Sunday, May 18, 2014

Are We Complacent or Petrified?


On my recent one day visit to San Francisco when I spent 12 hours on planes for a two hour meeting, I chatted briefly with what seemed to be an intelligent stewardess. She wanted to know whether any of the papers I was discarding would make her rich if she read them. I suggested that she should enter the pilots’ cabin and learn to become a flight captain. She demurred as her friends who were pilots were mostly bored when flying these airliners. (Of course, boredom can turn to panic when something goes wrong.) Her comment echoed in me when I read that Dave Tepper, the New Jersey-based, very successful hedge fund manager was quoted as saying the market had an air of complacency. Examining my own and others' current thinking, I believe our low level of activity could be that we have become petrified.

Why are we petrified?

Sir Isaac Newton introduced the concept that God was the watchmaker in the sky that kept all the physical forces in balance so it would appear that many countervailing forces were in balance. During this period of extremely low stock market volume we instinctively should be taking advantage of apparently reasonably priced securities. Except that our somewhat undefined fears or constraints are playing off against one another, so we are doing nothing.

What is the import of these messages for bonds?

Both German and more remarkably French 10 Year bonds are yielding below similar US Treasury bonds. The lower yields are caused by investors pushing prices up and therefore yields down as German and French bonds appear safer than those of the US.  At the same time the spreads on the five year TIPS have widened which is somewhat counterintuitive. If the dollar appreciates due to higher rates, in theory, both inflation and recession risks should decline according to Moody’s*. The desired loosening of underwriting standards for mortgages as dictated by the government brings fears that we are once again starting another residential housing bubble.

In terms of stocks: more confusion

One way to look at the stock market is to use a military approach. The large caps or if you will, the generals, are leading the grinding march upwards while the smaller caps are in retreat. In April, of the 10 S&P 500 stock sectors earning estimate revisions, telecom (+15.8%) was the only double digit gainer and discretionary (-10.2%) and financials (-11.0%) were the double digit losers. Five sectors were up and five were down which showed that within a relatively flat market there was a lot of selectivity. This selectivity was even more pronounced when one looks at movement within market capitalizations. In terms of price movements by sectors, eight of the large caps were up; led by energy (+5.11%) and utilities (+4.2%). In contrast for the S&P Small Cap 600, eight of the sectors declined, however the same two were the leading sectors but with much smaller gains of +1.84% and +1.08% respectively.

Thus hiding out in large caps has worked as it has in the past in a nervous, late stage bull market.

Better valuation methods

I am pleased that S&P is providing both reported estimated earnings price ratio and their estimate of changes in operating earnings. First, I have never been comfortable with the academically derived CAPE (Cyclically Adjusted Price to Earnings ratio) approach to valuation; i.e., accepting reported earnings as a basis for valuation. (Having run a company albeit a small private firm I am very conscious of the difference between operating earnings that one can spend and financial statements' bottom lines.) Second, the current market only looks reasonably cheap if one buys into the forward estimates. For example, the P/E for the S&P500 using 2013 earnings was 17.74x and 26.01x for the S&P600 (small cap) both declined using what looks to me a very generous estimate for 2014 price/earnings ratios of 15.1x and 17.99x respectively. The reason for my skepticism is based on S&P’s estimated gains in operating earnings, +17.51% for the 500 and +44.56% for the 600. In the latter case this is almost 3 times the operating estimate gain for 2013 of +15.96%.

The problem with too generous estimates

To my mind the overly generous estimate of operating earnings gains for small caps in 2014 is to some extent petrifying me in my investment management responsibilities. As regular readers of these posts know, I believe in utilizing time spans to segment portfolios. The longest time span is for a family fortune or an endowment for future users of an institution. Recognizing that a portion of the future belongs to those that successfully disrupt the markets of today, most often this kind of guts or perhaps desperation is found in smaller companies. Thus, smaller companies, particularly those found in small funds are a regular diet for most of our accounts. While I am looking for quintuples or “ten baggers” in this kind of merchandise, I can materially cut our returns by paying too high an initial price. Perhaps the very recent 10% correction in NASDAQ prices helps a little but not enough. I need a substantial discount in many of these biotech and new technology stocks which to use Warren Buffett’s term are beyond my circle of competence and thus I use appropriate mutual funds and related vehicles.

Count our blessings

The fashion of the times is moving away from the old numerical fads such as Modern Portfolio Theory (MPT) which was modern in the world of physics over one hundred years ago, had nothing to do with the construction of winning portfolios, and was a very much an unproven theory. During this current particular phase in the stock market as correlations within and among stock groups breakdown, we will need a new set of blankets to cover the different speeds the various proverbial horses are running. I would suggest two general approaches; the first has to do with operating results and second the nature of the ownership of the shares.

Correction: Last week I inadvertently gave a Caltech Degree to Charlie Munger which was not the case. He did get an education on meteorology from Caltech which probably helped him to become a very successful lawyer and investor as well as a partner in Berkshire Hathaway’s* operating and investment success.
*Owned personally and/or by my private financial services fund

Question: What are you looking at to characterize this market?
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