December 2013 – Monthly S&P 500 Market Strategy Update

Bubbles, Bubbles everywhere!

Huh?

In my almost thirty years in the financial business – it seems longer – I have been through a few market cycles.  What is inevitable is a chorus of money managers and analysts screaming ‘Bubble’ when equity markets start to recover from cyclical lows.  In most instances the people yelling ‘Bubble’ are the ones who have under-performed the market indices by a wide margin.  ‘Misery loves company’ is a popular idiom that comes to my mind when I see these people interviewed in the business press as bearish equity market strategists and investors love to hang out with each other and share the same echo chamber.  Hopefully by the end of this blog you will be scratching your head along with me when the plethora of ‘Bubble’ interviews and press stories that will be written on the spectacular returns for the S&P 500 for 2013 in the closing months of December and early January 2014.

Another item I would like to get off my chest is this whole subject of ‘Quantitative Easing’ thing.  Market experts have commented that because of ‘Quantitative Easing’ the equity prices are somehow fake or artificially high and cannot be trusted.

Really.

In our highly mathematical world of Model Price Theory (MPT) there is no evidence that I can see that links ‘Quantitative Easing’ to unjustified or artificially high equity prices.  Equity markets in general represent a complex system that can have many influences. Do I think ‘Quantitative Easing’ is a positive in the hundreds of thousands of potential agents acting upon individual equity prices?  Yes I do.  Is ‘Quantitative Easing’ wholly responsible for the levitation of equity prices?  This I cannot agree.

Equity returns over the last 5 years, since the financial crash of 2008, are largely a function of how far the US equity markets crashed in the first place.  I sense market professionals are only looking at the rates of return – that are good BTW – without consideration of where or what valuation level the market crashed in 2008.  As public policy and US Federal government found the right mixture of appropriate policy actions, including ‘Quantitative Easing’, the equity markets have returned to a ‘normal’ valuation level, in my opinion, that is commensurate with the economic activity of the US economy.

How can you call this a ‘normal’ valuation level for the S&P 500?

Listen carefully to these ‘Bubble’ talking heads in the financial press and they start talking price earnings ratios.  Here we are in the 21^st century where every industry has been touched by scientific innovation and technological advancements and finance professionals are still using a simple ratio of equity price versus earnings as a guideline to evaluate equity market valuation.

Laughable!

Want a more sophisticated filter to view equity market valuation?  Try Model Price Theory (MPT).

Let’s first look at our super long-term model price chart of the S&P 500.

S&P 500 Index with monthly price bars and EBV Lines (colored lines)

Before I detail what our model price chart is communicating let me tell you how it’s constructed.  First, every company in the S&P 500 has a calculated model price chart (data).  We then aggregate all companies by market capitalization, like the S&P 500 Index, on a daily basis. We then construct a time series by amalgamating the daily data over a selected period of time.  We use our calculated constant EBV lines to ensure users can track visually EBV (valuation) levels over time.  The number of calculations to do this is in the hundreds of millions.

A little more robust than the simplistic Price/Earnings ratio, don’t you think?

Observables from our chart

1.  This model price chart goes back to 1995.  Hopefully you can observe the S&P 500 Index is at the same valuation today as we were, some 19 years ago.

2.  From the valuation level of the S&P 500 in 1995, the Index almost reached EBV+6 in the early months of 2000.  (Our calculated EBV+6 for the S&P 500 Index today would be 4448 or 147% higher)

3.  After the tech ‘bubble’ crash of 2000, you can observe where the equity market bottomed in terms of the S&P 500.  Just over EBV+3.  Yes, the market bottomed – approximately – where the S&P 500 is today. (If intellectually honest the market mavens screaming ‘Bubble’ today would have been doing the same during the market lows of 2002, yes?  Probably not.)

4.  From 2002 to July 2007 the S&P 500 Index crawled along EBV+4.

5.  You can observe the waterfall decline in the S&P from July 2007 to March 9, 2009.  The S&P bottomed at EBV+1.

6.  From the market bottom of EBV+1 or March of 2009 the S&P 500 has been working its way upward with a positive transit of both EBV+2 and EBV+3.

A Closer look at our model price chart of the S&P 500

Let’s have a look at our short-term model price chart of the S&P 500

S&P 500 Index with weekly price bars and EBV Lines (colored lines).

Observations

1.  Back on the last week of June the S&P touched support or EBV+3 (red line).

2.  From the end of June, the S&P 500 has been working upward through 2^nd and 3^rd quarter earnings.  Also don’t forget the US Federal government was shut down from October 1st through to the 16^th of 2013.

3.  The potential upside for the S&P 500 is EBV+4 or 2029.  This represents a 13% upside from the December 2^nd close or 1800.90.

4.  The potential downside, or EBV+3 (red line) is 1622.  Representing a 10% downside, again, from the December 2^nd close.

Conclusion

Do you see a ‘Bubble’ in US equities?  I know it’s hard to fathom what the ‘Bubble Heads’ see but I certainly don’t see froth in this US equity market – at least not yet.  Could the market, as defined as the S&P 500, correct to EBV+3 or our red line?  Absolutely.  Would a correction offer investors and traders a great opportunity to purchase US equities?  Again, absolutely!  Will a correction occur?  I don’t know.  Savvy investors are always looking to buy cheaper assets or for model price users equity prices closer to support or their respective EBV lines.  But my gut tells me this US equity market as measured by the S&P 500 is on a roll and momentum can carry this market at least to EBV+4 at which time we can collect our breath and see what this market and individual stocks look like at this EBV level.

