Shifting tides

The stock market is frequently looked at as one amorphous whole.  It’s not.

Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance.  Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc. 

What seems to surprise investors is how long these trends can last–years, not months.  Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue.  Just the opposite is the case.

Mean reversion–the tendency of a prices to move back to average–is one of the most powerful forces in finance.  That which has performed best is likely to reverse over the long run.  Just when investors think the tide has gone out, it comes back in.

I believe this is especially the case today.  Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed…well…almost everything.  But, that which can’t go on forever, won’t.

In particular, I’ve been surprised at how well small has done versus large.  From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year!  If that doesn’t sound like much, let me rephrase: it’s the difference between no return over 12 years and doubling your money!

Let me clarify: small usually beats large.  Small companies can grow faster and are more nimble, so it’s normal for small to beat large over the long run.  But, the margin is usually a little over 1% a year, not more than 6%.  It’s the difference between having 12% extra money and having over 100% extra. 

Now, this can not last.  And, it won’t.  Regression to the mean will cause large to out-perform small for several years until historical relationships are restored.  I can’t guarantee that, but it’s as close to a sure thing as you can get with investing.

When will the tide come back in?  I don’t know.  I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out.  From 2004 until now, I’ve been shifting more and more from small to large in anticipation of the sea change.  What has surprised me is that I expected the tide to come in sooner (as it has historically).

Just because the tide seems to be going out more than I thought doesn’t mean I should try to ride it to the last.  Quite the opposite.  The smart thing to do is switch when it becomes prudent and wait for the inevitable.  I’m patiently waiting, and expect to be riding back in to shore soon enough.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Shifting tides

The wall of worry

It should be obvious by now–I’m not much of a short-term market prognosticator.

I can predict 5-10 year returns with a fair bit of accuracy, but I’m terrible over the next day or year.  Fortunately for me, the long run is what matters.

If you’ve read my blog posts over the last 6 to 9 months, you know I’ve been overly pessimistic about both the economy and the stock market.  Whereas I saw trouble brewing in Europe, China, and Japan, and poor U.S. employment and growth, things didn’t turn out that bad.  In fact, things are looking decidedly more upbeat of late.

Which brings me back to my title: “the wall of worry.”  It’s an old Wall Street saying that a bull market climbs a wall of worry.  If everyone is optimistic, big market gains are unlikely because everyone who will buy has bought.  In contrast, when some or many are pessimistic, the market has room to run if and/or when the fundamentals prove the doubters wrong.

I was a doubter, and the market climbed the wall of worry–right over my head, in fact.

But, that was yesterday, and to generate good returns over time we must focus on the future.  Is there currently a wall of worry for the market to climb over?

I think there is.  First, there are still plenty of doubters.  Several very intelligent market mavens with excellent long term records continue to forecast storm clouds ahead.  Perhaps it will be their turn to be stepped over. 

Second, look at the news and you’ll see Korea on the brink of war, China trying to slow down its economy, Europe’s peripheral countries in fiscal shambles, rising unemployment in the U.S., etc.  Bad news is frequently the wall of worry markets must climb. 

There are plenty of worries and worriers to clamber over, still. 

That doesn’t mean the market will necessarily rise, or stay flat, or climb (did I miss any possibilities?).  What it does mean is the market could continue climbing, and part of what can and may fuel that rise is the many concerns and few doubters out there. 

The short term may look okay, but the long term isn’t quite so sunny.  By my estimates, the S&P 500 is likely to return 4.1% annually from its present 1220 price over the next 5 years.  That projected 22.25% cumulative rise may be a steady 4.1% a year, but it’s much more likely to be more volatile.  For instance, the market could rise 20%, then tank 50%, then rise 103.75%.  Any way you slice it, though, 4.1% isn’t a huge annual return, and trying to time the market to sell at the top and buy at the bottom is a fool’s errand.

The short run (next year?) doesn’t look too bad (though my poor short run prediction record should now be scaring you). 

After that, the check will come due.  I don’t know when or how that will happen, but I’m preparing by buying investments that I think can solidly beat that 4.1% annualized return, regardless of how bumpy the path may be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The wall of worry

Expectations…fulfilled?

There’s a lot of news coming out next week, both mid-term elections and the Federal Reserve meeting to announce the much-anticipated launch of QE2 (quantitative easing, round 2). 

The key question for markets is: how much of the news is already factored into prices?

This points to one of the most difficult concepts for investors to grasp–prices do not reflect current or past information, but investor expectations.

