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A Conversation

Imagine a financial adviser* approached you with an investment opportunity** without telling you specifically what it was. And right up front he tells you it’s likely to generate a zero to negative return over the coming decade. What would you say?

I imagine any investor with any common sense would respond by saying something like, “why in hell would I want to own something that will generate a zero to negative return over 10 years?!

And the adviser would likely respond with: “Well the outlook for other asset classes over the next 10 years is no more attractive than it is for this one.”

Common sense investor: “Well if it’s going to return zero or less wouldn’t even a savings account do better? Why not just own safe fixed income instruments? We can ladder them so we don’t have too much interest rate risk or opportunity cost. And it’s plain to see that plenty of asset classes offer returns better than zero over the coming decade. Why not just own them?”

Adviser: “There seems a reasonable likelihood that inflation will accelerate at some point over the next decade, and this asset class is a good hedge against inflation.”

Investor: “Okay. If runaway inflation is the only reason to own it wouldn’t TIPS or precious metals provide a better hedge considering this asset class’s extremely unattractive valuation?”

Adviser: “I have learned the hard way that market timing is very difficult and is generally a terrible idea. It’s better to just own this asset class all the time regardless of its prospective return.”

Investor: “Okay. So you’re saying you’re not confident in your ‘prospective return?'”

Adviser: “No. We’re confident. We have a variety of valuation measures that are highly correlated to the future 10-year returns of this asset class and they all say the same thing: that it’s very highly likely to return zero or less over that time frame.”

Investor: “So you’re saying that you have proven valuation measures that have been highly accurate in forecasting the return of this asset class for decades but you don’t think they’re very useful.”

Adviser: “That’s right.”

Investor: “Gotcha. I’ve got an even better deal for you. How about I sell YOU an investment that returns nothing over the next 10 years? That’s better than negative right? I’ll take the money and put it into risk-free treasuries, keep the difference between what they pay me and what I pay you (nothing) and then pay you your initial investment back at the end. How much would you like to buy?”

Adviser: “Only my employer (major bank) and the Fed can play that game, I’m afraid.”

*Thanks to Henry Blodgett for playing the “adviser.”

**US Equities

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Dogma and Denial

“Don’t Be Trapped by Dogma – Which is Living With the Results of Other People’s Thinking” -Steve Jobs

There is a very strong and popular dogma out there that says, ‘you must own US stocks all the time no matter what.’ It’s really at the heart of the “buy and hold” mantra which is something I’ve railed against recently.

I’ve railed against it because it’s pretty plain to see that there are times when US stocks are attractive to own – the vast majority of the time, in fact. But there are also times when they really aren’t.

Right now just happens to be one of the very few times US stocks have offered investors a negative 10-year forecast return based on Warren Buffett’s favorite valuation metric (total market capitalization to GNP).

So I ask, “why in hell would you want to hold something that is likely to give you a negative return over the coming decade?”

I imagine these dogmatists would answer, “because you can’t time the market.”

To which I would answer, “On what time frame? Because it’s pretty clear that this tool is fairly good at predicting 10-year returns. (It’s about 83% negatively correlated).”

Admittedly, on a one or two year time frame it has little or no value in timing but is that your investment horizon? If so, you shouldn’t hold ANY stocks at all, US or foreign! On the other hand, if your time frame is 10 years or longer you should probably be very interested in what a measure like this has to say. And it’s not just this one. There are measures that are even more closely correlated to future 10-year returns that say essentially the same thing: stocks are extremely highly-valued/offer unusually low rates of return.

And there are plenty of other asset classes to own that offer more attractive prospective returns! Hell, the 10-year treasury bond, at a mere 2.2% yield may offer better returns than US stocks over the coming decade with FAR less risk (so long as you intend to hold to maturity). In fact, nearly ANY other country around the world offers better value/prospective returns than US stocks do right now.

So why the hang up? Why are investors (and their advisers) so stuck on dedicating the majority of their investable assets to US stocks despite the fact that they are so unattractively priced?

