The chart below shows the Baltic Dry Index (blue line), which monitors global shipping rates, and the CRB Raw Industrial Spot index (black line), which is made up of 22 economically sensitive commodities. As you can see, typically the lines of the chart are somewhat in sync, but right now they are giving very divergent messages. So the question is, which indicator is wrong about the future direction of growth? We’ll be mulling this one over.
Everyone by now is aware of the bullish argument for precious metals including gold and silver. They’re in a secular bull market that has lasted for 10 years and fiat currency concerns may take them to bubble levels. But technically speaking, they may be overdue for a breather that appears to be occurring, and many indicators are showing this deterioration. The Relative Strength Index (black line in lower part of chart below), which is a momentum oscillator created by J. Welles Wilder, is confirming the price drop as it has fallen to new lows.
Several independent research services, including Ned Davis Research and the folks at the Bank Credit Analyst, have warned us of precious metal weakness in the short term. With their warnings and the emerging technical deterioration, we recently reduced our GLD (gold ETF) position from 5% to 3% in client accounts. We still believe in the secular story for precious metals which is why we maintained a small position, and we may add back to our positions as this correction unfolds. But at the moment, we’re anticipating a little more selling and will wait for oversold levels to start that discussion.
One of the things we are always trying to assess is what the current “consensus” market opinions are. Contrarian investors typically look to steer away from the herd, since the market presumably has discounted most of the news by the time the most investors have gravitated to a particular idea. This is especially important at market tops and bottoms, but perhaps less relevant somewhere in between – but I digress. Here are a few thoughts I think are somewhat consensus right now:
Equity Markets – Many investors seem to be bullish on equity markets for the next six months, beyond that it seems most believe a bear market may be in the offing. The masses also seem to be looking for a pullback sometime soon as bullish sentiment has picked up to levels not seen in some time. But even those looking for a pullback don’t seem to be anticipating anything worse than a benign adjustment to clear the froth, and then it’s clear sailing until the second half of the year. We are more or less in this camp right now. But it does make me a little nervous that this seems to be a commonly shared view right now.
Bond Markets – Everyone seems to figure that an improving economy ought to lead to higher bond yields over the course of this year. There also seems to be a consensus of somewhere between 4.25% and 5% on the 10-year Treasury as an approximate area where yields could start to cause serious problems for the economy. Most analysts seem to view higher yields in a negative light, and aren't open to the idea that higher yields might actually be good for stock investors if it creates a widespread bond-to-stock move. And beyond a shorter-term pullback, not many other than the perma-bear crowd are looking for a major decline in yields right here. Again, beyond a temporary pullback that we think is likely, we generally agree that yields are likely to rise over the course of the year. But we also think that yields will ultimately be capped from going too high due to low inflation, the Fed anchoring short rates, and structural economic problems. So again, I think we generally favor the consensus.
That’s my view of consensus calls, and I’ve already covered that I’m a bit nervous that we appear to dead on the consensus with our view. Of course, it’s important to note that the research we read is usually independent and consists of very smart analysts that get paid to make such calls. One must also acknowledge that sometimes the consensus is correct. That being said, it still makes me a bit nervous to be aligned with the herd.
Below is a chart of two securities: the MSCI Emerging Markets ETF (EEM) in red and the S&P 500 Dividend Adjusted Index (SP-DA) in green. The line in orange at the bottom of the chart is the relative strength line of EEM/SP-DA. When EEM is outperforming the orange line rises, and when EEM is underperforming the orange line falls. The start date for this chart is 1/23/2009 (to help illustrate my point), and it shows strong outperformance of EEM versus the S&P 500 through yesterday. But the chart can also be used to identify divergences, or differences between the S&P 500 and the relative strength line.
There are a few divergences that I can point out on this chart, which will hopefully highlight the leading characteristics of Emerging Market stocks. At the very far left of the chart, the S&P 500 fell into March 2009 while the orange line was rising. The market bottomed shortly after this positive divergence as the emerging market stocks led US stocks higher. Another positive divergence occurred in June/July 2009 as the relative strength line started moving higher while the S&P 500 made its bottom in July. There are also negative divergences, like when the relative strength line started to head lower before the S&P 500 top in April, and most recently the relative strength line has moved lower from the October peak as the S&P 500 continues higher. Does this negative divergence foretell of another correction in the S&P 500?
Here is a trick question for you. Would you rather earn a 10% return with 10 units of volatility (don’t worry about how to measure the volatility units, I’m trying to make a point here), or would you rather earn an 8% return with 4 units of volatility? Clearly the second choice is the more efficient portfolio earning higher returns for each unit of volatility (two percent return per unit of volatility in the second choice versus one percent return per unit of volatility in the first choice). The correct answer is to choose the inefficient portfolio with the highest returns. Why? Because we know the return! In hindsight, volatility shouldn’t matter, even to the most risk adverse investors. If you know that portfolio A will earn 10% versus 8% for portfolio B, then you would cheerfully choose portfolio A even though it is 150% more volatile that Portfolio B. Volatility, as a measure of risk, is only meaningful in the context of uncertain returns. However, if you don’t know, with certainty, the future returns of Portfolio A or B, a condition that reflects the reality that investors face every day, then volatility as a measure of risk becomes very relevant. Perhaps Portfolio A is on the way to losing 10% instead of earning a positive return of 10%?
