Are the markets priced for perfection?
November 22, 2017
Shashi Mehrotra is the Chief Operating Officer and Chief Investment Officer of Legend Advisory and a pioneer in the application of artificial intelligence to the field of investment management.
He is the chief designer of Legend's Asset Allocation Neural Network (AANN). AANN is a sophisticated computer model that uses mathematical algorithms to forecast the relative strengths of different asset classes. Mr. Mehrotra spent over a decade on the research, development, testing and implementation of AANN's state-of-the-art artificial intelligence system.
4th Quarter 2017 Market Commentary
Conventional wisdom for the potential tax cuts has started to move from "tax cuts will never happen" to "tax cuts won't matter." We believe they will not only happen but they will also matter. Markets may perceive this differently, which could be a catalyst for much-needed correction. However, when this correction comes it should be a buyable dip.
We remain bullish on equities for the longer term as tax reform could potentially raise S&P 500 earnings estimates by about 8-10%, which can provide further fuel for equity prices going forward. We believe the risks have risen in equities and particularly in domestic stocks, which on a valuation basis are the most expensive game in the investing world. We are getting more concerned about the potential of rising inflation since higher inflation, particularly at levels around 3.5% - 4.0%, can do a lot of damage to valuation measures. There is also evidence that our markets may be priced for perfection:
- A historical 'rule of thumb' has dictated that the sum of inflation and trailing Price to Earnings ratio (P/E) above 23 denotes market risk and below 14 implies that markets are attractive. As of the end of the third quarter, this figure was just over 23, based on a trailing P/E of about 21 and a Consumer Price Index (CPI) of 2.2%. Recently, the Investors Intelligence weekly investment advisory survey reading got to 3.99 bulls to bears, which is one of the highest readings since 1987. The ratio of household equity assets to disposable income is at 155%, compared to just 59% in March of 2009.
- The S&P 500 price to book ratio appears expensive when data is observed back to 1926.
- The CBOE Volatility Index, which is supposed to measure fear among investors, hit a record low showing complacency.
- Margin Debt is at record high levels relative to GDP and, in nominal terms, double the level established prior to the 2000 market peak.
- The mutual fund cash/asset ratio stands at 2.8%, which is barely above the record low of 2.6%.
Technically speaking, it is worth noting that there has not been a 3% or greater correction in over a year, which makes this the longest bullish run of such kind in over 90 years. Impressive but also scary! If you go back in time to 1926 and calculate average corrections, you would notice we have suffered a 3% or greater correction about once a month. Gauging markets by this measure, I would conclude that a noticeable correction is on the horizon and I believe it should arrive in weeks or months, not years.
Overall, a pause in a market advance could be normal and healthy for the long term. On a total return basis, high yield bonds peaked in late October while equities have continued to enjoy positive returns since then. As you may recall, in some of our portfolios we cut down on our high yield bond exposure months ago in anticipation of sour times. Given that high yield bonds are trading near historic low spreads over Treasuries, being invested in these bonds felt like picking up nickels in front of a steamroller.
Another area where we have concerns is cryptocurrencies. Bubbles in the most basic form develop due to an excessive price appreciation coupled with the fear of missing out. While the potential bubble in bitcoin has given birth to many variations, bitcoin has risen nearly 1000% this year alone. Opaque is how I would describe pricing structures and extremely high commissions are pervasive. The value of a bitcoin has doubled in just the last quarter with no discernible reason for this appreciation. This is easily the biggest bubble around and when it pops, it will not likely have serious consequences from an economic point of view, but it could presage a greater risk reduction in other bubble areas such as e-commerce. However, risk reduction could help the bond market.
As worrisome as this environment is, I am reminded of a quote from economist and philosopher John Maynard Keynes who said, "Markets can remain irrational longer than you can remain solvent." It is critical to appreciate and respect the fact that no matter how right you think you may be or how right you might ultimately turn out, the markets can disagree for a long period of time. We know this to be true since markets rarely stop their ascent at fair value. Most of these risks could be diluted if earnings continue to escalate in the near future.
