Of all the divergences and reasons to think this bull run might be coming to an end, the one I thought most probable was the momentum wreck we saw from March to May. These “leading” stocks that are on every traders’ screen were absolutely annihilated. It was a fair question to ask “how long can this continue before it spills over to the Clorox’s and Pepsi’s of the world?”
The damage was fast and severe as these names were punished with impunity. Fundamentals just didn’t matter, if the market had blessed you with a high multiple, you were now cursed ten fold. FireEye lost 75% of its value in only fifty trading days. This is something you can expect to see in penny stocks; FireEye at one time had a $13B market cap! Workday, a company who once boasted a $20B market cap, lost nearly half its value in only thirty-two trading days!
This devastating action brought the Russell 2000 down with it, which succumbed to a 10.9% peak-to-trough pullback. The S&P 500 on the other hand only sneezed back 4.4% and barely ticked into negative territory on the year.
Four months later, as the broader indices are making new highs, it really is pretty remarkable that we were able to fight off such a major warning sign. After a thirty percent year in 2013 and the fourth longest streak of all time without a twenty percent correction, this market had every opportunity and excuse to pull back, only it didn’t and still hasn’t. This should be a good reminder that in bull markets, divergences are guilty until proven otherwise.
The outlook for banks has been underwhelming to say the least and understandably so; there are plenty of reasons for the recent under performance:
1) Regulatory overhangs persist, just the other day Citigroup announced a $7B settlement over mortgage bonds.
2) Trading revenue has completely dried up. JP Morgan just told us that trading revenue was down 14% Y/O/Y AND Citigroup’s was down 22%.
3) Net interest margin, a key measure for banks profitability is the lowest it has been, ever.
The thing is, none of this is unknown and certainly most of this is priced in. Financials are the only sector trading at less than 15x earnings. JP Morgan, Bank of America and Goldman Sachs are all trading at 10x trailing earnings and right at or even less thank book value!
XLF, State Street’s Financial sector SPDR ETF has been showing relative weakness since April. At 16% of the S&P 500 (the second largest sector weight) if this group gets moving to the upside, the SPY should move out of the sideways chop we’ve seen since the beginning of July.
I like to pay attention when beaten down, loathed names start acting better . Below are charts of JPM & C which both look like they have a lot of upside. If this shunned group can get going, the S&P 500 has a good chance of getting above 2,000 in a hurry.
Today EEM, the iShares Emerging Market ETF, hit the highest level since January ’13. To say that EM equities have been a laggard would be a colossal understatement. Domestic equities have bested Emerging Markets on nearly every time frame for the past few years. Since the bottom in March ’09, EEM is up 90% while SPY is up 160%. Last year alone SPY outperformed EEM by 3500 basis points!
Rather than take advantage of this beaten down asset class, investors have ferociously ripped money away (shocking, I know). Through the first two months of 2014 more money had been pulled out of Emerging Market stocks and bonds than they had for all of 2013! This “just get me out” behavior, coupled with the severe under performance and fear-inducing headlines should have gotten the attention of any investor, contrarian or otherwise.
Five months later, after a 20% run, we should see the narrative start to change. The ratio chart below shows a declining 200-day moving average going back to 2012, a pretty powerful down-trend. We’re now seeing this line poke its head above the triangle and the 200-day, which acted as resistance earlier in April and May.
This pattern has a lot working against it so it’s hardly a foregone conclusion that any durable bottom has been made. However, as stories tend to follow price, I am 100% certain that if this action continues, we are going to hear some very interesting theories. I imagine it will go something like this: “Attractive valuations coupled with severe under performance and fears over the end of the Taper, it’s no wonder investors have started to look outside the United States.” Whatever the media says, I know that people who follow price will sit back and smile.
The New York Times ran a pretty amazing story this weekend which spoke to the difficulty mutual funds have with consistently outperforming their peers. The data point that was particularly jaw-dropping is that just 2 out of the 2,862 funds observed were able to live in the top 25% of performers for the four years ending in March 2014.
What is truly astonishing is the loudest opponents of efficient markets are typically the same people that are most persecuted by the fact that for the most part, markets are efficient. It reminds me of a video I saw on Vice recently; an interviewer went down to Texas to speak to the people about a severe drought that has been plaguing their economy and lifestyle. Like under performing traders laughing at the EMH, these kids- in the eye of the storm- were laughing at the idea that the planet is undergoing a climate change. As the nation’s cattle population falls to 87.7 million — the lowest its been since 1951 and prices rising to all-time highs, we see that Cognitive dissonance is a powerful phenomenon.
