Stock Market Analysis and Perspective On Risk vs. Reward
by the Curmudgeon with Victor Sperandeo
Note: Part II will take another look at S&P 500 earnings estimates and expand on Victors comments.
Strong Stock Price Action; Weak Economic Reports:
"Don't fight the tape," said the late Marty Zweig, esteemed Wall Street Week panelist, hedge and mutual fund money manager. The market's tape (price action) has been strong for several weeks. This Thursday, August 11th, all three major indexes (DJI, S&P 500, and NASDAQ) made all time new highs, as did the NASDAQ 100. Breadth (A/D line) has been stable, new highs are far ahead of new lows, Leuthold Major Trend Index is a bullish 1.22 (as of August 5th) and Investech's Negative Leadership Composite has moved up to +42 with bearish distribution =0 (considered to be a Selling Vacuum").
Thats all very bullish price action, which has been accompanied by extreme investor complacency. After shooting up to 25 after Brexit, the VIX volatility index has collapsed to a 2 1/2 year low of 11.55.
Well respected technical analyst Martin Pring said on January 29, 2016 that we were at the beginning of a bear market. Last week, he said on MoneyLife with Chuck Jaffe that:
The market looks pretty good and my indicators have started to turn bullish. Prings indicators that had been bearish have become more positive despite the market not taking any sort of broad dive. He described the market action as having come through something of an internal bear market, where the indexes trade in a band or range and avoid a big decline. That trend has ended, Pring noted, and everything looks to be going up in lockstep. Not only does he see a good up move in the US market, but Pring is bullish on stocks worldwide, largely based on his global advance/decline indicator. Emerging markets and Asia look particular good, Pring said.
Such bullish price action has defied the economic news, which has been uniformly bad with almost all numbers coming in below the consensus estimates of economists and analysts. Here are the important US economic numbers from last week:
· Productivity fell (for the 3rd consecutive quarter) by -0.5% vs consensus estimates of +0.5% as we reported this past week in a special blog post.
· Retail sales were flat vs a consensus estimate of +0.4%,
· Consumer Sentiment (University of Michigan index) was essentially flat at 90.4 for the August flash report (a tiny .04 gain on the month) vs a consensus estimate range of 90.5 to 93.0. It was 1.5 points below the year ago (August 2015) reading of 91.9.
· Bloomberg Consumer Comfort Index1 fell sharply in the August 7th week. It was down 1.2 points to 41.8, which is the lowest reading of the year. Though the presidential election and the effects of Brexit are uncertainties, the decline is a surprise given strength in the labor market (as per last two BLS non-farm payroll reports) and record highs in the stock market (despite declining earnings).
· US federal government budget deficit was at $112.8 billion in July; the highest since February's $192.6 billion. The deficit so far this budget year (ending Sept 30th) is running 10% higher than a year ago, the Treasury Department reported.
· The US governments budget shortfall for the first 10 months of the year was $514 billion, up from $466 billion in the same period a year ago. Gross corporate tax receipts have dropped 12% so far this budget year, reflecting a drop in business profits.
· The US Producer Price Index was down 0.4% in July vs. a 0.1% increase expected. That was the first decline since March and the largest since September 2015 in yet another sign of economic weakness.
-->As noted, all those numbers came in BELOW analysts expectations/estimates!
Also of note was that the value of negative-yielding (global x-US) bonds increased to $13.4 Trillion, according to the Financial Times (on line subscription required). That indicates an extraordinarily week global economy, but stock markets dont seem to be worried.
Note 1: The Bloomberg Consumer Comfort Index is a weekly, random-sample survey tracking Americans' views on the condition of the U.S. economy, their personal finances and the buying climate. When the index falls sharply it almost always results in decreased consumer spending which lowers GDP (68.4% of US GDP is due to consumer spending AKA "Household Final Consumption Expenditures," according to the World Bank- 2014 statistics).
Victor on Risk vs. Reward in the US Stock Market:
The essence of successful investing and/or trading in any market is winning big and losing small. That comes from the ability to analyze "risk versus reward."
Let's use two popular equity indexes - the S&P 500 (large caps) and the Russell 2000 (small caps) - over two different time periods to examine if the risk versus reward was favorable or not.
· The annual compounded return (not including dividends) from 12/31/14 to 8/12/16 on the S&P is 3.8%.
· For the Russell 2000 the return was 1.31% during that time frame.
· The S&P recently made a series of new all-time highs this month (most recently on Thursday 8/11/16), eclipsing the May 21st 2015 high of 2130.82.
· The Russell made an all-time high on 6/23/2015 at 1295.99. It closed Friday, 8/12/16 at 1229.82. These were the rewards of these equity markets.
The US economy as measured by GDP was 1.74% compounded from December 2014 to June 2016. The Curmudgeon has pounded the table that corporate earnings have been declining for well over most of that time (5 consecutive quarters of down earnings according to FactSet).
So US stocks have been flat to up in a minor way for the last 20 months, while the economy has stagnated and corporate profits have been flat to down.
Curmudgeon Note: There have also been two sizable corrections in the last 12 months that caused many investors to sell out and miss the rally from February 11th to date. Many experts called for a severe bear market earlier this year. On January 12th the Royal Bank of Scotland said: "Sell everything except high quality bonds."
-->So you be the judge: was the risk worth the reward for most investors and traders during the last 20 months?
Lets now look at the risk of owning stocks based on Standard Deviation (S/D) applied over almost four decades.
· From 1979 to date, the S/D of the S&P 500 is 15.16%, with a mean compounded rolling 12-month return of 11.72% in 536 rolling periods.
· The Russell 2000 has a S/D of 19.49%, with a mean compounded return of 12.87% during the same time frame.
Note: one S/D means the S&P 500 can range from +26.88% to -3.44%, while two S/Ds can result in a +38.6% to -18.60% gain or loss based on a given mean return of 11.72% and 12.87%, respectively from 1979 to date.
The Russell 2000 can range from +32.36% to -6.62% with one S/D. Using two S/D's, which takes into account 95% of the distribution of occurrences, the advance or decline can range from +52.85% to -26.11%.
The worst declines since December 31 2014 have been:
· S&P 500= -14.45% (5/21/15-to-2/8/16)
· Russell 2000 = -26.4% (thats two S/D's from the closing highs) in 2015.
Clearly the risk is high and not good considering the S&P 500s +6.9% 2016 YTD return, which has been accompanied by 1% US GDP growth for the first six months of the year and NEGATIVE growth in S&P 500 corporate profits (also expected to be negative for all of 2016, as to be described in Part II of this post). Using a two S/D decline, the S&P would be down -23.42% from Fridays (8/12/16) closing price. Of course, it could move up by two S/D's also.
However, at this very late stage of the business cycle, with all other fundamental factors considered (e.g. declines in corporate earnings/ profits recession, a weak global economy, impact of Brexit on the UK and EU, China islands disputes, US election uncertainty, etc.) this clearly doesn't indicate a great upside for stock prices.
What might drive earnings upward after the 2016 elections? We dont know at this time. After the election, that can be reevaluated and well share our views.
This quote should be kept in mind if you are long stocks, considering the weak economy and declining corporate profits:
"The irrationality of a thing is no argument against its existence, rather a condition of it." by Friedrich Nietzsche
Good luck and till next time...
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2016 by the Curmudgeon and Marc Sexton. All rights reserved.
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