Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

THE DAILY EDGE (12 September 2017)

SMALL BUSINESS OPTIMISM HOLDS ITS ALTITUDE IN AUGUST

The Index of Small Business Optimism rose 0.1 points to 105.3 in August, basically unchanged from July. Five of the 10 Index components posted a gain and five declined.

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Leading with large tax cuts is a dangerous policy

Good piece in Larry Summers’ blog who demonstrates that logic points to larger government in the future. Large tax cuts at this time would therefore aggravate the budget problem longer term.

  • First, the population is ageing and the federal government disproportionately takes responsibility for the aged.
  • Second, inequality has increased substantially. If one of the functions of the federal government is ameliorate inequality, it will experience pressure to expand to even partially offset rising inequality.
  • Third, the relative price of what the government buys has soared (…) with health and education costs rising faster than GDP.
  • Fourth, presumably our defence spending needs to be calibrated to some extent to the defence spending of our potential adversaries.
Citi warns on sharp fall in Q3 trading revenues US bank, the first to offer guidance, forecasts a 15 per cent year-on-year drop

(…) Chief financial officer John Gerspach said at a banking conference in New York that Citi was expecting overall trading revenues to be down 15 per cent year on year in the three months to September 30, following a 5 per cent decline in the previous quarter. (…)

Citi was one of the better performers in the second quarter, when Wall Street’s big five banks recorded an average fall of 17 per cent in trading revenues. (…)

Why the Market Keeps Going Up and What Would Bring It Down Big, fast-growing companies have led the recent rally, and that should continue—but when it ends, get out fast

(…) The big winners so far this year have been huge, fast-growing companies such as Amazon.com , Facebook , Apple and Google parent Alphabet . So while the S&P 500 has risen 11% so far this year, the S&P 500 Growth Index, which is concentrated in companies with strong earnings and revenue growth, has risen 17%. In contrast, the S&P 500 Value Index—which focuses on stocks with lower price-earnings, price-to-sales and price-to-book ratios—is up just 4%.

The 10 biggest stocks in the growth index have increased 26% this year, according to FactSet, adding about $900 billion to the S&P 500’s market capitalization, which stands at about $23 trillion.

The gains for these stocks make sense for two reasons. First, investors tend to favor fast-growing companies in the latter stages of an economic expansion, which is where the U.S. economy is right now after eight years of growth. That is because it is harder to generate growth late in the cycle after the easy gains have been made, putting a premium on companies that still exhibit strong profit gains.

Second, many of the big companies leading the rally do a large portion of their business abroad, where many countries are experiencing economic upswings. Microsoft and Facebook, for example, both draw roughly half their sales from outside of the U.S. An added boost is the weaker dollar, which boosts the value of profits earned overseas.

For now, nothing seems likely to disturb this rosy scenario, which makes the gains self-reinforcing. Investors who want to beat the market need to plow cash into the shares of large-cap growth stocks. Passive investors who simply track the index are seduced by the market’s healthy gains and low volatility, and they boost their investments, pulling the whole market higher. Those who chase performance will buy growth-oriented funds, which further drive these trends.

The love affair investors are having with big growth stocks could eventually set them up for big losses. Stocks of large, fast-growing companies have performed poorly when the economy starts to falter and the growth that investors were paying up for disappears. That was how the growth-stock driven rally of the late 1990s ended. In the six months that preceded the recession that began in March 2001, the S&P Growth Index fell by third—and then fell by another third before hitting bottom in mid-2002. It was a repeat of patterns seen in the 1960s.

What could cause the turn? A run of weak data or any event that makes investors question the U.S. economy’s staying power. And if signs build up that an actual recession looms? History says it pays to get out fast.

Growth is outperforming value in all benchmarks, large, mid and small as this NDR chart shows:

Generally, relative stock performance follows relative earnings performance. In Q2’17, earnings of globally oriented S&P 500 companies rose 11.1% vs +8.7% for domestically oriented companies. This outperformance has been present since Q3’16 but really accelerated in Q1’17.