My best guess is they are simply in denial. They are so enamored with the returns they’ve witnessed over the past five years that they simply refuse to even entertain the possibility that stocks may serve up anything less going forward. And that’s just a shame because it’s precisely at times like these investors should question this sort of dogma, rather than near the end of a bear market when they usually finally do decide to abandon it.

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How To Handle An Environment Of “Low Returns”

First off, if you are expecting to achieve historical average rates of return from stocks or bonds from current prices please go read, “How To Time The Market Like Warren Buffett.” The bottom line is a 10-year treasury note pays you little more than 2% per year and stocks are likely to earn you even less over the next decade. So what’s a prudent investor to do? Here’s Howard Marks on your options:

How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
  • Invest anyway — trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.
  • Invest anyway — ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.
  • Hold cash — but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.
  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action — one classic mistake — that I most strongly feel is wrong: reaching for return.

-Howard Marks, “There They Go Again,” May 6, 2005

Clearly, investors are currently “reaching for return” like never before. I have no doubt this episode will any any differently than it has in the past. For prudent investors, however, I think the best options are currently either 3 or 4, so long as they understand all the pros and cons of each.

Choosing the third option means you should be willing to tolerate another decline of up to 50% over the next decade in an attempt to capture the low single-digit returns stocks currently offer. That’s just the simple risk/reward equation current valuations present investors with.

Choosing the fourth option means you may have to hear your friends brag about their gains for a while should the market witness another bubblicious blow off akin to the 1998-1999 episode.

Which is the lesser of the two evils for you? Neither are very appealing but that’s the name of the game when you’re playing financial market limbo.

For more Howard Marks I highly recommend you read his excellent book, “The Most Important Thing

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The Trend Is Now Your Frenemy, Part Deux

A month ago the major indexes broke down below their uptrend lines. They have since gained back all of their losses and then some. But that doesn’t mean everything’s peachy again.

In fact, I believe there’s a good chance that last month’s correction was only the beginning of a resurgence in volatility and very possibly could evolve into a major topping process for the stock market.

I’ve spent a lot of digital ink here discussing how overvalued I believe the market is currently. Mr. Buffett’s favorite yardstick, total market cap to GNP, shows the market to be currently trading at a level that is nearly twice its long-term average valuation. In other words, stocks would need to fall nearly 50% just to return to an average level, let alone an undervalued one.

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Sentiment is also stretched about as far as it has ever been. Investors could hardly be more bullish than they are today, based simply on the percent of household financial assets allocated to stocks. In the simplest terms, this means that potential demand for stocks is not nearly as great as potential supply (see Philosophical Economics’s terrific post on the supply demand dynamic in stocks).

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While these two measures are very highly correlated to future 10-years returns in the stock market, they have very little utility in trying to time a market peak or even a correction. That’s why we have to consider the overall trend. Fundamentals and sentiment won’t tell us when the trend may be coming to an end. Only the market can tell us that.

And the market is sending plenty of signals that this may be happing right now.

The simplest way to analyze a trend is to see if prices trade above or below a simple 200-day moving average (approximate to the 10-month moving average) and/or draw a long-term trend line. (Meb Faber recently wrote an interesting piece on just how important the 200-dma is to hedge fund titan Paul Tudor Jones). And this is what we looked at in the last post in this series.

But we can also get a good feel for the overall health of a trend by looking at what is commonly called its “internals.” This is just a fancy way of referring to things like the percent of stocks trading above their respective 200-day moving averages, the cumulative advance/decline line and the number of new 52-week highs or lows being made.

Essentially, these are all ways to look at how the components of an index are performing relative to the overall index. A healthy trend is driven by a majority of the index’s components. Likewise, an unhealthy or weakening one is driven by fewer and fewer components. (Lowry’s has done some fantastic research on this phenomenon you can read here).

Right now all of these measures are suggesting that the current long-term uptrend is waning in strength. Let’s take a look first at the NYSE Composite:

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This index is actually one of the few that has failed to make new highs during the ramp over the past few weeks. Still, it’s plain to see that the cumulative advance-decline line (top black line), the percent of stocks trading above their 200-dmas (middle black line) and the pattern of new highs-new lows (bottom black bars) are all diverging from the new highs being made by the major indexes. The last time all three of these internal indicators diverged this way was in October of 2007, just prior to the bear market that coincided with the financial crisis.

