Saturday, January 20, 2018

Will The Stock Market Ever Decline Again?

For many investors it may seem difficult to believe since it has been so long ago, but the equity markets do go through negative returning periods. The average intra-year decline for the S&P 500 Index since 1980 is 14% and the last double digit decline was in February 2016, nearly two years ago. So what in the world is going on that has stocks in what seems an uninterrupted climb?

The below 'monthly' chart shows the S&P 500 Total Return Index since the beginning of 2016. Over the course of the two years, 2016 and 2017, the S&P 500 Index has experienced only three negative returning months (red bars) with no down months in 2017. The last bar on the chart represents the January 2018 return and the start of this year has been decidedly bullish.


If one is to believe individual investor asset allocation responses reported by the American Association of Individual Investors, individual investors are nearly all-in on their equity exposure. The bottom half of the below chart shows equity allocation at 72% as of December which is near the 77% high reading. Also, cash allocation is at 13% and near the low reading of 11%. If interest rates are moving higher, thus bond prices declining, an underweight in bonds seems to make sense.


The next chart shows AAII's individual investor bullish sentiment moved higher this week to 54.1%. This move higher followed a decline in sentiment last week. Also continuing higher is the 8-period moving average. As I noted in a post on sentiment on January 11, the contrarian sentiment reading is the most actionable at market bottoms versus market tops.


Not only are consumers expressing positive sentiment, businesses are as well. As seen in the below chart, the NFIB Small Business Optimism Index (green line) has seen a steady improvement since the financial crisis with a big jump in the NFIB Optimism Index in December of 2016. The December 2016 reading was one of the top readings for the index since its inception. In fact, 2017 was a record year for the Optimism Index since it was created 45-years ago. The monthly average for the Index during 2017 equaled 104.8 and the prior record year was in 2004 when the index averaged 104.6. In NFIB's report on the December 2017 Index reading, it was noted,
"2017 was the most remarkable year in the 45-year history of the NFIB Optimism Index,” said NFIB President and CEO Juanita Duggan. “With a massive tax cut this year, accompanied by significant regulatory relief, we expect very strong growth, millions more jobs, and higher pay for Americans."

Historically, high NFIB Optimism readings have been associated with strong equity market returns in the 12-months following high index level readings. As seen in the below chart, the 1-year equity market return of 18.3% following the high December 2016 reading (orange line) was the highest returning 12-month period compared to the other four completed one year periods. The red line represents the S&P 500 Index's return since December 2017.


I could show a number of additional sentiment and confidence measures and nearly all of them are extremely positive. Sentiment is important in supporting equity market returns, but the strong equity market returns seem to be built on improving fundamentals as well. This improving fundamental picture is being partially supported by the anticipated benefits from the recent passage of the Tax Cuts and Jobs Act. These tax reform measures are not simply one time stimulus boosts, like sending out one time checks. This reform incorporates structural changes in the tax code that will have benefits over a multi-year period.

A lower corporate tax rate means companies will have additional cash they can reinvest in their businesses, both in capital expenditures and in their employees through higher pay. Also, the lower tax rate provides a tailwind for earnings and this is beginning to be reflected in analysts' forward earnings estimates. As seen in the below chart, the forward earnings growth estimate for the S&P 500 Index was 10% in November and in just six weeks, the 12-month forward earnings growth estimate is now 13%. This is a 30% improvement in the earnings growth rate and is an important reason why stock prices are moving higher, i.e., adjusting to a higher earnings level. The market correlation to earnings is .94 or nearly 1.0. As is said often, stock prices tend to follow earnings.


Finally, it takes cash to buy stocks and cash levels seem high if one reviews the Federal Reserve's Flow of Funds z.1 report. The below chart shows household deposit levels along with deposits as a percentage of GDP.


What seems to be occurring with stocks then, is an adjustment in valuation in anticipation of higher corporate earnings growth. Equities in the U.S. have certainly done well; however, those investors that bought and held in 2000 and 2007 have been invested in a sideways trending market. Not until 2013 did the S&P 500 Index break out of this 13 year trading range. From 2000 to January 2018, stock returns have been unexciting, i.e., returning an annualized 3.42%.


Scott Grannis, former Chief Economist at Western Asset Management, recently wrote a blog post, Putting Bonds and Stocks into Perspective, where he included the below chart and noted US equity market capitalization as a percentage of global equity capitalization is lower today than in 2004.


I would say the equity markets in the U.S. seem priced for perfection; however, stocks usually do not correct simply based on valuation. The economic and fundamental underpinnings seem strong and are expected to remain so in the coming year. In a non-recessionary environment, stocks can continue to perform well. Is a pullback, and a double digit one at that probable? Yes. However, I believe the pullback will be a normal market function and not caused by say an economic recession. Business and consumer sentiment levels are decidedly positive and for justifiable reasons.


Saturday, January 13, 2018

A Balancing Oil Market, But Will It Last?

