Archive for April, 2016
Michael Jordan and Market Statistics
Basketball is in the air as the NBA playoffs are once again upon us. While growing up in high school, Michael Jordan was my basketball idol, and he dominated the sport globally at the highest level. I was a huge fanatic. Besides continually admiring my MJ poster-covered walls, I even customized my own limited edition Air Jordan basketball shoes by applying high school colors to them with model paint – I would not recommend this fashion experiment to others.
Eventually the laws of age, physics, and gravity took over, as Jordan slowly deteriorated physically into retirement. On an infinitesimally smaller level, I also experienced a similar effect during my 30s when playing in an old man’s recreational basketball league. Day-by-day, month-by-month, and year-by-year, I too got older and slower (tough to believe that’s possible) as I watched all the 20-somethings run circles around me – not to mention my playing time was slashed dramatically. Needless to say, I too was forced into retirement like Michael Jordan, but nobody retired my number, and I still have not been inducted into the Hall of Fame.
“Air Wade” Before Retirement: No Photoshop in 1988, just an optical illusion created by an 8-foot rim.
Financial markets are subject to similar laws of science (economics) too. The stock market and the economy get old and tired just like athletes, as evidenced by the cyclical nature of bear markets and recessions. Statistics are a beautiful thing when it comes to sports. Over the long run, numbers don’t lie about the performance of an athlete, just like statistics over the long run don’t lie about the financial markets. When points per game, shooting percentage, rebounds, assists, minutes played, and other measurements are all consistently moving south, then it’s safe to say fundamentals are weakening.
I’ve stated it many times in the past, and I’ll state it again, these are the most important factors to consider when contemplating the level and direction of the stock market (see also Don’t Be a Fool, Follow the Stool).
- Profits
- Interest Rates
- Valuations
- Sentiment
While the absolute levels of these indicators are important, the trend or direction of each factor is also very relevant. Let’s review these factors a little more closely.
- Profits: Profits and cash flows, generally speaking, are the lifeblood behind any investment and currently corporate profits are near record levels. When it comes to the S&P 500, the index is currently expected to generate a 2016 profit of $117.47. Considering a recent price closing of 2,092 on the index, this translates into a price-earnings ratio (P/E) of approximately 17.8x or a 5.6% earnings yield. This earnings yield can be compared to the 1.9% yield earned on the 10-Year Treasury Note, which is even lower than the 2.1% dividend yield on the S&P 500 (a rare historical occurrence). If history repeats itself, the 5.6% earnings yield on stocks should double to more than 10% over the next decade, however the yield on 10-year Treasuries stays flat at 1.9% over the next 10 years. The strong dollar and the implosion of the energy sector has put a lid on corporate profits over the last year, but emerging signs are beginning to show these trends reversing. Stabilizing profits near record levels should be a positive contributor to stocks, all else equal.
- Interest Rates: Pundits have been pointing to central banks as the sole reason for low/negative interest rates globally (see chart below). NEWS FLASH: Central banks have been increasing and decreasing interest rates for decades, but that hasn’t stopped the nearly unabated 36-year decline in interest rates and inflation (see chart below). As I described in previous articles (see Why 0% Rates?), technology, globalization, and the rise of emerging markets is having a much larger impact on interest rates/inflation than monetary policies. If central banks are so powerful, then why after eight years of loose global monetary policies hasn’t inflation accelerated yet? Regardless, all else equal, these historically low interest rates are horrible for savers, but wonderful for equity investors and borrowers.
Source: Calafia Beach Pundit
- Valuations: The price you pay for an investment is one of the, if not the, most important factors to consider. I touched upon valuations earlier when discussing profits, and based on history, there is plenty of evidence to support the position that valuations are near historic averages. Shiller CAPE bears have been erroneously screaming bloody murder over the last seven years as prices have tripled (see Shiller CAPE smells like BS). A more balanced consideration of valuation takes into account the record low interest rates/inflation (see The Rule of 20).
