same period.

The difference in ending values is largely due to the ability of measures of normalized valuation to pick up extreme levels of sentiment. When valuations are in the top quartile, sentiment is often extreme and euphoric markets are present. On the flip side, when valuations are in the bottom quartile, sentiment is often extremely pessimistic.

A recent Barron’s survey highlighted today’s current euphoric sentiment.  Nobody thinks the market is capable of falling. Bearish sentiment has fallen to levels last seen in 1987.  As a result, equity allocations have recovered to previous highs while cash levels are at record lows, despite what you might hear from the market pundits.

The market may appear “cheap” to many money managers that don’t know any better, so we’ll give them a clue as to why.  The chart below shows S&P earnings relative to trend.  It also shows that Morgan Stanley was at least partially right in their analysis – earnings have historically grown at 6% annually.  This can be seen by the trend growth in real earnings shown here (net of inflation).  But one thing should be painfully obvious here – earnings ALWAYS revert back to trend.

Trend Earnings

Today’s extreme levels are what makes forward and trailing earnings ratios appear cheap to the untrained eye.  But it is extremely dangerous to extrapolate today’s extreme level of earnings forward assuming trend growth from these levels.

Dow 36K

Doing so, would leave you susceptible to reaching just about any conclusion you’d like. Why stop at three or four thousand on the S&P when Dow 36,000 makes for such a better headline? Oh, right.  That book was already written . . . in 1999.

Workin’ on our night moves…