The Good News…

After a sharp decline in the stock market last week, investors were once again awakened to the reality that stocks are called risk assets for a reason… sometimes they go down. The reason why stock investors have been well compensated over the years, is because they have to put up with these types of volatile events from time to time. Nonetheless, I know the financial media will be quick to dwell on all the negative aspects of last week’s action. However lets take a look at the good news.

  1. Dividend Yields have increased.

DIVIDEND YIELD

Dividend yields have an inverted relationship to price. As the price of a stock or index (S&P 500) rises, the amount of the dividend (in percentage terms) decreases. And vice versa.

The chart above is the dividend yield on the S&P 500 index. We hit a low of 1.73% as the market topped out in January. After the decline, the dividend yield has increased to 1.82, a 5% increase.

     2.  Valuations have gotten cheaper

EPS_GROWTH

Earnings Per Share (EPS) projections for the S&P 500 companies in 2018 and 2019 have risen sharply in the last two months. The 2018 estimates were for $146 per share in December and are now $157.02 per share. An increase of about 7.5%. The 2018 earnings growth estimates are nearing 20%.

PE

So the increase in the earnings estimates coupled with the decline in the price of the index has culminated in a decrease in the valuation investors are paying for those earnings. Before the decline investors were paying almost 19x 2018 earnings. Now investors paying 16.3x for 2018 earnings, which is closer to the historical average. Especially given the low inflation, low interest rate environment we are in.

Investors are paying 16.3x forward earnings when earnings growth is projected to be close to 20% for the year. And interest rates are still below 3%, at least for now. That’s a pretty enticing offer.

    3. The correction has almost equaled the 2015-2016 decline.

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In 2015, the stock market experienced a correction of about 12% and then proceeded to get off to the worst start to a year ever recorded in 2016. The total combined correction was about 12.31% on a closing basis, and 15.21% on an intra-day basis.

If we project that from the all time highs hit earlier this year, potential support should be in the area of 2519 and 2435 on the S&P 500. We got close to that level on Friday and have bounced back a bit since then. It’s possible that the market may be “scrapping bottom” in terms of the Friday low. Further downside appears limited even though this bottoming out process could likely take time. This correction will setup the next leg higher.

     4. Largest volume amounts have come on the up days

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The chart above is the S&P 500 index ETF, the most liquid and popular fund used to track the S&P 500. As you can see, the days with the most amount of volume have come on the two days that the market has closed higher.

I take this as a positive because you often see the reverse during corrections. The down days are usually accompanied by higher volume totals. Not this time. At least not yet.

5. “Black Monday” 1987 was the buying opportunity of a lifetime!!!

1987

No two situations are ever truly alike. But the pace of last week’s decline surely brought up comparisons to the 1987 stock market crash. The 1987 crash was the only technical bear market that wasn’t accompanied with an economic recession in the post WWII period. A bear market is highly unlikely without an economic recession, but there is always a slight chance. However if we really look at what happened, and it’s aftermath, my hope is that by facing our fears we can learn from them.

The above chart shows the daily price action in the S&P 500 index in 1987. The index had been rising sharply, showing a year to date gain of 39.5% by September! So the crash came sharp and fast, a 36% decline which came mostly during the last 3 days. But the year to date decline maxed out at 10.62%, which isn’t out of the ordinary. In other words, the market got way ahead of itself and had to readjust.

I can’t imagine what that must have felt like. There is no way to not let such a steep decline bother you. But we do have a choice of how we react to those emotions.

In this case the decline was short lived and presented the buying opportunity of a lifetime.

1987_-_2000.png

The chart above shows what happened after the 1987 crash. The crash is barely visible. It kicked off one of the biggest bull markets in history from 1987 to 2000. Resulting in a total return of about 816%.

The emotions were real. But as long as you didn’t panic, you made out well.

Summary: Corrections and volatility are a typical part of the market cycle. What happened in 2017 isn’t the norm. We experienced a rising market without anything more than a 3% correction for almost 2 years. And now we are making up for lost time.

The financial markets are adjusting to the new reality of a stronger global economy. Yes rates are starting to rise, but it’s for good reasons. Sooner or later the market will realize this. In the mean time, investors should try to remain as balanced as possible. Not getting too high when things are good, and too low when things turn down.

It’s very unlikely that a significant bear market will occur. But even it if does, as we saw in 1987, it would likely be short lived and setup a strong rally.

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What Happened!?

Well its been awhile since investors felt what it’s like to experience a correction. As a result of todays close, the markets have now experienced its largest pullback in almost two years.

