Notes on Commentary

I realize at times some of what I write is difficult to comprehend, and I do my best to try and simplify things.  While that is a concern, what worries is reader misinterpretation, and feel it may minimize the chance of that happening, by explaining how I write the 10 or so paragraphs a week:

1. From amongst the enormous amount of reading I do every week, I try to find some things of interest in the wealth management arena, typically investment related.
2. Try to simplify those concepts into an easy read, and shine a light on them, which provides a perspective, which may be of interest to the reader.
3. Have a colleague review what I write so I don’t sound like the follow when trying to simply things:  
• .
4. Give it a third look to make sure the points are clear and concise.
5. Submit to our Compliance Department according to SEC regulation, so I don’t get into trouble.
6. Post online, usually the week after I write it, but at times a few weeks after I write the original.

Remember, nothing I write is static.  For instance, this post on utilities being overvalued was written in early May, but since then Utilities are down roughly 5%.  They are still overvalued relative to their historical norm, but less so than previously. 

The dynamic nature of markets and my opinions on those markets is important to consider when reading these blogs, especially in regard to the equity market, where I am currently bullish but have a more bearish intermediate term view. 

Circumstances change so will my views will be fluid.  Further, momentum, which I believe is a good risk control indicator, can change quickly.  My views on shorter term outlooks one week could begin to diminish a few weeks later.  In other words, these blogs are time sensitive, as is most commentary, and this must be considered when reading not just my opinions, but those of others. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Fast Forward Earnings

Forward earnings projections for the S&P 500 are at record highs.  Glass half full – earnings should continue to improve.  Glass half empty – high earnings means high expectations.

Rather than project where earnings will be, I will give my interpretation of how to read the consensus.  This chart from Dr. Ed’s blog helps:

While difficult to read (so see the notes), some things stick out:

• The bulk of the time forward projections are too high start too high (see the blue lines trending down)
• Forward earnings projections tend to be reliable (notice slope of blue line is small) most of the time…
• Unless there is a recession (see the slope of the blue line is massively negative 2001, 2008, 2009)
• Even if forward earnings projections move down, sideways, or slow in growth, equities can still advance due to multiple expansion, i.e. stocks become more expensive relative to the earnings they produce (see the red line in 2012 and 2013)
• Though there is certainly a limit on this expansion, for instance a forward PE in the mid 20s in 2000 was certainly an alarm signal when the long-term average is around 15

And my subsequent takeaways:

• We are below the longer-term average on forward PE, thus even if forward earnings come down the equity markets can move higher
• An exception to this would be if we hit a recession, in which case all bets are off
• Another would be if the multiple gets too high, where falling earnings would yield a falling equity market as multiple expansion can’t offset the decrease in earnings
• We are currently around 14 P/E.  In 2007 at the peak we were around 15 and 25 in 2000.
• Thus given we appear to be at a reasonable valuation level on this metric, the risk to stocks lies in the risk of a recession
• So far the data doesn’t seem to indicate a recession is coming
• Still, since equity markets tend to lead the recession (even ones that don’t come to be) it’s important to gauge the momentum of the market for any possible hint 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Lack of Evolution Leads to De-Evolution

"I've never sent an e-mail and I never will." -- Bud Selig

Bud Selig is the commissioner of Major League Baseball.  He made those comments a few weeks ago, was the butt of a few jokes, and now it’s gone away.  Bud (I think) is going to retire in a year and baseball will move on.

I point this out, not to make fun or pass judgment, but to shine a light on its symbolism.  What this represents is baseball’s inability to evolve.  Our nation’s pastime, baseball is stuck in the past while its competitors - football and basketball - are proactively moving forward.  

Pick your issue - steroids, instant reply, player marketing, speed of the game, etc. - baseball moves at a snails pace. Baseball has a history of being reactive, rather than proactive.  The evidence of baseball’s relative decline are in the ratings. 

Become complacent, stop making positive progress, stop evolving, stop growing and the gradual decent to extinction begins. This is true of any business including wealth management, portfolio management, and the delivery of client advisory services. Whether it’s a company, economics, or an advisor, the key is to be reasonably progressive.

Change for change sake is not what I am talking about: that is silly, futile and empty headed.  But, rather evolution to improve productivity and services to the end user is that to which I refer. Give the customer/client not just what they want, but give them that which they didn’t even know they could have. Set the bar high and then exceed it. Baseball could take some lessons from companies, who strive for excellence, something we attempt every day. Our website contains a page entitled, Guiding Principles, which are some general principles, which MLB could afford to adopt.