- Sentiment: There are an endless number of indicators measuring investor optimism vs. pessimism. Generally, most experienced investors understand these statistics operate as valuable contrarian indicators. In other words, as Warren Buffett says, it is best to “buy fear, and sell greed.” While I like to track anecdotal indicators of sentiment like magazine covers, I am a firm believer that actions speak louder than words. If you consider the post-crisis panic of dollars flowing into low yielding bonds – greater than $1 trillion more than stocks (see Chicken vs. Beef ) you will understand the fear and skepticism remaining in investors minds. The time to flee stocks is when everyone falls in love with them.
Readers of Michael Lewis’s book Moneyball understand the importance statistics can play in winning sports. Michael Jordan may not have been a statistician like Billy Beane, because he spent his professional career setting statistical records, not analyzing them. Unfortunately, my basketball career never led me to the NBA or Hall of Fame, but I still hope to continue winning in the financial markets by objectively following the all-important factors of profits, interest rates, valuations, and sentiment.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Want to Retire at Age 90?
Do you love working 40-50+ hour weeks? Do you want to be a Wal-Mart (WMT) greeter after you get laid off from your longstanding corporate job? Do you love relying on underfunded government entitlements that you hope won’t be insolvent 10, 20, or 30 years from now? Are you banking on winning the lottery to fund your retirement? Do you enjoy eating cat food?
If you answered “Yes” to one or all of these questions, then do I have a sure-fire investment program for you that will make your dreams of retiring at age 90 a reality! Just follow these three simple rules:
- Buy Low Yielding, Long-Term Bonds: There are approximately $7 trillion in negative yielding government bonds outstanding (see chart below), which as you may understand means investors are paying to give someone else money – insanity. Bank of America recently completed a study showing about two-thirds of the $26 trillion government bond market was yielding less than 1%. Not only are investors opening themselves up to interest rate risk and credit risk, if they sell before maturity, but they are also susceptible to the evil forces of inflation, which will destroy the paltry yield. If you don’t like this strategy of investing near 0% securities, getting a match and gasoline to burn your money has about the same effect.
Source: Financial Times
- Speculate on the Timing of Future Fed Rate Hikes/Cuts: When the economy is improving, talking heads and so-called pundits try to guess the precise timing of the next rate hike. When the economy is deteriorating, aimless speculation swirls around the timing of interest rate cuts. Unfortunately, the smartest economists, strategists, and media mavens have no consistent predicting abilities. For example, in 1998 Nobel Prize winning economists Robert Merton and Myron Scholes toppled Long Term Capital Management. Similarly, in 1996 Federal Reserve Chairman Alan Greenspan noted the presence of “irrational exuberance” in the stock market when the NASDAQ was trading at 1,350. The tech bubble eventually burst, but not before the NASDAQ tripled to over 5,000. More recently, during 2005-2007, Fed Chairman Ben Bernanke whiffed on the housing bubble – he repeatedly denied the existence of a housing problem until it was too late. These examples, and many others show that if the smartest financial minds in the room (or planet) miserably fail at predicting the direction of financial markets, then you too should not attempt this speculative feat.
- Trade on Rumors, Headlines & Opinions: Wall Street analysts, proprietary software with squiggly lines, and your hot shot day-trader neighbor (see Thank You Volatility) all promise the Holy Grail of outsized financial returns, but regrettably there is no easy path to consistent, long-term outperformance. The recipe for success requires patience, discipline, and the emotional wherewithal to filter out the endless streams of financial noise. Continually chasing or reacting to opinions, headlines, or guaranteed software trading programs will only earn you taxes, transaction costs, bid-ask spread costs, impact costs, high frequency trading manipulation and underperformance.
Saving for your future is no easy task, but there are plenty of easy ways to destroy your savings. If you want to retire at age 90, just follow my three simple rules.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in WMT or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Avoiding Cigarette Butts
Too many investors hang their hat on investments that seem “cheap”. Unfortunately, too often something that looks like a bargain turns out to be a cigarette butt from which investors are hoping to take a last puff. As the old adage states, “you get what you pay for,” and that certainly applies to the world of investments. There are endless examples of cheap stocks getting cheaper, or in other words, stocks with low price/earnings ratios going lower. Stocks that appear cheap today, in many cases turn out to be expensive tomorrow because of deteriorating or collapsing profitability.