See what happens.

Let’s Talk About Market Bottoms

Now that the panic and fear is over about the Greek elections and its’ emanate break out of the Euro maybe we can have a logical, rational discussion about the potential bottom for the S&P 500.

I’m NOT saying the equity markets will go to these given levels. However, I think it helpful that these levels are considered for individuals who have money in equities and/or thinking of adding more capital to their positions. I just think it is a matter of interest where previous bottoms have occurred and where are we in relation to said previous bottoms. If fact, we are closer then you think.

S&P 500

Here is the Model Price chart for the S&P 500. Remember, we amalgamate all the model price company graphs in the S&P 500 into one chart, see below, to help us see what is going on in the market as a whole. With today’s positive market action you can see we are potentially on our way back to EBV+3 as I predicted here and here.

S&P 500 Model Price Chart. The S&P 500 closed 1344.78 on June 18, 2012. Economic Book Values (EBV) are the coloured lines.

The S&P 500 closed at 1344.78 on June 18, 2012. As you can observe from the chart, EBV+2 is a significant level for the S&P 500. Looking back at our past data, EBV +2 was the level the market bottomed during the crash of 1987 and the recession bottom and S&L financial crises of 1990. During the 2008 crises the market pierced EBV+2, spiking down almost to EBV+1, before recovering to EBV+2.

More recently, this past correction was the third since the market bottom of March 9, 2009. Each correction may have seemed terrifying but didn’t come close to EBV+2 as in past major market bottoms.

What am I saying?

1. As of June 18, 2012 we are 21% from EBV+2 or a major market bottom going back some 34 years. Yes, I agree going down 21% would not be fun, (and I’m not predicting this) but you would have to agree this would be an important market bottom that could put an end to the 2008 financial crises and mark an important point for recovery.

2. As the market corrects and comes closer to EBV+2, an investor will be taking less risk in the US market than EBV+3. This is hard I realize, but this is where hopefully our model price charts can help average investors. As markets move lower, equity shares have more value for you to benefit in the long run. Hopefully, by pointing out market lows going back decades this will help investors reach for buy tickets instead of sell tickets. See my previous blog on the Rational Investor here.

Apple as an Example of What is wrong with our Global Economy

In Saturday’s Wall Street Journal we couldn’t help but notice Holman Jenkins column where he wrote this about Apple.

“Apple …. [and] its abnormal profits are not likely to last, which brings us to this week’s decision to pay a dividend and buy back its stock.  The efficient markets hypothesis may be a poor old thing, but it’s all we’ve got.  In buying its own shares at the market price, Apple is merely exchanging one asset for another of equal value.  In paying a dividend it is merely shifting cash from one shareholder pocket to another.

 There’s only one good reason, then, for the stock to have lurched upward on the announcement, as it did:  Shareholders will be getting their hands on some of the company’s cash before management can squander it.  This week’s announcement, moreover, was but a teensy down payment on the discipline that will be needed.  Even after allocating $45 billion to dividends and buybacks over the next three years, Apple’s cash hoard is likely to grow – to as much $200 billion from today’s $100 billion according to Sanford C. Bernstein analyst Toni Sacconaghi.”

The Lex Column, in the Financial Times, Monday, March 26, 2012.

“… the news that Apple would begin paying a $2.65 per share quarterly dividend and authorise [sic] a $10 billion share buyback programme [sic].  To be sure, payouts give signals and little old ladies love receiving regular cheques [sic] in the mail.  But Apple’s worth does not change a single cent because Tim Cook chose to pay out Steve Job’s hard-earned cash.”

Reading such comments in arguably the best financial newspapers in the world make our blood pressure explode.  We are often asked, why we are doing this blog?  Simple. We can’t take it anymore!  So here are our financial concepts.  This is our voice.  Even Mr. Jenkins concedes the efficient markets hypothesis (EMH) is a load of crap, which we agree with, however he does say the EMH is all they got.  Hopefully 2008 was a teachable moment in financial history.  We need new financial theories, need a different approach.  Trillions of dollars are locked away in global corporations today.  According to our leading global newspapers, if these funds were returned to their shareholders nothing would happen.  Really?  Is this so?  Does it pass the common sense test?

“I’m getting that headache again!”

If corporations paid out this latent capital, this will lift the model price calculation in all companies taking such action.  Two things would happen, first an enormous amount of capital would be injected into the world, saving governments from stimulating excess demand by accumulating more deficits.  Second, the market would reward corporations in increased market value; assets would increase, recognizing more efficient use of capital on their balance sheets.    How do we know this?

We can pretend Apple is symptomatic of the world today.  Yes, we applaud Apple’s announcement of dividends and buybacks, however let’s look what they will be doing on our Solvency Curve.  Even with their meager give back to shareholders they will be even more solvent three years from now, if nothing is done between now and then.  See our blog “Apple Computer – A Special Dividend of $75 Billion would Reward Shareholders, Management and the Economy.”

See our formula for the calculation of the Solvency Ratio in the “Key Concepts” tab.

In much of the world today, global businesses are sliding down this same curve as Apple.  Yes, their cash piles are building however their market prices are sliding (relative to their potential), with the lack of optimal values for solvency.

We are optimists, and we can say “we will all get there eventually” in terms of a growing, functioning global economy but we have to admit it’s painful to watch the process unfold.  Also, reading comments in the newspapers, like the above, make us crazy because high placed opinions such as these will further encourage managements to hoard cash yielding more sub par growth and further government spending.