Certainly I am not suggesting baseball change the game, no more than I would suggest a successful investment manager tearing up their strategy and starting from scratch.  What I am suggesting is that in order to maintain that success, the focus must be on the future and not the past, on how it represents itself to the public and on those who it seeks to serve.

When looking at a stock, a manager, an advisor, or what sport will have the highest likelihood for a favorable outcome moving forward, the safest bet is the dynamic one.

Stock Market Risks – Investors Tendency to Get Ahead of Themselves

In the near-term there appears to be little risk to the equity market, which alone is reason for investor concern.  From a macro standpoint, there appear to be two outcomes:

1. The economy is stable and continues to grow, albeit slowly.  Top line revenue improves.  Earnings look good.
2. The economy is slows and growth looks like it is coming to a halt.  Fed easing continues.  Bottom line improves + valuations expand.  

It really seems like a no lose proposition with short-term valuations at reasonable levels (though those can be be distorted).  Let’s consider some of the known risks.

• China property bubble pops.
• Europe in recession.
• Middle East trouble.
• Other - flash crash, natural disasters.

The last two bullets are always going to be on the list.  When hasn’t the Middle East been on the verge of erupting?  You can’t use that to justify not investing in equities or you would always be in cash.  Same with “other”. As for China and Europe, you can simply underweight those positions to mitigate risk. The US stock market has shrugged those off.

Back to the original point, aside from those unknown risks, which by definition I can’t list, I can’t seem to find a whole lot of risk in the stock market in the near-term.

The risk, as I see it, might be a few years out where various intermediate valuation and trend measures are less favorable (note: these have been confirmed by our own independent research).  And unless this time is different, as in the past, they will revert to the mean.  Though still this says little to nothing about the next 12 months, and leaves us in a precarious position.  By example, a 40% loss reduces a 140% gain to a 44% gain.  Still, as mentioned earlier, nothing in the near-term causes me to think it will happen soon and those valuation measures are meaningless over a shorter time horizon.

Further, we appear to be about at the average of most bull market cycles, as Jon Hussman notes:

Bull market advances [since 1940] have averaged a 123% price gain, a 162% total return, and a duration of 4.4 years.

Thus, while we may be long in the current bull market tooth, nothing YET indicates an immediate move into bear territory.  Further, while sentiment has been improving, at least in my mind it doesn’t seem to have reached “all in” mood yet. (note: this is subjective based on my research, experience, and conversation with clients and retail investors).

Ultimately I am comfortable with a cautious approach to equities.  Investors should recognize the unfavorable intermediate-term signals, but not base their buy/sell decision totally on those.  Investors can do this by current bull market run with allocations to higher quality equities and pumping the breaks when appropriate. 

I don’t know whether market complacency, Fed tightening, China, Europe, a flash crash, our own recession etc. will start the next bear market, but I am willing to see where the things go and scale back exposure when the market signals to do so.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  Nothing in the above writing should be taken as an investment recommendation. 

Too Good to Be True?

If an investment sounds too good to be true, it usually is.  If you don’t understand how the investment or the market in which it exists, that only amplifies things.  Still, neither of those means it’s a bad investment, it only means the following:

1. You probably don’t understand the risk
2. It’s time do some research

I bring this up as we were just pitched by an investment firm which is waist deep in experience and credentials on an investment strategy with:

1. High yield
2. Low risk
3. Non-correlation to the assets in the portfolio
4. Non-correlation to other asset classes

What an investment!  Frankly, I came out of that meeting, and my only concern was the title of this commentary.  So I dug a bit deeper…

1. High Yield – Yes, the yield was nice, but has also come down as other investors took a liking to this asset class
2. Low Risk – Kind of, but it remains unclear if the models used to price these investments are accurate.  Further, the now lower yield enhances this risk (i.e. you aren’t compensated enough for the risk)
3. Non-correlation to other assets in the portfolio – In theory, yes; however, it’s possible these assets all move together if everyone tries to leave the same broad market.  Hard to gage the likelihood of such an event
4. Non-correlation to other asset classes – Yes, until it isn’t.  By this I mean there are instances when this asset class would move with equities, and only at the time when you would need them not to do so

I don’t want to divulge the asset class because we are still doing our due diligence.  I just wanted to give an example that there is always more than meets the eye, and it is critical to dig and dig deep when presented with a possible investment.

However, just because we uncovered some risks doesn’t mean it’s not a good opportunity.  It just means we need to be aware of all of the downsides, weigh those against the possible return, and if it passes our screening process, explain all of this to the client where is fits accordingly.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  Nothing in the above writing should be taken as an investment recommendation.