Source: Natixis, @joshdigga (via The Daily Shot)

The Oil Market is Bigger Than All Metal Markets Combined

Chart: The True Size of the Oil Market

ABOUT INVESTING AND… EDGE AND ODDS

  • Investing is not black or white, in or out, risky or safe. The key word is calibrate. The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive.
  • It’s not what’s going on; it’s how it’s priced…When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.
  • If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not out, but less risk and more caution.
  • Observations regarding valuation and investor behavior can’t tell you what will happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.
  • Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling or lightening up closer to the top, and buying or,
    hopefully, loading up when we’re closer to the bottom.

The above is from the September 7, 2017 letter (Yet Again?) of Howard Marks, Oaktree Capital’s CEO. Marks expresses what Edge and Odds is all about.

Equity market cycles are made of 2 components: profit cycles and valuation cycles which may or may not overlap each other.

Profit cycles are essentially tied to the economic cycle as revenues and margins fluctuate with expansion/recession cycles. The science of economic forecasting remains very iffy and much less precise than the science of understanding the present economic situation.

Valuation cycles are even more complex as human psychology mixes with trends in inflation and interest rates to inflate or deflate profit multiples. Valuation cycles are even more significant for investors as their multiplier effect offers enormous money making opportunities… and money losing possibilities.

Relying on forecasts on these 2 different sets of crucial variables is thus highly dangerous to anyone’s financial health. It is best to concentrate on understanding

  • where we are today on the economy in order to evaluate the cyclical economic upside/downside probabilities;
  • and where we are today on valuation in order to calculate the cyclical upside/downside ratio on equities.

Knowing “where we stand today” on each of these two crucial variables (the Edge) enables us to know “the Odds that will govern the intermediate term” and thus helps us “calibrate” the risk profile of our investments.

Economic and profit cycles can only be evaluated and are thus subject to assessment risk.

Valuation cycles, using the reasonably stable Rule of 20 value band, provide a precise view of the risk/reward equation. History shows that the Rule of 20 P/E fluctuates between 15 and 23 (most of the time) and that it always goes from one extreme to the other, from undervaluation to overvaluation and vice-versa (see below). The calculation of risk vs reward is thus always clear, enabling investors to calibrate their risk exposure using objective data.

Steve Blumenthal (CMG Wealth Management) illustrates the need to cyclically adjust equity exposure

Here is how you read this next chart:

  • The top section looks at the S&P 500 from 1900 through August 31, 2017.
  • The shaded green areas are the BULL markets.  Also shown are the annualized returns over the period.
  • The shaded white areas are the BEAR markets with annualized return numbers.
  • The data box (red arrow) shows the GPA, or gain per annum, for secular bull and secular bear periods.  Also shown is the percentage of time in each secular period over the length of the study.
  • The middle section looks at yields of long-term U.S. government bonds, while the lower section looks at the commodities market as measured by the NDR Commodity Composite.

When one takes a step back and looks at full market cycles, the need for navigating secular trends becomes apparent.  This is true for all asset classes.

Chart 2: 54% of Time in Bull Markets vs. 46% in Bear Markets Since 1900

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Now, visualize the various cycles over time:

  • The profit cycles are generally synchronized with the economic cycles, but not always. Profit recessions occur from time to time. Hence the need to really focus on profits.

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  • Valuation cycles can be violent. Hence the need to focus on valuation.

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  • Absolute P/E analysis can be hazardous if inflation is not taken into account. The Rule of 20 is the best tool:

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Notice how the Rule of 20 P/E is much less volatile than the absolute P/E and fluctuates much more evenly around its central 20 value. This is much more useful when trying to assess “where we stand today”.

BTW, Byron Wien, the Blackstone strategist who hosts lunches every August to tap the collective wisdom of financial experts to see what’s next, recently wrote in Barron’s that

one investor recalled the “Rule of 20” from what now seems like ancient times: the combination of inflation and price earnings ratios should be no more than 20. On that basis, the market is a little more than fully priced but not egregiously overvalued.

Ancient times! Jim Moltz, strategist at C.J. Lawrence (now I am showing how ancient I am) developed the Rule of 20 in the mid-1980’s, really not that ancient. But simple, useful and reliable. The pretty ancient wheel remains simple, useful and reliable…