I’m not sure that markets at all times accurately reflect all known and unknown information, but I do believe that markets are efficient in the sense that an infinitesimally small number of people can consistently outperform the markets. The fact that you can be a market participant for more than a few weeks and still deny this is truly remarkable.
This Bull Market has certainly gotten a little trickier over the past two weeks. From the Espírito Santo International news last week to the tragedy we saw yesterday, we have been reminded that markets go up and down, a simple fact that is easily forgotten in a market that has been so forgiving.
I find it’s a helpful exercise to look at weekly charts; they give us the ability to mute all the noise which is extremely difficult if you have a pulse. Price may not be able to tell us where markets are going, but it does give you a real sense of how buyers and sellers are behaving.
So, what does the recent price action say? All told, we have emerged this recent bout of volatility relatively unscathed. Let’s take a look at how some areas of the market have been behaving lately.
The equal-weight biotech ETF, XBI, found support at the 50-week moving average. Chair Woman Yellen’s recent comments regarding thieir valuations weighed on the group earlier in the week. Having dropped 15% in eleven sessions, the bounce on Friday is definitely what the bulls wanted to see.
The S&P 500 is just seven handles away from new all-time highs and is up 7% on the year. The large caps have been grinding higher all year.
The Regionals have been acting crummy all of 2014. These names are like the small caps in the sense that you would expect weakness here to be followed by their large cap brethren. Banks represent 16% of the S&P 500 and it would be nice to see some leadership out of them. XLF is up just 4.7% YTD.
Tech has been extremely strong. Microsoft, Intel, Google, and Amazon were up an average of 5% this week. The QQQ is now up 9% YTD.
Small caps caught a bounce at the 50-week moving average. Under performance has been a theme all year and amazingly has not spilled over to the other indices. It continues to be on head and shoulder watch.
Junk sold off hard on Thursday as people rushed to safety. Gundlach calls junk the most overvalued he’s ever seen. To me, it would be extremely bullish if like small caps, junk can come in a little without bleeding over to the rest of the market.
If you’re like most people, you’re bullish on green and bearish on red. Take a step back, relax and look at what price is doing not on a 10 minute chart, but on the weekly.
Here are a few things he would see:
1) Companies are retiring shares like they’re burning a hole in their balance sheets.
2) TLT:HYG ratio is at levels not seen since the Taper Tantrum of July ‘13 (not a bullish sign for risk appetite)
3) IBM is trading at 13x trailing earnings, FB is trading at 86x trailing earnings
4) $50B companies are being swallowed up
5) A rising rate environment where rates refuse to rise. The ten-year yield is below 2.5%, down 50 bps for the year.
6) The S&P 500 hasn’t had a 10% correction since November ‘11, the 4th longest streak of all time.
7) After outperforming large caps for the last 15 years, small caps- which have been lagging all year- are 7% off their recent highs and below every moving average
8) 40% OF Russell 2000 stocks are down 20% from their 52-week highs.
9) Intel, the face of the dying PC industry is at its highest levels since 2004.
10) The Vix just had its 22nd biggest one-day gain ever (32%).
I’m not the biggest fan of Gold Bugs. Their “thesis” doesn’t sit well with me. To me, if you are a perma bull on Gold, you are short America, short prosperity, and short innovation.
I do like data and truth. And the truth says- much to my chagrin- Gold has been a pretty decent long term investment. Since we went off the Gold Standard in 1971, a $100,000 investment in Gold has turned into $2,763,661. Had you invested that same $100,000 into the S&P 500, you would end up with just $1,810,520.
However, if we can all agree that investing in the S&P 500 entitles you to dividends, the numbers change ever so slightly. The same $100,000 investment in the S&P 500 turned into a whopping $6,508,258, compared to the $2.7M you would have gotten had you bought and held Gold.
We can always cherry pick data to support our conclusions; if you said Gold has been a better investment than stocks over the last ten years you’d be right. But how about the last twenty, thirty, forty? Nope, stocks have bested the shiny metal in all those time frames.