The average intra-year decline is around 15%, when the markets haven’t pulled back more than 3% since 2016. Stocks are called risk assets for a reason. Sometimes they do go down. And when they go down, it’s usually sharp and fast. Investors need to be aware of this and not allow themselves to get caught up in the short term noise, even though this is much easier said than done! If you’re prone to get anxious on days like this, it’s best to shut down the computer screen and change the channel to something else until the dust settles. Remember, not every correction leads to a crash. A crash is a low probability event in and of itself, and even rarer to experience one without an economic recession. You’d have to go back to 1987 (30+ years) to find such an event.

 
So what happened?

 
Two things in my opinion:

 
1) Overdue for pullback.

 
As I mentioned in the intro, the market hasn’t pulled back more than 3% in almost two years. This is highly unusual and a reversion to the mean is to be expected at some point.

 

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Take a look at the above chart to see how far above the market is/was trading above its 50 and 200 day moving average. This is unsustainable in the near term.

 
2) The sharp increase in interest rates.

 

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The benchmark 10 year treasury rate has risen almost 50% since September. This is because of good reasons, the economy is improving, corporate profits are at all-time highs (expected to grow 16% for 2018) along with tax reform and infrastructure spending benefits as well.

 
However the rapid pace of the advance in rates is what the market needs to now “reprice”. Cash flows are discounted by the risk free rate, and the 10 year treasury rate is subtracted from the earnings yield on the S&P 500 to come up with the “equity risk premium”. Which basically means that as rates rise, fixed income becomes more competitive to stocks, thus potentially reducing valuations on stocks. I don’t see this as being an issue unless the 10 year treasury rate gets above the 3.5% – 4% range.

 

January

 

Some good news. If we look at historical returns on the S&P 500, each year that included a positive January performance is included in the attached chart. The outcome looks impressive. 82.6% of the time the stock market closes the year above the January highs. The average annual gains are around 16%, and the average gain above the January close has been about 12% higher.

 

Midterms

 

Also looking at the market performance during midterm election years since 1950, we see precedence for volatility.

 
The average and median intra-year pullback is 16-17%, while the total return a year later averages 32%. This means we should be ready for a correction, but staying the course should prove most prudent in the end.

 
This is good data to look at, especially on a bad day like today. It doesn’t tell us what the future holds (this year could be one of the 18% of times the market closes the year below the January close) though.

Investors should also keep in mind there’s positives about stock declines. Dividend yields and future expected returns go up.

 

Conclusion: No one knows whether Friday’s decline is the end of the pullback, or the beginning of a correction in the 5-15% variety. Economic fundamentals continue to improve, financial stress is low, corporate profits are high, interest rates are rising but are still well below average, and valuations are reasonable in comparison to rates and inflation.

The key point is to not let yourself be swayed by short term market reactions in either direction. Don’t get caught up in the hype and get aggressive when markets are rising rapidly. And don’t get too low when the inevitable volatility events occur either.

Financial Markets Chart Package…

Here is a quick review of the global markets. Most markets are in the midst of a pullback within a broader uptrend.

S&P 500 (US)

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The S&P 500 is down about 3% from it’s recent all time highs. Currently fighting to stay above the 50 day MA. A break below 2417 makes the 200 day ma (red line) likely to come into play.

Nikkei Average (Japan)

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After breaching the 20,000 level earlier this year, Japan’s stock index is currently testing the 200 day MA on a pullback closer to 5%.

CAC 40 Index (France)

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France’s stock index has retraced all of the gains post election. It’s down about 6.6% from it’s recent highs, but still trading above the 200 day MA for now.

DAX Composite (Germany)

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Germany has a similar setup, also down 6.5% from recent highs.

FTSE Index (UK)

ftse

UK is also in a similar setup, only down 3.50% from recent highs.

Shanghai Stock Exchange (China)

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Bucking the trend is China, which has broken out of its recent trading range and making new highs.

Internals (Advance – Decline line)

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The NYSE advance decline line continues to show strength overall. A short term bearish divergence could be setting up (possible lower high) if the cumulative average breaks below the recent low.

Equity Performance

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A currency adjusted performance chart shows US stocks under-performing International developed and emerging market stocks by a wide margin year to date.

The reason for this has to do with the performance of the US dollar.

fredgraph

The trade weighted average peaked in late 2016, right around the prior high in 2001.

usd

If we drill down and look closer at recent price action, we can see the decline more clearly. This accounts for much of the international equity out-performance.

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The 10 year treasury rate has also stalled this year. In fairness, it was quite a run in rates post election. So some consolidation was necessary. But it’s also possible that although the stock markets have largely ignored what is going on in Washington, perhaps the bond and currency markets are reacting to it. I’d like to see the 10 year stay above 2%.

Conclusion:

Global equity markets continue to trade on decent fundamentals (increased global GDP and corporate profit growth). Recession risk is low and valuations compared to alternatives and inflation are positive. I expect the secular uptrend to continue, although with stops and starts along with way (of which no one can predict with any consistency).

