Bullish Investor Sentiment Continues Its Decline

This mornings release by the American Association of Individual Investors of its weekly investor sentiment survey shows the individual investor continues to become less bullish on the equity markets. The bullish sentiment level declined to 32.2% versus last weeks 38.1%. At the end of December the bullish sentiment reading equaled 55.1%. The bull/bear spread stood at +36.5 at the end of December and now has turned negative at -.6. The sentiment measure is a contrarian one and tends to most accurate at its extremes.

From The Blog of HORAN Capital Advisors

The Week Ahead Magazine: January 26, 2014

I suppose building on last week's magazine that contained article links to a weakening job market, this week's magazine contains a number of links surrounding the emerging markets correction this past week. Are these data points a sign of a global slowdown? The downdraft in the emerging markets did spill over into the U.S. market with the Dow Jones Industrial Average falling more than 300 points. In a recent article by Michael Hasenstab, Ph.D., Executive Vice President, Chief Investment Officer Global Bonds for Franklin Templeton Fixed Income Group®, the article lead-in noted,

"When the masses are against you, it’s hard to stand your ground. Going against the crowd is familiar turf for Michael Hasenstab...and certainly knows the virtue of patience. He has staunchly defended his investment theses over the years, tuning out the naysayers and market noise time and again. Ireland, a country that only a few short years ago, few investors wanted to touch, is a case in point. It’s become one of the biggest turnaround stories emerging from Europe’s debt crisis. Hasenstab continues to stress the importance of taking a long-term view and standing your ground (non U.S. investor link): , and says investors should exercise patience not only in other parts of Europe today, but also in select emerging markets, including China (empahsis added.)"

After the U.S. equity markets generated such strong returns last year, it is not surprising a correction is before us. However, we still believe the correction, or better yet, consolidation, likely will not lead to a full blown bear market. With that, below is the link to this weeks magazine.

• The Week Ahead Magazine: January 26, 2014

Disclosure: Long Templeton Global Total Return Fund (TTRZX)

The Consquences Of The Short Term Structure Of U.S. Treasury Debt

Since the financial crisis, increasingly, U.S. Treasury issuance has occurred at the short end of the interest rate curve. Unlike many mortgage borrowers who refinanced their mortgage debt to lock in lower long term interest rates, the government has issued a majority of new debt at the short end of the interest rate curve.

From The Blog of HORAN Capital Advisors

The consequence of this short term structure is the negative impact higher interest rates will have on the U.S. budget. As the below chart shows, 6% of the government's budget goes toward paying interest on the U.S. debt outstanding.

From The Blog of HORAN Capital Advisors

Source: J.P. Morgan's Guide to the Market

With the outstanding debt now totaling over $17 trillion, a one percentage point rise in interest rates equates to an additional $170 billion in interest payments on the outstanding debt or 75% increase.

From The Blog of HORAN Capital Advisors

In just the last year and a half, the 5-year yield has increased over one full percentage point. And as the below chart indicates, it is not inconceivable that this rate can move much higher over time. In a lead up to the financial crisis, the 5-year yield was over 5% and just recently broke resistance.

From The Blog of HORAN Capital Advisors

Aside from the fact the U.S government's debt continues to grow unabated and will certainly need to be addressed sooner versus later, the issue to play out near term is in Washington, DC. It is projected the U.S. government will reach its debt ceiling limit in early February. Ultimately, Congress will certainly increase the debt limit as they always do; however, the negative news flow might impact the equity markets in the short term.

Broader Implications Of A Weakening Retail Sector

It has been a while since I have seen so much written about the weakness impacting a particular segment of the market. In the recent case much is being written about the retail/discretionary sector of the market and its recent underperformance. This comes on the heals of the sector generating strong returns since the bottom of the financial crises in 2009.

• Amazing run for consumer discretionary stocks (Charts etc.)
• Q4 retail sales frozen by polar vortex (AlphaNow)
• Caution: XRT underperformance puts retailers in focus (See It Market)
• The first domino to fall: Retail-CRE (oftwominds)
  

The first chart below details the return of several discretionary segments of the market relative to the S&P 500 Index since 2006. The contraction in consumer spending that occurred through 2008-2009 is evident on the chart as well as the recovery from 2009 until today. In the second chart below the two retail/discretionary sectors are displayed, but over a shorter two month time period. The weakness within the discretionary/retail sector is clearly evident.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

Thomson Reuters recently noted the weakness within the sector and the subsequent reduced earnings guidance. A number of retail stocks have exhibit market weakness: L Brands (LB), Abercrombie & Fitch (ANF), Best Buy (BBY) and Family Dollar Stores (FDO) to name just a few.

