So there I was rereading my last blog and I could sorta kinda understand why some of my readers e-mailed me to sarcastically thank me for my gloomy outlook. To those readers and everyone else let me proclaim...
The world is NOT coming to an end! (and no that's not a change of mind on my part.) My intention in my last blog was to make sure everyone is aware that the economy is sick and likely to stay that way for a long time given the crushing debt load - both public and private. As well, I wanted to make sure you folks understood that the market risk level is extremely high. However...
You can invest prudently, even in today's overvalued stock market, and earn a positive return over the next 10-year period. But chasing momentum, volatility, or credit risk will likely lead to losses over the long-term unless you happen to be a very good speculator. Fair value for the S&P 500 is somewhere around 800-850 based on a number of very good long-term valuation metrics (which are not widely followed by Wall Street because they have limited use for speculators focusing on short term returns). For instance, investors using Tobin's Q, price to trailing 10-year average earnings, and the long-term dividend growth rate as guidelines would have anticipated the 10-year period of negative stock market returns that began in 2000. Currently those valuation metrics are forecasting a return of 3.5% to 4% during the next 10-year period - a big step up but still well below the long-term historical return of 10%.
The current rally is not based on attractive valuations but rather speculative forces chasing higher risk, lower quality assets, egged on by the Federal Reserve's blatant promises of more money printing. Examining return factors makes it painfully obvious that speculators are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk, and volatility while avoiding stocks with reasonable valuations, stability, high-quality earnings, and attractive dividend yields. In fact, looking at thirteen week factor returns tells a compelling story of speculation that, when coupled with an overpriced market, makes it almost inevitable that bad things will eventually happen to those investors choosing to play the risk game.
Return sources for the 13-weeks leading into year-end 2010 from high to low were: Market Beta (Risk) - 17.8%; Raw Materials Beta (Commodity sensitivity) - 17.5%; Credit Spread Beta (Macro Economic Sensitivity) - 14.7%; Small v Large Beta (Style sensitivity) - 12.5%; Silver Beta (Commodity Sensitivity) - 10.9%; Sigma Risk (Volatility) - 10.7%; Operating Cash Flow Yield (Valuation) - (- 4%); EPS Stability (Quality) - (-5.6%); Value v Growth Beta (Style Sensitivity) - (-5.9%); Return on Invested Capital (Profitability) - (-6.6%); Dividend Yield (Valuation) - (-9.3%); 10-Year T-Note Beta (Macro Economic Sensitivity) - (-9.6%); High v Low Quality Beta (Style Sensitivity) - (-15.7%)
Clearly the high risk, low-quality garbage stocks have dominated the rally into year end while lower risk, high-quality stocks have trailed sharply. Tellingly, Operating Cash Flow, Sales/Price, Market Cap, and EBIT/Enterprise value lead all other return factors over the last 10-years, meaning valuation does eventually win out! More specifically, those investors who focus their attention on the underlying value of the businesses in which they are investing will do just fine over the long run as price (eventually) always follows value. Buying good businesses at great prices only adds to both the margin of safety and the ultimate returns. Businesses that are steadily growing cash flows over time create a situation where it is nearly impossible for an investor to lose money - as long as the investor is willing to wait for market prices to reflect underlying values. Which brings us back to current valuation levels....
Given that fair-value for the S&P 500 stands around 800 to 850, it would seem prudent for investors to set aside at least some cash now in order to take advantage of better valuations sometime in the (near?) future. And for those of you reluctant to raise some cash because you're worried about missing the next great bull market? Relax! The gains we are currently experiencing in the market will almost certainly reverse sometime in the next few years and quite possibly in the next few quarters. The fact that net profit margins are currently 50% above their long-term mean (and it is a strongly mean reverting series) all but ensures that corporate profits will begin to disappoint sometime in the next few years (few quarters?) and cause a market sell off back toward fair value. Capital preservation is still the priority of the day and cash is not a dirty four letter word!
Biechele Royce Advisors is holding more cash than normal for its clients. We don't buy stocks unless we can invest in good companies at great prices. We are focused on high-quality, dividend paying stocks in our domestic portfolios and expect to have an opportunity sometime this year to add to our holdings at lower prices.
