Observations and Outlook January 2018

Investors have not been as fully invested in the stock market since 2000.  Does this mean anything?

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)


The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA

The Definition of “Long Term Investor”

What is the difference between long-term characteristics of the market, and owning the market for a long term and how can an investor benefit from knowing the difference.

The phrase “Long Term Investor” is used quite often, and there are many definitions.  The IRS defines a long-term investment as anything held more than 1 year.  Most people though would agree that long-term refers to a much longer time frame, usually at least 5 years.  However, when we read about equity market statistics, we are shown 30 and often 70 or even 100-year time spans.  I saw a recent article with a 500-year time span.  Given the average human life span, and that our peak earning and accumulation years are from our mid-40s to mid-60’s, most investors actually have about a 20-year time horizon of accumulation.

A “long term investor” isn’t one who buys and holds for a long span of time.  A long-term investor recognizes the long-term characteristics of equity (and other) markets.  For example, over the very long term (+20yrs), earnings per share follow GDP growth, the average 20yr annualized return is just over 7% (with dividends adding to this), and that over shorter periods of time, actual returns can vary greatly from the average.  The long-term investor also understands that the averages over the more volatile shorter periods of time are the pieces that create the 20-year average. One can see the volatility, or range of returns, over shorter periods below.

1-3-5-10-20-yr-avg-returns-schwab-ctr-for-financial-research      Source: http://www.investopedia.com/articles/stocks/08/passive-active-investing.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

The periods when we most often hear the phrase “I’m a long-term investor” being used, unfortunately, are when stock markets have experienced a significant decline.  To assuage the pain of real or paper losses, investors will often claim this characterization, with the unspoken assumption that ‘it will come back’.  And it always has, if you waited long enough.   From Charles Schwab Inc., via Investopedia.com we can see that yes, over very long periods of time, 20 years in this case, the market always has a positive return.

The chart below shows us the extremes. The low seen in 1979 to 1982 at about a 3% 20-year annualized returns, and the late 1990’s, from 1998 to 2001 which saw 20 year annualized returns over 13%.  While still positive, it’s much more helpful for an investor to invest over the right period! But how can one tell when ‘the right period’ might be at hand? Or even better, when the ‘wrong time’ might, so one can avoid a period of poor returns.  While not widely disseminated, missing the bad times has a far more powerful impact than staying invested, per this study by Meb Faber of Cambria Investment Management https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908469

avg-20-yr-returnsSource: https://www.quora.com/What-is-the-average-S-P-500-return-over-20-years

So, while it is clear that, ‘in the long run’, if you wait long enough you will have positive returns.  From the chart above we can see that there are periods when long term returns are well below and above the 7% average.   How can we avoid being drawn into the low return eras?   Another long-term characteristic of equity markets is that Price to Earnings (P/E) ratios expand and contract.  That is for $1 in earnings, sometimes people pay $25 in price (a 25 P/E ratio) and other times less than $10.

For those well versed in market history, we know that the exemplary 20 year annualized returns seen in the late 1990’s, saw their birth in the low Price to Earnings era of the early 1980’s.  There are many studies showing how long term returns are borne from low P/E multiples.   Given that currently we are only beginning to enter the 20-years-later period after the dot.com bubble, we only have the first 20-year cycle from 1995, which gave us 7.3% annualized price growth.  Given that the late 1990’s saw large price appreciation, this acts as a headwind to the 20yr annualized returns in the next few years.  The S&P 500 started 1997 at 766 and if we end at 2200 in 2016 that will give us only 5.4% 20yr returns.  The S&P500 started 1998 at 963, and to maintain the 5.4% 20yr returns, the S&P500 would need to end 2017 at 2765, a gain of more than 25%!    The propensity is for the 20 year annualized returns to continue the downward slope that began in 2002 and likely repeat the bottoms like 1980, 1949 and four other periods where long term (20yr+) returns were very low.  The chart below is from Barry Ritholtz.

rolling-20-yr-returns-ritholzSource: http://ritholtz.com/2011/12/dow-jones-industial-average/

The results since this chart was created in 2010 are indeed following the red dashed line down.  Knowing that the market in 2000 was amongst the most expensive ever (highest P/E ratio) it should be considered that the 20 years ending in 2020 may see results that are amongst the worst in the past 100 years.  To have 0% return from 2000 to 2020, the S&P 500 would only need to decline by 31%, about the average for a bear market.   To have 2.5% annualized return from January 2000 to January 2020, the S&P500 would end 2019 at 2335, a change of about 6%, or only 2% annually.    The moral of the story is outlook for equity returns over the next 2-3 years is low and likely volatile, not a good risk to return prospect.

What Should One Do?

While 20yr annualized returns are slow moving data points, it’s clear that the long-term average is in decline.  Paying a high price (high P/E multiple) leads to poor long term returns is a slow lesson investors simply don’t have the time to learn from experience, and that many Baby Boomers can ill afford to learn now.

Knowing, or rather, expecting returns from stocks to be low going forward will enable an investor to seek returns from other asset classes.   Few Investment Advisors currently work with models outside of the traditional stock/bond portfolio mix.   An Advisor who recognizes that there are indeed 7 asset classes with which to pursue returns has an advantage.  Being successful at putting that understanding to work, is, indeed, the work of portfolio management.

Investors who want to earn returns in the medium term should look to other asset classes for returns, ideally ones that meet the ‘low’ metric for their markets.   True diversification is the call today, not simply bonds and stocks, but also commodities like oil and agriculture, precious metals and even cash.

If you would like more information on my Volatility Based Dynamic Asset Allocation process that seeks positive gains regardless of how equity or bond markets perform, contact me via email at awaszkowski@namcoa.com.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.