From The Blog of HORAN Capital Advisors

One concern associated with the weak performance of this sector is the potentially broader implications to the health of the overall consumer. The consumer (consumption) accounts for about 70% of of the economy or GDP. If the consumer is pulling back does this portend further weakness in the overall economy and hence the equity market? As the below chart displays, there is a high correlation with the retail sector price movement and the overall S&P 500 Index.

From The Blog of HORAN Capital Advisors

Source: See It Market

On the other hand, if the pervasive market sentiment is the consumer has rolled over, vis-à-vis the market and the economy, the efficient market hypothesis would imply this type of news is factored into current stock prices. We have written a number of posts on our blog regarding some of the weaknesses of the efficient market hypothesis as well as modern portfolio theory, but suffice it to say that significant stock price moves, up or down, suggests the markets are not fully efficient.

Concluding, the retail sector performance is a potential canary in the coal mine as it relates to the health of the consumer and the economy. The mixed financial and economic data we have cited in the recent past continues to be reported. As an example, Norfolk Southern (NSC) reported stronger earnings than expected today and the stock jump 4.7%. NSC is transporting materials and products for consumption. On the other hand, CSX (CSX) reported earnings last week and provided cautious guidance. CSX stock fell over 6% on the report. This mixed data picture is confounding investors at the moment. At HORAN, we do believe the consumer may have gotten ahead of itself; however, as one of the links in the introduction to this article notes, the wide spread cold weather could have had a negative impact on a number of brick and mortar retailers. The weaknesses in some consumer stocks is certainly worth paying attention to; however, the market/investor already knows a lot about this weakness and a majority of this bad news may be factored into stock prices. The question for investors is to evaluate specific company valuations relative to their anticipated growth expectations. The stocks that will fall the hardest on a missed earnings report are those that are trading at premium valuations.

Investor Letter: Is This An Equity Market Bubble

Last week we published our year end 2013 Investor Letter that reviewed highlights from the past year and more importantly our outlook for 2014. In the Investor Letter we comment on a recent report from Charles Schwab highlighting that the previous five year cumulative return of the S& P 500 Index at the end of 2012 was 9%. Just one year later, the previous five year cumulative return is a whopping 126%. Given the recent strong U.S. equity market returns, some investors are assessing whether the market has entered "bubble" territory.

We often caution investors that they should not look at historical returns alone to assess the market’s future direction. What seems obvious is to research the valuation of asset classes, sectors and/or specific companies with respect to expected future returns. We discussed this in our third quarter 2013 newsletter as we highlighted PE multiple expansion (i.e., increasing market valuation or PE) occurring from 2009 until today. One of the charts in our most current Investor Letter shows the S&P 500 P/E ratio is roughly equal to its long term average. However, a wider valuation measure takes the economic profit figure used in the calculation of GDP. This profit figure is an actual data point taken from company reported profits to the IRS. By using this valuation measure, the P/E is below its long term average.

Our specific thoughts on the year ahead can be read in our most recent commentary at the following link:

• Fourth Quarter 2013 Investor Letter

From The Blog of HORAN Capital Advisors

Rising Interest Rates Can Be Good For Stocks

In December the Federal Reserve indicated they would begin reducing their bond buying (taper) at the rate of $10 billion per month starting in January. The bond market had certainly factored in this announcement and had expected this outcome to be announced at an earlier Fed meeting. The direct consequence of the taper discussion and ultimately its implementation is interest rates rose dramatically in the last two quarters of 2013. As the below chart shows, the 10-year Treasury yield rose from 1.61% in May to 3.03% at year end.

From The Blog of HORAN Capital Advisors

A result of this increase in interest rates is bond prices fell with most bond or fixed income categories generating negative returns for investors in 2013. If bonds are not a favored investment in a rising interest rate environment, and if rates trend higher in 2014, what is the likely impact of higher rates on stock prices?

The table below is provided courtesy of T. Rowe Price and from their Winter newsletter. The table details equity performance during periods of rising rates going back to 1970. During most of the rising interest rate periods, equity prices moved higher during this period of time.