Although, some of it does hinge on tax reform. According to two of the more well-known sources (Thomson Reuters & IBES), earnings per share of the S&P 500 Index in both 2017 and in 2018 should increase at double digit pace. Seasonality is another variable that favors equities since historically, mid-November to mid-January has been some of the best times to own them.
In 2018, we expect volatility to escalate and to see more sell offs of 5% to 10%. We also believe that the level of the S&P 500 may breach 3000 within the next twelve months or so. If we had to name a few catalysts that may drive volatility higher, they would include earnings retreat, rate revisions, geopolitical uncertainty, rising inflation and slowing economic activity — in that order. We ascribe a very low probability to an economic recession, as most of the fundamental economic variables do not point to one in the near term. We believe the most important catalyst for the current market rise has been earnings growth, and a lack of earnings growth could be the most likely candidate to derail it going forward.
While this market appears to be in a late stage of a secular bull market, we do not yet have high confidence that we have reached the point of maximum optimism. Therefore, we would rather let profits run until our models indicate that we need to start preparing for a bear market decline. We will remain mindful and prompt clients to remember that this is a long-term game and being invested could be the most critical ingredient to achieving long-term success. So please remember, as volatility increases, it may give birth to opportunities in the investment landscape.
Ned Davis Research
AM Global Family Investment Office, LLC
Shashi Mehrotra, Chartered Financial Analyst, is the Chief Operating Officer and Chief Investment Officer of Legend Advisory. The opinions and predictions expressed herein are those of Shashi Mehrotra solely and not necessarily the opinions or expectations of Legend Advisory or any of its affiliates. Such opinions and predictions are as of November 22, 2017, and are subject to change at any time based on market and other conditions. No predictions or forecasts can be guaranteed.
Current market and economic data is as-of November 22, 2017. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Important Disclosures and Definitions
Investing involves risk including the potential loss of principal. The opinions and material presented are provided for informational purposes only. No person or system can predict the market. Neither asset allocation nor diversification guarantee a profit or protect against or eliminate the risk of experiencing investment losses. All investments are subject to risk, including the risk of principal loss. There is no assurance that the investment goals and process described herein will consistently lead to successful investing.
The information shown does constitute investment advice, does not consider the investment objectives, risk tolerance or financial circumstances of any specific investor. The information provided is not intended to be a complete analysis of every material fact respecting any portfolio, security, or strategy and has been presented for educational purposes only. Data obtained from the sources cited is believed to be reliable and accurate at the time of compilation.
Past performance is no guarantee of future results.
The S&P 500 Index is a capitalization weighted index of 500 of the largest exchange-traded stocks in the U.S. from a broad range of Industries whose collective performance mirrors the overall stock market. Capitalization weighting results in the larger components (stocks) carrying a larger percentage weighting. The Equal Weighted S&P 500 consists of the same stocks but equally weighted and consequently may provide insight into the breadth/disparity of market performance. Investors cannot invest directly in an index.
There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counter parties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
High yield bonds entail higher risks, including greater credit risks. Their values are sensitive to interest rate movements (a rise in interest rates can result in a decline in value of the investment). High Yield bonds are often called and may carry a rating of 'BB' or lower by Standard & Poor's, or 'Ba' or below by Moody's. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.
U.S. Treasury securities—such as bills, notes and bonds—are debt obligations of the US government.
Cryptocurrencies - A cryptocurrency is a digital or virtual currency that uses cryptography for security. A defining feature of a cryptocurrency is that it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation. Because cryptocurrencies are virtual and do not have a central repository, a digital cryptocurrency balance can be wiped out by a computer crash if a backup copy of the holdings does not exist. Since prices are based on supply and demand, the rate at which a cryptocurrency can be exchanged for another currency can fluctuate widely.
The Chicago Board Options Exchange (CBOE) Volatility Index shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge."
Price/Earnings (P/E) ratio is the price of a stock divided by its earnings per share that gives investors an idea of how much they are paying for a company's earning power. High P/E stocks are typically young, fast-growing companies and are far riskier to trade than low P/E stocks.
Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Hyperinflation, with prices rising at 100% a year or more, causes people to lose confidence in the currency and put their assets in hard assets like real estate or gold, which usually retain their value in inflationary times.
A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession.
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