As we approach the previous peak in the S&P 500 index, I’m sure talk of making a new post-recession peak and all time high for the S&P 500 index will draw the index towards those previous peak levels and maybe even beyond.

I will rarely talk about “culture” outside of an investment context on the blog (for obvious reasons I won’t go into). For those of you into the Trance (an underground form of electronic music and culture, it’s roots are in Europe) music scene over the years, the current US stock market environment reminds me of the opening verse from the classic Trance song “Lost” by Zara Taylor and Sunlounger (aka DJ Shah or Roger Shah)

Lost (Lyrics by Zara Taylor)

Forget the peace inside
You’ve given way to the gods of destruction
Full of desire
You feel afraid that there’s nothing left

Oh oh, oh no
Oh oh, oh no

This little poem sums up where the US equity markets sits currently, and what could play out over the next couple of years. You’d think it’s 1998/1999 again from the amount of “bears need to throw in the towel” posts I’ve seen in the mainstream media today after the biggest daily gain in the major US indices in a year. The message is simple and is classic crowd psychology: “Don’t bother fighting bullish sentiment….buy stocks now or you’ll continue to miss out on the party”. You all know how that story played out a short time later from 2000 to 2002 (the start of the lost decade in US equities). Then to make things worse, people unknowingly sell at the bottom and the cycle starts all over again.

Strange really, it’s days like today (given the high valuation conditions in the US equity markets and the weakness in the economic data) when you should be selling your some of your weakest fundamental long equity positions and finding better risk/return options for your investment cash. Assuming you’ve been net long equities and have upside gains, at least take half your profits and your initial investment off the table and play with the house’s money(there are various ways to reduce your downside equity portfolio risk, a discussion for another day).

The key is understanding where the average risk/return profile on US equities sits right now and whether you have determined that your individual investment/trading strategy will provide the appropriate return for the risk you are currently taking on with your US equity positions. Maybe there are those out there wise enough and nibble enough to get out when the time comes. On average, history suggests a lot of unknowing people will get burned.

Holding long equity positions through a potential 25% to 40% decline in the major US equity indices (aka buy and hold) is not a wise strategy.

Courtesy of S&P 500 Index (Long-term view):

S&P 500, long-term view
S&P 500, long-term view

As the long-term S&P 500 chart clearly shows, we’re simply approaching the previous highs of October 2007 on the Dow Jones Industrials and the S&P 500 (the large cap indices).

On a positive note, the Russell 2000 (US small cap index) made a new all-time high today. To be optimistic, if the US small caps can establish a consistent out-performance trend (meaning a multi-month and then multi-year out-performance trend) in both fundamentals and relative market price action (Russell 2000 vs. the S&P 500) it can be taken as a signal that the US economy is breaking out of the slow growth funk. Right now, the US economic data performance is not in line with such a trend being able to establish itself.

Courtesy of Russell 2000 vs S&P 500:

Russell 2000 Index vs S&P 500 Index
Russell 2000 Index vs S&P 500 Index

Let’s take a look at valuation on the S&P 500 index to understand the current average risk/reward profile. I’ve mentioned before that one of the US based portfolio managers who is good enough to share his knowledge publicly is Dr. John Hussman who runs the Hussman Funds. He’s known in the mainstream media as ultra bearish and some Wall Street trader/sales guru types downright dismiss his views and his record during the market rallies.

In my view, given where the US stock market has been since he started running his main US focused equity mutual fund (Hussman Strategic Growth Fund) and looking after other people’s money, his approach has been the right strategy for the US equity market during this time period. Strategy and tactical implementation are two different things. You can argue that his timing has not been 100% on(he missed opportunities to catch equity market bottoms and accept more upside market risk during the big equity rallies). Even the best have a hard time getting the timing 100% right. But since he has to look after other people’s money, he has to think capital preservation first and foremost and I understand and respect his discipline not to chase rallies during what he feels are over valued conditions.

Note: Dr. Hussmans’s recent absolute performance for his U.S. equity fund (the Strategic Growth Fund) is nothing to write home about and the fund has actually returned -12.62% for the 1 year period ending December 31st 2012. In theory, even with Dr. Hussman’s conservative hedging strategy, the fund should not be returning -12.62%, and I’m currently studying why this fund has been experiencing such trouble the last couple of years. That said, overall, over the last 10 years, his US equity fund performance is still well ahead of the S&P 500 index in performance.

Simply, his investment research approach is theoretically and fundamentally ahead of how the average sell side analyst goes about valuing the equity markets and their individual stock picks. Always remember, the average sell side analyst supports “selling securities” and ultimately that is what they are paid to do by the banks they work for. Whether they actually turn out to be right or not in their calls is not near the top of the priority list and generally gets forgotten in short order.