In bull markets it makes perfect sense that risk and volatility are undervalued. Why would anyone complain about too much upside volatility in their portfolio? It’s fun to imagine that phone call – “Ken. I’m calling you because my portfolio is making a lot more money than you said it would. You will be hearing from my attorney in the morning.” Hindsight is an amazing tool for diminishing the value of risk management of any kind in bull markets. Any strategy that reduces returns, or potentially reduces returns, has no value. Perhaps that’s why they coined the phrase, “you can’t eat risk-adjusted returns.” In bull markets, all that matters is the magnitude of the gains.
Professional investors have several tools to measure whether or not the amount of volatility in a portfolio is “worth it” considering the amount of portfolio return that is earned. Portfolio Alpha is a well known metric that measures the excess returns of a managed portfolio to a benchmark portfolio, and then divides the excess returns by the amount of beta of the portfolio (beta is the volatility of the portfolio compared to the volatility of the benchmark). A positive alpha means that the portfolio is earning more than you should expect for the amount of risk that you are taking. So, let’s go back to our first question. Portfolio A earns 10% with a negative alpha (very bad) and Portfolio B earns 8% with a positive alpha of 4.6 (very good). Which portfolio should you invest in? I already told you…Portfolio A. It made more money than portfolio B. Alpha only matters when you are trying to figure out what will happen in the future. If you get to make the decision with 20-20 hindsight (you never get this choice), then choose the highest return every time.
According to Yardeni Research, the 3rd quarter of 2010 saw corporate America reach near record profit margins of 8.6%. One obvious way of growing corporate profits is to grow profit margins, but to plan on outsized margin growth from today’s record levels seems a little too optimistic. In fact, profit margins are mean reverting so while margins could still expand from here it seems more likely that investors should plan on flat to lower margins in the future. Another way to grow profits is to increase corporate top line sales growth. U.S. consumers continue to confound bearish analysts (I include myself in this group) who thought that consumption might be curtailed by stubbornly high unemployment statistics. The dismal number, including part-time workers who want to work full-time as well as discouraged workers who have recently dropped out of searching for a job, remains at about 17% of the workforce. You might also think that consumers would be less than enthusiastic if their home values continued to fall, which according to Case-Shiller- they have for the past four months. Nonetheless, year over year growth of retail sales was 7% by the end of November and real personal consumer expenditures grew by 2.5%. Not bad for an economy that is supposed to be saddled with consumers who are anxious to cut their spending and repair their balance sheets.
Historically investors would, quite sensibly, discount the amount that they are willing to pay for future earnings when profit margins are at record highs. In that light, paying 13 times next year’s projected operating earnings makes sense. To be exact, at today’s S&P 500 price of 1276 and current consensus 2011 operating earnings estimates of $95, the market is trading at 13.4 times estimated 2011 earnings. The question is, is 13 times earnings too low in the midst of an economic expansion? Over the past thirty years the median forward operating earnings multiple is 14 times earnings. Of course, for most of the past 30 years interest rates haven’t been at 0 and the Federal Reserve didn’t more than double the size of its balance sheet. Is it possible that investors should give this economic recovery a little more benefit of the doubt?
To get to this year’s (2010) estimated per share earnings of $83.75 companies grew operating earnings at an amazing 38% year over year rate from 2009. To get to the 2011 forecast of $95 we need a more reasonable 13% growth rate for operating earnings. If investors simply give the market its median multiple of 14 times 2011 earnings we could see the S&P 500 trade to a price of 1330 without any growth in earnings estimates for 2011. A multiple of 15x, which in my mind is unwarranted, gets us to 1,425. For the market to advance without an expansion in the multiple, something good needs to happen with consumer spending or corporate profitability. I’ve seen bullish forecasts of 4% GDP growth for 2011 fueled by 4% increases in consumer spending. Against the backdrop of an economic expansion, perhaps consumers will come to the rescue and the bulls will be rewarded. It seems as though everyone is making an argument to be more bullish nowadays.
As always happens, the bulls have trumpeted this news, and the bears pick away at the details of the report. Tomorrow will bring the over-hyped monthly payroll report, and market watchers will focus on the unemployment rate, and total nonfarm payroll jobs created. The consensus is currently for a job gain of 150,000, with 175,000 anticipated out of the private sector (meaning losses from the government sector). Anywhere around the consensus would be encouraging from a cyclical perspective, and it wouldn’t be surprising to see a decent number that coincides with the pickup in the aforementioned trends we’ve been watching. But there is no use in guessing what the actual number will be since the median difference between estimated and actual is close to 100,000, and any miss within around 100,000 is statistically insignificant anyhow.
What I really wonder about is whether a good number will matter much in the short term. We’ve been monitoring elevating levels of complacency among stock investors lately and worrying that the market might be due for a countertrend correction. Watching the market’s reaction to tomorrow’s payroll report will be as interesting as the number itself. I’m watching to see if a good report is met with selling, which might be an indication that a short term top is in. A bad number followed by buying might be equally interesting and imply that right now even bad news can’t keep this market down, so maybe stretched is about to become ultra-stretched. Tune in tomorrow, it should be an interesting show.
Chart: ADP Employment Report (yardeni.com)