For instance, take Haliburton Company (HAL), an energy services company. Wall Street analysts are forecasting the Houston, Texas based oil services company to achieve 2016 EPS (earnings per share) of $0.32, down -79%. The share price currently stands at $37, so this translates into an eye-popping valuation of 128x P/E ratio, based on 2016 earnings estimates. What has effectively occurred in the HAL example is earnings have declined faster than the share price, which has caused the P/E to go higher. If you were to look at the energy sector overall, the same phenomenon is occurring with the P/E ratio standing at a whopping 97x (at the end of Q1).
These inflated P/E ratios are obviously not sustainable, so two scenarios are likely to occur:
- The price of the P/E (numerator) will decline faster than earnings (denominator)
- AND/OR
- The earnings of the P/E (denominator) will rise faster than the price (numerator)
Under either scenario, the current nose-bleed P/E ratio should moderate. Energy companies are doing their best to preserve profitability by cutting expenses as fast as possible, but when the product you are selling plummets about -70% in 18 months (from $100 per barrel to $30), producing profits can be challenging.
The Importance of Price (or Lack Thereof)
Similarly to the variables an investor would consider in purchasing an apartment building, “price” is supreme. With that said, “price” is not the only important variable. As famed investor Warren Buffett shrewdly notes, the quality of a company can be even more important than the price paid, especially if you are a long-term investor.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
The advantage of identifying and owning a “wonderful company” is the long-term stream of growing earnings. The trajectory of future earnings growth, more than current price, is the key driver of long-term stock performance.
Growth investor extraordinaire Peter Lynch summed it up well when he stated,
“People Concentrate too much on the P, but the E really makes the difference.”
Albert Einstein identified the power of “compounding” as the 8th Wonder of the World, which when applied to earnings growth of a stock can create phenomenal outperformance – if held long enough. Warren Buffett emphasized the point here:
“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
Throw Away Cigarette Butts
I have acknowledged the importance of aforementioned price, but your investment portfolio will perform much better, if you throw away the cigarette butts and focus on identifying market leading franchise that can sustain earnings growth. The lower the growth potential, the more important price becomes in the investment question. (see also Magic Quadrant)
Here are the key factors in identifying wining stocks:
- Market Share Leaders: If you pay peanuts, you usually get monkeys. Paying a premium for the #1 or #2 player in an industry is usually the way to go. Certainly, there is plenty of money to be made by smaller innovative companies that disrupt an industry, so for these exceptions, focus should be placed on share gains – not absolute market share numbers.
- Proven Management Team: It’s nice to own a great horse (i.e., company), but you need a good jockey as well. There have been plenty of great companies that have been run into the ground by inept managers. Evaluating management’s financial track record along with a history of their strategic decisions will give you an idea what you’re working with. Performance doesn’t happen in a vacuum, so results should be judged relative to the industry and their competitors. There are plenty of incredible managers in the energy sector, even if the falling tide is sinking all ships.
- Large and/or Growing Markets: Spotting great companies in niche markets may be a fun hobby, but with limited potential for growth, playing in small market sandboxes can be hazardous for your investment health. On the other hand, priority #1, #2, and #3 should be finding market leaders in growth markets or locating disruptive share gainers in large markets. Finding fertile ground on long runways of growth is how investors benefit from the power of compound earnings.
- Capital Allocation Prowess: Learning the capital allocation skillset can be demanding for executives who climb the corporate ladder from areas like marketing, operations, or engineering. Regrettably, these experiences don’t prepare them for the ultimate responsibility of distributing millions/billions of dollars. In the current low/negative interest rate environment, allocating capital to the highest return areas is more imperative than ever. Cash sitting on the balance sheet earning 0% and losing value to inflation is pure financial destruction. Conservatism is prudent, however, excessive piles of cash and overpaying for acquisitions are big red flags. Managers with a track record of organically investing in their businesses by creating moats for long-term competitive advantage are the leaders we invest in.
Many so-called “value” investors solely use price as a crutch. Anyone can print out a list of cheap stocks based on Price-to-Earnings, Enterprise Value/EBITDA, or Price/Cash Flow, but much of the heavy lifting occurs in determining the future trajectory of earnings and cash flows. Taking that last puff from that cheap, value stock cigarette butt may seem temporarily satisfying, but investing into too many value traps may lead you gasping for air and force you to change your stock analysis habits.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in HAL or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Spring Has Sprung: Market Weather Turning
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (April 1, 2016). Subscribe on the right side of the page for the complete text.