From The Blog of HORAN Capital Advisors

Source: T. Rowe Price

One reason equities tend to move higher as rates rise is the fact rate increases are generally associated with an improving economic environment. The higher rates can ultimately hinder economic growth; however, at the onset of increasing rates, stocks tend to shrug off the higher interest rate move. Page 16 of the T. Rowe Price Report is a worthwhile read and goes into greater detail on this. If rates are increasing due to inflationary factors, a different outcome may occur. We wrote about stock prices and inflation in an earlier post, Where To Invest In An Inflationary Environment, that readers may find of interest as well. At this point in time we do not believe the stars are aligned that will give us significant inflation near term.

Lastly, one chart that made the rounds within the investment community recently was the one below showing equity correlation in a rising interest rate environment. This chart comes from J.P. Morgan's first quarter 2014 Guide To The Markets (page 12). The chart indicates when the rate on the 10-year treasury is rising from a level below 5%, stocks are positively correlated to the rate move, i.e., rates and stock prices move in the same direction. When rates are rising from a very low level, it is an indication rates are simply getting back to a more normalized level and this level does not inhibit economic growth. When rates are rising above 5%, this may occur because inflation is becoming an issue, the economy is beginning to grow too rapidly, etc. and this higher rate level could slow economic growth; thus, negatively impact corporate profit growth.

From The Blog of HORAN Capital Advisors

Source: J.P. Morgan GTM

For investors, the Fed seems certain to begin tapering QE. If this reduced QE level does cause rates to rise further, bonds are likely to be a more challenging investment versus stocks in the coming year. We do believe if the tapering does cause a broader market disruption, the Fed will be quick to turn on the QE pump again. It seems the central banks around the world are addicted to this stimulus activity. An interesting perspective on this activity was discussed in the WealthTrack interview with Ed Hyman that we posted yesterday.

The Week Ahead Magazine: January 20, 2014

Below is the link to this week's Week Ahead Magazine. A number of articles provide commentary on last week's weak jobless report. Many are attributing the weakness to the wide spread cold weather experienced in the U.S. in December. Several additional articles in the magazine highlight recent fund flow data as well as a review of important data to be reported this week.

• The Week Ahead Magazine: January 20, 2014

A Constructive View Of Global Markets In 2014: Ed Hyman And Bill Miller Interview

Consuelo Mack of WealthTrack conducted a two part interview with Ed Hyman, ranked #1 economist for 34 years by Institutional Investor, and Bill Miller that reviewed 2013, but more importantly their outlook on 2014. Just as at the beginning of 2013, Ed Hyman continues to believe we are in an environment that is "pedal to the metal" in equities. He does caution though that 2014 could see a sell in May environment develop this year. Ed also believes the biggest potential surprise in 2014 is another 30+% market return. Ed notes it has been some time that economic growth is occurring globally. Certainly it is not strong growth, but it is not the contractionary environment that was thought to be taking place at the beginning of 2013. Bill Miller comments on investors under allocation to equities and disbelief in the markets moving higher from here. Although investors maybe stating they are constructive on the equity markets, their actions speak otherwise. Both of the below episodes are worthwhile interviews for investors to take the time to watch.

Double Digit S&P 500 Returns Far More Common Than Single Digit Returns

A recent report by Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, highlighted the fact that double digit calendar year returns for the S&P 500 Index are not that uncommon. As the below chart shows, returns greater than 10% have occurred 51 times out of 88 years since 1926. That is, double digit returns for the S&P 500 Index have occurred 58% of the time since 1926. In 73% of the calendar years (64 years), returns greater than 0% have occurred. Notable is the fact that single digit returns are far less common than double digit returns.

From The Blog of HORAN Capital Advisors

The Week Ahead Magazine: January 5, 2014

The first full trading week of 2014 begins on Monday. This past week was a split one with the markets closed mid week due to the Christmas holiday. A number of the article links in this weeks magazine provide expectations for 2014 from various market pundits that readers may ind of interest. A few of the links provide a synopsis of this past year.

• The Week Ahead Magazine: January 5, 2014

U.S. Equity Market Entering Euphoric Phase?

In the December newsletter of Absolute Return Partners and written by Niels C. Jensen, he provides a detailed discussion on whether the market has reached bubble heights. The newsletter contains a large number of charts circulated through the investment community during 2013 that seem to confirm that U.S. equities are in bubble territory. Niels Jensen provides commentary to many of these charts providing a counter argument to what the chart is actually depicting. The first chart in his newsletter is the one below and Jensen notes the 2013 return for the S&P 500 is far from an outlier.

