The following is a quarterly communication from Bryce James. Bryce, the president of Smart Portfolios, employs leading edge portfolio management embracing Nobel Prize winning strategies for portfolio design based on risk management. Since his strategies are a critical component of our clients’ portfolios, we are confident that his views on the markets will be a particularly interesting read.
The Federal Reserve Board (the Fed) continues to lower rates and print money in an attempt to stimulate the economy. Even with tapering, the Fed is injecting $25 billion¹ a month into the system with its purchase of longer-term US Treasuries and adding $20 billion¹ per month to its holdings of agency mortgage-back securities This large scale experiment seems to have stabilized the economy, at least during the short-term; but no one knows the long-term effects of inflation and debt on our society. Perhaps the biggest winner of the Fed activity is Wall Street. Both the financial industry and investors have benefited from the massive cash infusion since the 2008 crash. In fact, the stock market is only two months away from becoming the longest bull market run in history.
Interest Rates on Bonds and Real Estate
The Fed policy to lower rates has been a boon to holders of fixed income securities. However, it has become harder in some ways for investors to participate in this bond market rally. One reason is that the major bond funds, like PIMCO, Fidelity and Vanguard, control most of the new issue float, making it difficult for anyone else to participate in the issuance of new bonds. Secondly, few corporations offer long-term bonds, and if they do, they typically have a call feature to redeem the bonds early.
The Fed stimulation has also made home buying more affordable, and as a result, has driven up home prices in the growth areas of the country. Many places like Seattle and San Francisco are seeing home prices near or at record highs. Supply and demand plays a big part in home price appreciation; but the key driver is lower interest rates. As a rule of thumb, a buyer that can afford a payment of $3,000/mo., when rates are around 10%, can afford a $300,000 home. But when rates come down to 4%, the $3,000 monthly cash flow can afford the same buyer a $750,000 home.
The big fear is therefore interest rates. Rising rates will adversely affect both the bond and real estate market. The fear of credit may become constricted will quickly spread to the stock market and investors typically flee riskier assets during uncertain times.
A Game of Musical Chairs
Sometimes you can equate an over-valued stock market to a game of musical chairs. As you are walking around the circle, you can anticipate the music stopping. The problem is, you just don’t know when. To quit the game early negates the ability to win, while staying in too long can be very painful. So my goal of this writing is to attempt to predict signs of when the music is coming to a halt. In this game of musical chairs there are actually prizes for second and third place participants. You don’t have to be the last person sitting to win. You just need to come close. Let’s examine the drivers that will lead to the last note.
- Security and market valuations (Fundamental Analysis)
- Economic indicators and benchmarks (Economic Analysis)
- Chart patterns and strength indicators (Technical Analysis)
- Market perception indicators (Sentiment Indicators)
- Security and market volatility indicators (Risk Analysis).
I will attempt to address the key drivers that concern us.
In the past 100 years, the Price-to-Earnings (P/E) Ratio of the S&P 500 hit an annualized low of 4.2 after the crash of 1929 and an annualized high of 44.2 in 2000 prior to the dot.com crash. These were the extremes. Today, the price of the index is just shy of 22 times earnings. Below is a histogram of SPY (ishares S&P 500 index ETF) over 1, 2 & 5 years, and since 2007. This same data is also shown as an oscillator to better illustrate its historical range in that time sequence.
SPY (ishares & S&P 500 index ETF) Time Periods Ending June 9 2014
The red line in the Frequency chart depicts the relative position of the SPY ETF relative to the listed time series; while the dots in the oscillator do the same. These charts would suggest that the market is expensive relative to its historical market valuation. If an investment professional were only to rely on fundamental analysis, like Price to Earnings (P/E) ratios, Price-to-Cash Flow (P/CF), Price-to-Book Value (P/BV), etc. then most would have missed a significant part of this recent rally. P/E ratios can be a bit misleading as corporate earnings post-crash tend to be very low creating extremely high P/E ratios. For example, the P/E ratio of the S&P 500 on 1/1/2009 was 70.89³. A look at Price-to-Sales or Price-to-Book Value may give clearer insight into relative market value.
S&P 500 – 12/31/1999 to 6/9/2014
Min: 1.78 (March 2009)
Max: 5.06 (March 2000)
00’-02’ H/L: 5.06 (3/00) to 2.43 (9/02)
07’-09’ H/L: 2.91 (9/07) to 1.78 (3/ 09)
Using Price-to-Book Value you can see the market is relatively high based upon the past ten years of market data, but the current P/BV of 2.73 is still cheap when compared to the dot.com bubble of the late 1990s. The low interest rates and unprecedented Fed activity make it hard to find anywhere else to invest other than the stock market. Of course, this is the breeding grounds for the next stock market bubble.
Technical indicators are mostly an indication of momentum or trend. The longer a trend is in place the more distance the price moves away from its historic mean return. In the chart below you can see the SPY has had a long bullish run and, just prior to the recent correction, was trading far above its 200 day moving average; as it is now again. Also note how the Relative Strength Index chart (bottom) was also trading near its highs. Technical traders love this strength, but the music can only play so long before it stops and the chairs get pulled out beneath them. The longer the market trends in one direction, the greater the probability is for a mean reversion correction.
SPY (iShares S&P 500 ETF)
Modern risk analysis attempts to measure the potential loss in a security on a given day. The most common risk metric for measuring daily loss is known as Value-at-Risk, or VaR. VaR is an estimate of the average daily losses a percentage of the time. For example a VaR 1% = 3.4 suggests that 1% of the time (1 in a 100 trading days), a security would expect to lose 3.4% on a given day, on average. The red line in the following chart is a rolling 3 month VaR estimate.
The green line in the top chart is the price of SPY since 2006. The black line in the lower chart is the daily price fluctuation (% up/down change). Notice the amount of times the daily loss (black line) exceeds the red line; mostly during market crashes and corrections. You can see how poorly VaR estimate loss, especially when you need it the most, when markets are going down. Now notice how the blue line more accurately depicts the current level of risk. The blue line (called Expected Shortfall) is our method to measure of risk and it provides a better method of tracking the probability of loss on a daily basis.
(Technical note: the blue line, Expected Shortfall, is computed using GARCH modeling using fat-tail distributions. Expected Shortfall may also be computed with other distribution models.)
SPY (iShares S&P 500 ETF)2 12/31/2005 to 6/9/2014
The benefit of using Expected Shortfall (blue line) is not only the ability to better estimate losses, but it allows us to see the level and direction of risk. When risk is low, or decreasing, securities tend to rise. When risk is increasing securities tend to go down.
Investors can get fooled near market tops because risk (volatility) is low and recent returns are high. In other words, the risk/return tradeoff looks very attractive at market peaks. However, once volatility starts to rise markets can accelerate downwards quickly. Having a risk metrics that attempts to track daily risk affords us insight of potential outcomes, not seen in traditional risk models.
An Over-Valued Stock Market
The market valuations are high relative to the past ten years but nowhere near their exuberant levels of the dot.com era. That said, the valuations are near where they were previous to the 2008 crash, so anything is possible. Not surprisingly, the popular technical charts are over-extended. We have many reasons to exhibit caution in the markets at this time. If risk where to start to climb we anticipate our models to rapidly become more conservative.
Information provided is the opinion of Bryce James of Smart Portfolios and is not a solicitation or offer to purchase any investment. Information provided is believed to be from reliable sources. Charts and graphs are internally generated unless otherwise indicated. The data for internally generated reports is provided by Thomson Reuters.
² Sources: Smart Portfolios Internal Research with Reuters Data
³ Source: http://www.multpl.com