The Nasdaq Composite looks very similar:

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The main difference here is that the three indicators diverged not just in 2007 but also in 2011 prior to the selloff precipitated by the European sovereign debt crisis. Overall, I think it’s safe to say the current uptrend is not as healthy as the bulls would like to see. And both of these composite indexes are important components of the S&P 500 index so don’t think it’s immune.

Still, it’s true that prices for both of these indexes have regained their 200-day moving averages and multi-year uptrend lines. Ultimately, this tells me that the overall uptrend is still in tact. But these internal diverging indicators suggest that it may be nearing its end as more and more of the underlying components have, in fact, given up their own uptrends.

What’s more, considering the extreme levels of overvaluation and bullish sentiment, the next cycle lower, when it does finally turn, may be more than just your average market correction.

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Stocks Shoot The Moon

Here’s an interesting chart I put together today that coalesces a few posts I’ve done over the past few months:

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It plots the S&P 500 ETF (red and black bars), which recently hit a new, all-time high, alongside:

  1. Junk bond risk appetites – blue line (see: “Obscene Risk Hidden In Plain Sight“)
  2. The inverse volatility ETF – red line (see: “Crowded Trade Du Jour: Short Volatility“)
  3. Consumer discretionary ETF vs. Consumer staples ETF – green line (see: “TFR: Stocks, Gold & China” – technically this was a newsletter, not a post – subscribe here)

Clearly none of these indicators have kept pace during the rally over the past few weeks. Have stocks overshot the mark or will these indicators now play catch up? Or maybe they just don’t matter anymore. Who knows?

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Overcrowded Trade Du Jour: Short Volatility

Periods of low volatility are to investors what a sweet lullaby sung by whispering nanny is to an overtired baby. It relaxes them, gets them to put their worries aside and believe that everything is going to be okay. Great for babies. Not so great for investors.

Because Mr. Market is a sadistic nanny, usually lulling investors into a sense of calm and security right at the worst time.

The few years that led up to the financial crisis were the last great period of low volatility investors witnessed. Clearly, the overwhelming sense of calm in the market (lack of fear), even through the first half of 2007, was unrealistic. You may remember that all of the gains earned during those years were quickly given back and then some during the financial crisis.

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But investors were simply doing what they do best: projecting the results of the recent past way out into the future. They were lulled into believing that volatility was no longer cyclical and that the goldilocks economy meant that it was smooth sailing as far as the eye could see.

Alas, we learned shortly thereafter that volatility AND the economy AND the credit markets were, in fact, still subject to cycles.

“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.” -Howard Marks

I bring this up today because volatility has once again witnessed a period of sustained depression and investors have once again been lulled into a sense of extreme complacency (if that’s even a thing).

ETFs that track the inverse performance of the VIX have become hugely popular this year. They have now attracted nearly $2 billion in assets, $800 million of that coming just in the month of September. In effect, these are bets that the current period of low volatility will last for the foreseeable future – that’s the only way they will make any money.

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Chart via FT.com

The problem is that the VIX currently stands at about 15. It’s lowest point in the past few decades is around 10. From the beginning of the year to early July when the VIX neared that 10-ish level these ETFs saw about a 35% gain (on about a 35% decline in the underlying index). Nice! Right?

Wrong. During the brief, not-even-10% correction we witnessed last month these ETFs declined nearly 50%!! Imagine what would happen if we actually saw a 20% decline… or more. These funds would be obliterated.

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I was recently listening to Tony Robbins on the Tim Ferris podcast and he shared an insight about one thing the world’s greatest investors have in common: they look for fantastic risk/reward setups. They look to risk a penny to make 25 cents. To me this looks just the opposite. It’s like risking 50 cents to make pennies. Good luck with that.

Further reading:

“Now that everyone’s a volatility seller…” – FT Alphaville

“Record short VIX notes sounding alarm to Deutsche Bank” – Bloomberg

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Wagging The Dog

Regular readers know I like to try to combine fundamentals with technicals and sentiment to form a holistic investment/trading thesis. Right now I believe that these three factors are lined up on the bears’ side in the case of small cap stocks, which have led the broader indices of late – the proverbial tail wagging dog.