From The Blog of HORAN Capital Advisors

As shown below in another of his charts, he discusses where the U.S. market might be in terms of the equity market cycle. The chart he highlights in the newsletter is from Goldman Sachs and is specific to Europe ex the U.K. In his commentary though he believes the U.S. market is closer to exiting the "growth phase" and entering the "optimism phase." Interestingly, the optimism phase is generally known for strong returns as investors become irrationally exuberant.

From The Blog of HORAN Capital Advisors

Might the S&P 500 produce returns in 2014 similar to 2013? No one has a crystal ball, but Jensen notes, "it is, after all, the most unenthusiastic rally I have ever experienced." At HORAN we to believe this market advance has felt like one of the longest "climb a wall of worry" rallies in some time.

Source:

Squeaky Bum Time
Absolute Return Partners
By: Niels C. Jensen
December 2013
http://www.arpinvestments.com/downloads/Absolute-Return-Letter/2013/The_Absolute_Return_Letter_1213.pdf

Dividend Payers Return Trails Non Payers In 2013

S&P Dow Jones Indices reports the equal weighted return of the dividend paying stocks in the S&P 500 Index trailed the non paying constituents in 2013. The equal weighted return of the payers totaled 40.67% versus the non payers return of 46.27%. However, for both groups, the equal weighted returns did outperform the overall cap weighted return of the S&P 500 Index which equaled 32.39%.

From The Blog of HORAN Capital Advisors

This outperformance by the equal weighted index resulted from smaller cap stocks within the index outperforming larger caps. A number of the larger cap stocks in the S&P 500 Index generated relative performance that was less than the overall index return. For example, Apple (AAPL, +7.6%), International Business Machines (IBM, -.5), Exxon Mobil (XOM, 19.8%) and Wal Mart (WMT, 18.1%) under performed the index while smaller caps like E-Trade (ETFC, +119.4%), Electronic Arts (EA, +58%), Genworth Financial (GNW, +106.6%), and First Solar (FSLR, +77.1%) generated significantly better returns than the overall index.

The below chart of the Guggenheim Equal Weighted S&P 500 Index ETF (RSP) is compared to the S&P 500 Index itself as well as a couple dividend paying ETFs: the SPDR Dividend ETF (SDY) and iShares Select Dividend ETF (DVY). The Guggenheim ETF outperformed the three other indices contained in the chart.

From The Blog of HORAN Capital Advisors

Lastly, the outperformance of smaller caps was evident in the capitalization based indices as well. The S&P MidCap 400 Index returned 33.5% and the S&P SmallCap 600 Index returned 41.3% in 2013.

Disclosure: Long XOM

The Volatile Bullish Sentiment Measure Experiences Significant Decline

This week's bullish sentiment reading reported by the American Association of Individual Investors declined 11.97 percentage points to 43.09% versus last week's bullish reading of 55.06%. The changes in this indicator from week to week are volatile and investors should evaluate a multi-period average for a better gauge of the sentiment's direction. With this said the 8-period moving average of the bullish sentiment reading declined slightly this week to 43.8%. As a point of reference, the average of the 8-period moving average of the bullish sentiment reading is 39% with a standard deviation of plus or minus 8%. This measure is a contrarian one and is most predictive at its extremes.

From The Blog of HORAN Capital Advisors

Source: AAII

Expectations For The Market In 2014

We have written many times on this blog that the simple change of one calendar day to another should not drive one's investment decisions. Just as investors are faced with the last trading day of 2013, Thursday will begin the first trading day of 2014. In spite of the opening sentence in this post, and a new year seeming to reset the clock, what is the likely market return in the coming new year?

The difficulty in predicting the market's return in 2014 is the fact one's point of reference is greatly influenced by the very strong returns achieved in 2013. The S&P 500 Index returned 32.39% in 2013. This strong market return is not a frequent occurrence; however, it has occurred in the past. The below chart is a snapshot of annual market returns for the S&P 500 Index going back to 1980. During the mid 1990's (1995 - 1999) the market was able to string together outsized gains for five consecutive years. Could 2014 be another year that rewards equity investors with strong returns?

From The Blog of HORAN Capital Advisors

Following are a couple of technical and fundamental market factors that are influencing HORAN's view of the market in the coming year. Some of these factors point to a positive market return this year while others point to negative influences.

Doug Short at Advisor Perspectives wrote a detailed article on margin debt. Currently, nominal margin debt is at an all time high and the below chart shows this level of margin debt has been associated with market tops. If investors are fully leveraged their additional buying power is limited.