Many investors are surprised when good news comes out–“company earnings grew 50%”–only to see a stock’s price tank.  Why?  Because market price already reflected greater than 50% growth. 

Or, they’re surprised to see bad news–“the economy shrank by 2%”–lead to a jump in the stock market.  Why?  Prices reflected a more than 2% economic decline. 

Prices, whether for bonds, stocks, commodities or currencies, reflect investor expectations.  Prices move up when actual news is better than expectations and down when it’s worse than expectations.

Which raises the question in my title: will news next week exceed, fulfill or disappoint expectations?  If fulfilled, prices won’t move much; if exceeded, prices will jump; if disappointing, prices are likely to fall.

Right now, investors clearly expect the Federal Reserve to announce a quantitative easing package that is favorable to bonds, stocks and commodities and bad for the dollar.  Will that announcement fulfill, exceed or disappoint?  Markets seem too optimistic to me, but as the old Wall Street saying goes: “don’t fight the Fed.”  On the other hand, is the Federal Reserve printing dollars really a cause for stocks and bonds to appreciate?  Something to think about.

Investors currently expect Republicans to take back the House of Representatives and make gains, if not restore a majority, in the Senate.  Do market prices already reflect that expectation, or will they be disappointed?  For that matter, are market participants correctly reflecting what will actually happen if their expectations are fulfilled?  Will Republicans cutting spending be good or bad for stock prices in the short run?  Something to ponder.

The S&P 500 is selling for around $1180 right now, reflecting an expectation of 14% per share earnings growth over the next year.  With the economy likely to grow at around 2% and profit margins at cyclical highs, is overly optimistic earnings growth expected?  What will happen to stock prices if those expectations go unfulfilled?

In the long run, investing success is all about paying the right price for an asset.  In the short run (which is what Wall Street does with less than 6 month holding periods), investing success is all about guessing investor expectations.  For those focused on the long run, next week is a non-issue.  For those focused on the short run, next week will be a nail-biter.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Expectations…fulfilled?

The stock market is down, but is it cheap?

Caution: please remove sharp objects from arms reach before you read this!

The S&P 500 is almost in bear market territory, down just short of 20% since its most recent high.

This fact leads market commentators to question if the market is getting cheap.

My answer: looking at long term, historical evidence, the market is not cheap. In fact, it would have to drop another 23% from current levels or remain flat for 4 1/2 years before trading at historical, fair value.

Before you read my reasoning below, please keep in mind that you don’t have to invest in the market as a whole. In fact, there are times when it’s better to invest in active managers who are trying to beat the market (but make sure they really can beat the market). Because I believe we are in a secular bear market that started in 2000, I think this is one of those times.

I’m finding some of the best bargains I’ve seen in my 12 1/2 years of investing. I’m absolutely giddy about the great companies I’m finding at great prices. This evaluation does not, however, include the stock market as a whole.

Why do I think the market is expensive. In a word, history. Looking at the history of the S&P 500, you can clearly see that earnings per share grow at around 6% a year over the long term. A plot of S&P 500 earnings per share with a simple exponential fit is a wonderful thing to behold (send me an email if you want to see it). Every time earnings per share deviates from the long term average, it regresses to the mean. Every time.

Using such a plot, I can see what the average, forward price to earnings ratio has been since 1948 by simply dividing year end price by the one year forward estimate of earnings (using the 6% growth rate fit on historical S&P 500 earnings per share).

Since 1948, the forward price to normalized earnings ratio has been 14.85. Let’s keep things simple by rounding up to 15. That allows for the fact that price to earnings ratios have been creeping up over time.

Using my plot of normalized earnings per share for the S&P 500 of $65.70 (June 30, 2009 normalized earnings per share for the S&P 500) and an historic price to forward earnings of 15, I come up with a fair value for the S&P 500 of $985.50, or 23% below current levels ($1,280 at the time of this writing).

By my reasoning, the S&P 500 wouldn’t be at fair value unless: 1) it drops another 23% tomorrow or 2) remains at $1,280 for the next 4 1/2 years.

I don’t mean to scare anybody with my forecast, I’m simply showing that, in the long term, price follows earnings. And, if earnings grow at historic rates and the market is willing to pay in the future what it was in the past for those earnings, then the S&P 500 is anything but cheap right now.

I wouldn’t assume a lot better results if you’re invested in the market, or with a professional investor who is so diversified as to essentially be mimicking the market (a lot of them are, a whole lot).

Take heart, though. You don’t have to invest in the market. Look for stocks that are better quality and cheaper than the market and you’ll do just fine. Or, better yet, find a professional who can do it for you.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.