One of Dr. Hussman’s better posts over the years covers Wall Street’s tendacy to use their “forward earnings estimates” to continually say that stocks are “cheap”. Some analysts are even disingenuous enough to mix one year forward P/E’s (based on their earnings estimates, which most often are no where near accurate vs. the pending actual earnings) relative to trailing P/E’s. I can’t believe analysts can still get away with this, but I’ve seen it with my own eyes.

Anyhow, go through Dr. Hussman’s post called “Valuing the S&P 500 Using Forward Operating Earnings” and take note of how he develops the following model:

Long term total return = (1 + g) (future PE/current PE)^(1/T)-1 + dividend yield(current PE/future PE + 1)/2

In english, this formula means the total annual nominal return on your equity investment is the average annual capital gain (price increase) plus the average dividend yield over the holding period. Let’s use a 10 year time horizon like Dr. Hussman does for this example. There are those who argue they will never hold a stock for 10 years, such that the long-term risk profile of the stock market described in this model does not apply to their strategy. I understand that point, and it’s valid. Again, it comes down to understanding the equity market long-term risk/reward profile vs the risk/reward profile for your individual strategy. Most people are not good enough to time the market on a short-term basis, so Dr. Hussman’s model is valid with respect to a long-term time horizon. Back to the model.

g = nominal growth in S&P 500 earnings. Let’s use 6.5% for the next 10 years, which is higher than historical average for the S&P 500 (about 6.3%). Trying to account for the fact that the S&P 500 is really a global index now and companies have generally gotten more efficient. This may or may not be a valid fact.

current PE (trailing) = 22.35 (using current Case Shiller P/E)

future trailing PE = 19 (let’s assume trailing PE’s continue to decline, but don’t go down to the long term historical average of 16.45 and remain in the higher end of the historical range. This is an aggressive assumption.

T = time period = 10 years

S&P 500 average dividend yield over next 10 years = 2.37% = .45*1/PE = 0.45* 1/19 = 2.3684% (assume large corporations pay out 45% of earnings as dividends)

Long term return (nominal) on S&P 500 index = (1 + .065)(19/22.35)^(1/10)-1 + .0237*(19/22.35+1)/2 = 0.047845 + 0.021909 = 0.069755 = 6.98% (forecast average annual nominal return on the S&P 500 over the next 10 years)

This simple model shows why valuation always matters eventually. Add in a reasonably low assumption for inflation say 2% (it’s really higher than this for the average person) and you’re receiving on average 5% real return on S&P 500 stocks the next 10 years. Better than the current 1.83% nominal yield on 10 year US treasuries, but history indicates the road to that 5% real average annual return on the S&P 500 will be a bumpy ride.

Now if the Shiller PE ratios stays above 20 like it has most of the time since the mid nineties and everything else stays the same, the nominal average return on the S&P 500 index goes to 7.46% and the real return about 5.46%. No where near the historical average real return on the S&P 500 index. The average historical nominal return on the S&P 500 going back to 1957 is about 9.6% to 11.12%, depending on how you calculate it.

From industry experience, the generally accepted nominal discount rate (required rate of return) used by sell-side analysts for large cap US industrial stocks is about 10% (on average). But with US treasury yields on the 10 year bond at 2%, most analysts are probably using 7% to 10% for their discount rate (required rate of return) for large cap US stocks, and that’s assuming they even use discounted cash flow in their valuation approach. Many do not, as proper discounted cash flow analysis generally requires more research and proper forecast assumptions over time. Again, from experience, most sell-side analysts investment research (modeling skills and valuation approach) work leaves a lot to be desired.

The point is many analysts just reverse engineer a 1 year target price (which gets regularly adjusted when it’s convenient) using a forward PE multiple and a 1 year EPS estimate using a very simple model that has nothing to do with historically statistically significant stock market research and analysis. People (clients, even supposedly sophisticated institutional clients) believe it, because the main stream media and the analysts at the big bank owned brokerages are very good sales people (that is a valid fact). They eloquently present and justify the use of simple models to justify their forecasts and price targets, but generally, from a proper investment research perspective (or any research for that matter) their research, analysis and forecasts turn out to be very flawed.

In summary, taking long positions in US equities (at least un-hedged long positions) in this environment is a risky bet by historical standard risk/return profiles. Unless your US equity strategy is focused on getting the timing correct on when and where to find the exit. Assuming you are good enough tactically to execute that strategy. Again, most are not.

Until next time.

PS – All the best in 2013 and beyond. Take care.


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