In May 2011 crude oil (WTI) hit $113 per barrel and remained elevated at or near that level until the summer of 2014. Given the high price of crude and the expansion of fracking at that time, crude supply continued to grow until peaking in mid 2017. I wrote about the high crude supply level in mid 2017 and its impact on keeping oil prices down, Higher Oil Prices Contend With Too Much Supply And Higher Energy Efficiency. Today, we are seeing crude oil inventory decline at a fairly rapid rate as can be seen with the green line in the below chart.



Thursday, January 11, 2018

Investor Sentiment More Actionable At Market Bottoms

Today's weekly AAII Sentiment Survey reports a drop in bullish investor sentiment of 11.1 percentage points to 48.7%. The bullish sentiment reading has been on a steady move higher since November 16 when the bullishness reading was 29.4%. The weekly readings tend to be more volatile and one can look at the 8-week moving average in order to eliminate some of this volatility. As a result, although the sentiment reading fell this week, the longer period average of bullish sentiment increased to 45.6%, largely due to dropping the 29.4% bullishness reading from November 16.



Wednesday, January 10, 2018

Winter 2017 Investor Letter: An Uninterrupted Climb

Our Winter 2017 Investor Letter provides commentary on 2017 and our thoughts and observations on the coming year. Many strategists and investors have either commented on or know from first hand experience, in 2017 the equity market saw very little downside market volatility. Our expectation for 2018 is the market will see a more normal level of volatility. As we comment on in our Investor Letter, that normal level of volatility would be a 14.1% decline from peak to trough. A decline of that percentage amount would equal 3,500 Dow points, and that would represent a normal pullback.


For additional insight into our views for the market and economy in the coming year, see our Investor Letter accessible at the below link.


Monday, January 08, 2018

High Beta Stock Outperformance Suggests A Strengthening Economy

For the first part of 2017 low volatility equities were outperforming their high beta counterparts. However, as tax reform talk began to look more a reality in late August, high beta stocks resumed their outperformance that really began in early 2016. As the maroon line in the below chart shows, this high beta outperformance is carrying over into the beginning of 2018.



Sunday, January 07, 2018

Sentiment: Simply More Buyers Than Sellers

I am re-reading Justin Mamis' book, The Nature of Risk, a worthwhile read by the way, and being reminded of the dissemination of information prior to the internet age, which is difficult for many to believe if they did not work in investments at that time. Simply gauging market sentiment prior to each day's market open at that time was much different than it is today, of course. As he notes in his book, when one inquired about, say, a higher market, the most appropriate answer was there simply were "more buyers than sellers" that day. In today's proliferation of business cable channels, that type of response will not sell many advertisements.

This focus on buyers and sellers is really an evaluation of investor sentiment and is one reason I write about sentiment reports on a fairly regular basis. To that end, the American Association of Individual Investors reported Sentiment Survey results last week and individual investor bullish sentiment jumped 7.1 percentage points to 59.8%. Most of this bullish improvement came from the prior week's bearish survey participants as bearish sentiment decline 5.1 percentage points to 15.6%. This spike in bullish sentiment can be seen in the below chart.


Saturday, January 06, 2018

Dow 30,000 By Year End

The Dow Jones Industrial Average pushed through 25,000 in the first week of 2018. True to form, the President weighed in on this record and indicated 30,000 is the next target, skipping over the 1,000 increment target milestones. His comment was replayed numerous times on television by the financial media Thursday with many commentators spinning his comment as hyperbole, but might a Dow target of 30,000 in 2018 be reasonable?

The below chart displays the calendar year returns for the Dow Jones Industrial Average going back to 1980. Also included on the chart are red dots representing the largest intra-year drawdown or decline. Looking at the mid 1990's returns, there was a five year period, 1995 - 1999, where the Dow returns ranged from 16% to 33%, but with four of the year's return above 20%. So what would it take for the Dow Index to hit 30,000? A 20% return.


The point being, with the Dow Index trading at a large absolute number level, these 1,000 or 5,000 point moves are not out of the realm of even a reasonable possibility. Just as today a 100 or 200 point decline in the Dow is not a significant drop at all, i.e., less than a tenth half of a percent. Importantly for the market and investors though, is the fact the market has not experienced a double digit pullback since February of 2016, nearly a two year period. The market will experience one of these double digit declines as it did 1997 and 1998, but looking at those prior years, the market can recover and generate strong returns for the entire calendar year period.


Tuesday, January 02, 2018

Equal Weighted Equity Performance Lagged In 2017

One equity market phenomenon that played out in 2017 was the fact larger capitalization stocks were larger contributors to market returns. One way to evaluate this is to review the return of the cap weighted S&P 500 Index versus the equal weighted Guggenheim S&P 500 Index (RSP). As the below chart shows, the equal weighted index underperformed the cap weighted S&P 500 Index by more than 300 basis points. Additionally, the largest 50 stocks by capitalization (XLG) outperformed both the the S&P 500 Index and the equal weighted S&P 500 Index.



Monday, January 01, 2018

Is The Glass Half Full Or Half Empty

The end of Friday trading was certainly interesting as the last thirty minutes of the trading day incurred most of the day's half of a percent loss. A few Twitter posts I read were comments in the vain of "this is the selling I have been anticipating." The market is over due for a pullback.