First, to say valuations are stretched in the case of small cap stocks doesn’t quite tell the whole story. In fact, they may have never been more stretched than they are today. (I’d love to see a CAPE ratio for the Russell 2000 if anyone’s got that data.)

The trailing price-to-earnings ratio currently looks fairly absurd:

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Chart via WSJ.com

I would assume that the astronomical level of the p/e is due to the fact that a large number of companies have losses rather than earnings. But even if you look at price-to-revenues the stocks look extremely overvalued. WSJ reports:

As of Sept. 30, for example, stocks in the Russell 2000 traded at 1.5 times their revenue of the previous 12 months, a measure known as the price/sales ratio. That is just a hair below the highest valuation seen going back to 1994, the earliest year for which data is available. Such levels were last seen during the stock bubble of the late 1990s, according to Russell Indexes.

The index would have to fall another 15% just to return to the average price/sales ratio of the past 20 years.

A price/sales ratio of 1.5 times in the Russell 2000 doesn’t happen often, says Lori Calvasina, a U.S. equity strategist at Credit Suisse Group CSGN.VX +0.08% who specializes in small and midcap stocks. “But whenever we’ve been there, the Russell 2000 has literally never been up 12 months later, and the average decline is about 16%,” she says.

So it’s hard to make the case that small caps aren’t currently overpriced and technically, they look vulnerable on a couple of time frames.

Back when the ETF broke out above the 82.5 level at the end of 2012 I called this chart the most bullish chart I could find. I’ve been watching ever since, adding the 1.618 Fibonacci extension which has proved to be significant resistance since early spring:

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What’s most glaring about this chart is the recent selloff has seen the uptrend line that dates back to the 2009 low break. The ETF is now testing the underside of the trend line along with its 20-week moving average. So this correction is more than the typical brief pullbacks we’ve seen over the past two years.

Comparing it to the 2010 and 2011 corrections, then might give us a bit better idea of what to expect from this selloff. Notice both of those pullbacks saw the ETF make lower lows with divergences in RSI, volume and MACD histograms. Should the current selloff follow this pattern we should see a lower low made over the next few weeks.

The daily chart confirms this view. RSI (at the top of the chart) is showing another divergence/non-confirmation with the latest high made on Thursday. The index has failed to overcome its 61.8% retracement along with the other major indexes. Finally, volatility looks to have broken out and the pullback is just a test of the breakout level, suggesting we could see another surge in volatility soon. Unlike the other indexes, this relative high for the Russell comes in the context of a clear pattern of lower highs and lower lows, the definition of a downtrend:

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All of this makes a retest of last week’s lows very likely, in my opinion. It may be putting the cart before the horse, but I believe the big question after this next pullback will be whether this all amounts to a larger topping pattern for index.

Last month the index closed more than 1% below its 10-month moving average which amounts to a long-term sell signal for trend followers. Should it be unable to regain that level by at least 1% over the next few months, the most bullish time of year for the markets, I think it will be safe to assume the Russell will be faced with a new bear market lasting anywhere from roughly twelve to twenty-four months.

In fact, should the complex head and shoulders pattern in the chart above play out it would see the index decline to around the 950 area, a 21% decline which meets the definition of a bear market. But as I said, let’s see what happens over the next couple of weeks first.

Finally, sentiment toward the sector has surged. StockTwits traders are absolutely rip-snorting bullish on the Russell 2000 futures contract right now – even more bullish than they were a month ago when the major indexes were hitting all-time highs:

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Chart via StockTwits

The bottom line is these stocks are overvalued, overbought and over-owned right now. What’s more, they have led the broader indexes over the past couple of months and I believe they could very well represent a significant “canary in the coal mine” investors should pay close attention to.

See also: “The Dominant Risk For Wall Street” May Be Manifesting In Small Caps and What Does “Reduce Risk” Mean To You?

Disclosure: I currently own inverse Russell 2000 ETFs (what amount to short positions) for myself and for clients.

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