It was a cold winter for stocks, but as we approached the spring season in March, the flowers have begun to bloom. More specifically, during the month of March, the Dow Jones Industrial index catapulted +7.1% and the S&P 500 index jumped +6.6%. While this roughly +80% annualized rate is unlikely to sustain itself, this flurry of strong performance could be the sign of warmer weather conditions in the economic forecast.
What started out as a cold and blustery January, with stocks posting one of the worst beginning months in history (S&P 500 down -5.1%), quickly thawed out in February and March. Fears over deteriorating economic conditions in the U.S., China along with plummeting oil prices proved fleeting. In fact, as Scott Grannis at Calafia Beach Pundit pointed out, there is no sign of recession in the U.S. as evidenced by a 43-year low in unemployment claims and a 4.9% unemployment rate (see chart below).
As I’ve stated for many years, focusing on the never-ending hurricane of pessimistic headlines is a wasteful use of time and destructive force on performance, if acted upon. Offsetting the downpour of negative news stories are the record low interest rates (now incomprehensibly negative in parts of the globe), which serve as a protective umbrella against the short-term stormy volatility. When investors face the soggy reality of earning a near-0% return on their bank savings and a sub-2% Treasury bond market for 10-year maturities, suddenly a 6-7% earnings yield on stocks certainly looks pretty sunny. There have been very few times in history when dividends earned on stocks have exceeded the payments received on a 10 year Treasury bond, but that is exactly the extreme environment we are living in today. No doubt, if the interest rate climate changes, and rates spike higher, stocks will face a more thunderous environment.
However, fortunately for stock market investors (and unfortunately for savers), this week Federal Reserve Chair Janet Yellen reiterated her forceful view of maintaining interest rates at a low, stimulative level for an extended period of time.
If It Bleeds It Leads – At the Expense of Your Portfolio
Even in the face of European terrorist attacks in Brussels and a turbulent (but entertaining) political presidential election season, the four pillars of earnings, interest rates, valuations, and sentiment are still protecting stock investors from an economic flood (see also Don’t Be a Fool, Follow the Stool). Scary news headlines may sell newspapers and attract advertising dollars, but the real money is made by following the four investing pillars.
Also contributing to a clearer outlook this spring is the steadying value of the U.S. dollar and stabilizing trend realized in oil prices.
For most of 2015, multinational corporations saw their profits squeezed due to a 20-25% spike in the dollar. For example, an auto manufacturer selling a car for $20,000 in the U.S. could suddenly see the price of the same car changed to $25,000 in Europe. Meanwhile, a different German competitor could price a similar car manufactured in their country at the lower $20,000. This all translates into diminished sales and profits for American companies. Mercifully, we are beginning to see these currency headwinds abate, and even begin to shift into a slight tailwind (see 5-year chart below).
Source: barchart.com
From copper and corn to silver and soy beans, commodity prices have been in a downward death spiral over the last five years. And crude oil hasn’t escaped the commodity collapse either…until recently. The supply glut, created by factors like the U.S. shale revolution and new added Iranian post-sanction reserves, led to price declines from a 2009 high of $147 per barrel to a 2016 low of $26. With China and U.S. dollar fears abating, oil prices have bounced about +45% from the 2016 lows to about $38 per barrel.
While the weather has been improving on our shores, not everyone appreciates the fact the U.S. has been the “best house in a bad global neighborhood.” As the chart below shows (February 2016), international stock markets have gone into a bear market (down > -20%) since the 2011 and 2014 peaks, while the U.S. has performed about 100% better. Even in the U.S. market, small-midcap stocks (small & midsize companies) fell about -22% from their 2015 peak before recouping much of the losses.
Source: Financial Times
Whether large companies, as measured by the S&P 500 index, which fell about -15% from the peak, suffer a true, technical -20% “bear market” or continue the current seven-year bull market is debatable. Regardless, what we do know is investors survived another cold winter and spring has produced a weather forecast that is currently predicting warmer weather and sunnier economic skies.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
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