From The Blog of HORAN Capital Advisors

On the flip side of the high margin debt issue is the high level of short interest on S&P 500 holdings. Todd Salamone of Schaeffer's Investment Research wrote an article, Why Stocks Could Be Set For a First-Quarter Surge, and includes a discussion on the high level of short interest as noted in the below chart. The Salamone article also details many market positives and a few market negatives that might impact the equity market in 2014.

From The Blog of HORAN Capital Advisors

Source: Schaeffer's Investment Research

Short covering may be a necessary factor to push equity prices higher this year. When looking at investors' mutual fund asset allocation it appears they are heavily weighted towards equities. The below chart details assets in money market and fixed income funds as a percentage of total mutual fund assets. The weighting in this non equity class is at near record lows. A major influence of this low weighting is the fact equity market returns were so strong last year; thus, pushing equity values to high levels.

From The Blog of HORAN Capital Advisors

In spite of the apparent low level of investor assets allocated to money market and fixed income investments, mutual fund flows would suggest the rotation out of fixed income investments into equities has only just begun as noted in the below chart. Not until 2013 did investors begin to rotate into equities. A recent article on the Minyanville website cites ICI data noting, "investors responded to 2013's climate by putting $160 billion of new money into equity mutual funds (investment flow data from ICI), a dramatic shift in a market that saw five straight years of outflows totaling $536 billion." One concern is the equity markets have had strong returns over the last five years and investors are just now rotating into equity investments. Individual investors could be arriving late to the bull market party, as they have a tendency to do.

From The Blog of HORAN Capital Advisors

From a fundamental perspective, the economy does seem to be strengthening. Real GDP in the third quarter of 2013 was revised higher to 4.1%. This is certainly a respectable rate of economic growth; however, the GDP growth rate since the end of the recent recession is below the rate of growth experienced by the economy coming out of prior recessions.

From The Blog of HORAN Capital Advisors

From an earnings perspective Thomson Reuters reports Q3 2013 earnings growth at about 6%. Earnings growth in Q4 of 2013 is expected to come in at 7.6%. Some of this earnings growth, however, has come by way of companies repurchasing their own stock. This has had the effect of inflating earnings per share growth since reported income is divided by fewer shares outstanding. We noted this strong buyback activity in a blog post a few weeks ago, Stock Buybacks Continue At A Strong Pace Through The Third Quarter. The expected earnings growth rate for all of 2014 is currently estimated at 10%. Top line revenue growth is forecast at about half this growth rate at 5.7%. Importantly, we believe companies will need to generate top line growth commensurate with expected earnings growth if 2014 returns are on par with returns in 2013.

Lastly, as noted in the first chart in this post, the market can generate outsized returns for multiple years in a row, i.e., the mid 1990's. Will 2014 resemble a year similar to the mid 1990's? A common theme evident in the mid '90's period was the phenomenon of PE multiple expansion. We touched on this factor on page 2 of our third quarter 2013 Investor Letter. The first chart below represents the period 1994 -1998. The second chart is the period 2007 - 2013.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

Two economic variables that are different now versus the mid 1990's is the level of GDP growth and the direction of interest rates. Multiple expansion is much easier to achieve in an environment where interest rates are falling due to how analysts value future earnings in a discounted cash flow model. In general, as interest rates decline, future earnings are valued higher in the current year period. In the mid 1990's the 10-year Treasury rate fell from 7.8% at the beginning of 1995 to a low of 4.5% before rebounding to 6.28% in 1999. This declining rate factor was a tailwind for multiple expansion. Today, the interest rate environment is completely different. In July of 2012 the 10-year Treasury yield reached 1.4% and now stands at just over 3%. This higher rate level (and the direction) makes future earnings worth less in today's discounted cash flow models and serves as a headwind to multiple expansion. Multiple expansion can still occur when the economic growth rate is picking up steam though. This occurs because investors expect company earnings to grow more quickly as the economic climate improves. Certainly the third quarter GDP report is suggestive of this. In 2014, a faster growing economy will be an important factor in order to generate outsized returns in the equity market.

What is evident from the above factors is the fact the data is mixed in regards to technicals as well as fundamentals. This mixed type of data has been prevalent since the end of the financial crisis and is likely a factor that has prevented investors from appearing to go 'all in' on stocks. There are a number of other factors we are reviewing at HORAN Capital Advisors in assessing the markets in 2014. For our readers though, we hope this provides you with a few of the potential influences that may impact the market in 2014. We will provide additional insights in our upcoming quarterly investor letter. We wish all of our clients and readers a healthy and prosperous New Year!