One of the pressing things that does concern me is the debt ceiling debate. Although this has more short term implications. For investors, any serious disruption should be short lived. So take advantage of the opportunity if it presents itself.

Thanks for reading.

Volatility Index takes out its pre-crisis lows…

2017-06-09-TOS_CHARTS

The S&P 500 volatility index shows the market’s expectation of volatility over the proceeding 30 days. Since volatility is attributed to declining markets, a rising VIX usually coincides with market sell-offs, and vice versa.

Today the VIX fell to 9.37, which took out the low of 9.39 that occurred on December 15, 2006. I want to stress that this is simply an observation and not a market prediction. The VIX can stay low for a long time, and even a rising VIX is not always a precursor to a bear market.

The observation; are we becoming too complacent to the risks that equity investing represent? The fundamentals continue to improve and confirm a recovery in it’s middle to late stages. But on the flip-side, the expansion is now over eight years long, and global central banks will soon be moving to tighten unprecedentedly easy monetary policy conditions at the same time.

Chances are your not going to be able to time the next major correction or serious bear market. So the better course of action is to take a look at your portfolio now and assess whether your taking more risk than you’d be comfortable with in a bear market. It’s better to prepare now (when stocks are at all time highs) then try to re-balance in the middle of a serious volatility event.

Interest rates at key support levels…

2017-06-06_1034

The 10 year US treasury bond interest rate is the benchmark for fixed income. Over the last 12 months, interest rates reached a generational low of 1.33% in July 2016. They rallied sharply post-election, almost doubling to 2.62%, on the expectation of higher growth and inflation. And have since traded sideways to lower over the last few months. Today the 10 year rate has declined back to 2.14% as I type this. However there is a confluence of support here that could potentially provide the next leg up in rates.

The chart above shows the price action. The support zone is a combination of the 38% retracement level of the rally off the 2016 lows. There is also an open gap from November 10th just a few ticks below. The support zone comes in between 2.11% and 2.13%.

I’ll be watching these levels carefully over the next few weeks. If it holds, I would expect a move higher in the vicinity of 4% (where I believe the real rate of interest should be – discussed below). If it fails, we still have the nice round number of 2%. But much time spent below that puts the uptrend in serious jeopardy.

2017-06-06_1053

This decline in long term rates has flattened the yield curve to its lowest levels in 8 years. It’s something the Fed must consider as it begins normalizing monetary policy, as an inverted yield curve has been a precursor to most recessions and bear markets post WWII. At this point it’s not anything to worry about. But at some point monetary policy will become restrictive enough to expire the business cycle. We are not anywhere near that point yet.

2017-06-06_1110

We must also take the global fixed income picture into context. US rates are at historic lows, but a case can be made that they still have value when taken into context with the global picture. Germany’s bonds are yielding 0.25%, and Japan is 0.03%. The only comparable yields in the developed world are Italy and Spain, both of which are currently struggling with double digit unemployment and shaky banking systems.

So what happens if interest rates continue to rally? Many have cited this market rally as being a bubble ready to explode at any moment. The problem with historical valuation methods (price/earnings, price/sales, price/cash flow, etc) is they don’t take into account for inflation and interest rates.

It’s true that trailing and forward price to earnings ratios are on the high side, however inflation and interest rates are also lower than at anytime in at least the last 20 years.

There is no perfect formula here, but I personally like using the equity risk premium as a gauge of valuation. The equity risk premium takes the earnings yield of the S&P 500 and it subtracts it from the interest rate of the 10 year.

Currently the earnings yield is 5.54% (forward S&P 500 earnings of 135 divided by the current price level of 2439), while the 10 year rate is 2.16%. This means the equity risk premium is 3.38%, which makes stocks still attractively valued even at these high levels. It also means that investors are getting compensated for the extra risks they are taking in stocks compared to the relatively risk-free rate of US treasuries.

Let’s assume the 10 year rate rallies to 4.00%, which accounts for 2% GDP growth and 2% inflation. The equity risk premium would still be positive at the current earnings yield. At some point interest rates will rally high enough to make current valuations high or even extreme. And corporate profits could decline and make the earnings yield on stocks less attractive to fixed income.

I do think there may be a bubble in corporate fixed income (and sovereigns too for that matter) as companies take advantage of low rates. But that’s probably not a near term concern as long as GDP growth and inflation remain subdued.

The key is to understand what purpose fixed income serves in your portfolio. If your looking at fixed income to continue the stellar performance of the last 20-30 years, your probably going to be disappointed going forward. You’ll probably be better off in stocks if you can handle the risk.

Most people can not stomach the volatility of being 100% in stocks. If you find yourself reacting to stock market volatility, then you know you’ve taken on more risk then you can handle. In this case bonds still serve a quality purpose, and you shouldn’t be scared out of owning bonds even in spite of the potential for higher rates in the future.