I have no beef with people that are bullish on Gold as a trade, or those who feel it has a place in a diversified portfolio. But, for those perma bulls that cherry pick data and think that Gold is the ultimate “safe haven” - protector of inflation, crisis, Congress, the dollar- please, give me a break.
*Note that I am not taxing the dividends, nor am I factoring in storage costs of Gold.
**Double note, yes I did read Noah Smith’s excellent post on Gold, but only after I was putting the finishing touches on mine.
Bet on Green
A lot of people came into 2014 thinking that after such a strong year for equities, the indices were due for a pause.
Looking at the data tells us a different story. There have been eighteen instances since 1921 that the Dow Jones Industrial average was up at least 25% (including last year). The average annual return following these periods has been 11.81%, nearly 50% higher than the 7.93% average we have seen over the last ninety-three years.
Looking at the data makes a few other interesting points:
- Double digit returns are the norm, not the exception. The Dow is almost 3x more likely to be up 10% or more than up single digits.
- On average, one in five years the markets are up at least 25%
- The Dow has been up double digits 51% of all calendar years.
- Just as strength begets strength, weakness begets weakness. The average return for the year following a 25% loss was just 1.91%, ~75% less than the 93 year average.
It’s important to remember these numbers are just averages. Markets don’t follow a schedule, often going through periods that don’t rhyme or reason. Consider that since 1921 there have only been five years when the market has been right near the average return of 7.93%.
Using a normal bell curve, we can say that 68% of the time, annual returns will be between -11.5% and 27.4%, which is a pretty huge range that doesn’t inspire much confidence. However, we can say with plenty of confidence that if you had to set your portfolio on auto drive, it pays to be long stocks, bet on green.
Lower interest rates have a very real affect on stock prices. Aside from some of the squishy arguments that are hard to measure like “lower borrowing costs stimulates the economy” and “bonds become less attractive relative to equities,” lower rates have an explicit impact on stock prices that can be easily quantified.
A staple of fundamental analysis is that a stocks’ price represents the present value of its future cash flows. Whether these cash flows are recognized as dividends, residual income, or free cash flow, the risk-free rate is a key component of the divisor.
Let’s take a look at stock “X,” a mature, stable company that grows its dividend every year by 2%. Assume that X paid a $1 dividend in 2014 and the risk-free rate is 4%. The Gordon Growth Model would value X at:
$1 x (1.02)/ (.04-.02) = $51/share
If the risk-free rate was cut by just 25 bps to 3.75%, the theoretical value of X would rise by almost 15%!
$1 x (1.02)/(.0375-.02) = $58.29/share
If/when rates rise, you can absolutely expect them to influence stock prices. Whether or not you’re able to anticipate the rise before the market does, I’ll take the under.
With domestic equities ending Q2 at all-time highs- and a few global indices not far behind- I thought it would be interesting to look at where funds were allocated over the quarter. Although examining money flows give no indication where markets are going, they do offer interesting insight as to where money was being put to work, and where that working money was being made available. Let’s take a look at some of the developments we saw over the most recent record breaking quarter.
- The only asset classes that saw outflows in Q2 were commodities and currencies.
- Spain (EWP) saw the biggest inflow of any iShares country ETF, with 58% of the AUM coming in the last quarter alone. As is often the case, these inflows came on the heels of a nearly 20% gain seen over the prior 2 quarters.
- After rising 26% in Q2, India (INDA), saw a $516M inflow. This was the third largest country inflow.
- Asia Pacific was the only region that saw equity outflows. China, which continues to lag (+2% YTD) saw the biggest out flow of any iShares country ETF.
- Emerging market equities had higher inflows than European equities which is interesting considering Europe is several times larger than EM.
- IJH (mid-caps) experienced the highest inflow of any developed market equity while IWM (small caps) had the largest outflow of any developed market equity, pretty interesting.
- Of any domestic sector, energy saw the biggest inflow by a wide margin, which is hardly surprising considering the under performance over the past few years coupled with the huge out performance in Q2. Industrials and utilities also saw substantial inflows.
- Consumer discretionary had the most outflows of any domestic sector (for a second straight quarter) followed by financials, health care and technology.
Again, watching flows only tells us where money went, which is usually towards hot asset classes and sectors and away from the poor ones. What is really interesting to keep an eye on is when these trends start to change.