Are you ready to be a contrarian cigar butt investor?

How would you feel about a star value manager with the track record shown in the chart below. While he beat the market in the wake of the dot-com bubble, he has only matched the performance of the S&P 500 since 2011. To be sure, he did beat his style benchmark (second panel).

 

The star manager is none other than the legendary Warren Buffett and the chart shows the relative performance of Berkshire Hathaway’s stock price relative to the S&P 500 and the Russell 1000 Value Index. Buffett’s best known recent win was his purchase of Apple in 2016 which became his largest holding, and whose relative returns are shown in the bottom panel.

 

I examine how he achieved his results, and offer studies of sources of alpha as examples of different investing styles.

The full post can be found here.

Commodity supercycle: Bull and bear debate

Is it too late to buy into the commodity supercycle thesis? The latest BoA Global Fund Manager survey shows that respondents have moved to a crowded long position in commodities. Many analysts have also hopped on the commodity supercycle train, myself included (see How value investors can play the commodity supercycle).

As a cautionary note, one reader alerted me to a well-reasoned objection on the commodity supercycle thesis.

The full post can be found here.

Debunking the Buffett Indicator

There has been some recent hand wringing over Warren Buffett's so-called favorite indicator, the market cap to GDP ratio. This ratio has rocketed to new all-time highs, indicating nosebleed valuation conditions for the stock market.

Worries about this ratio are overblown. Here's why.

The full post can be found here.

How Buffett's business empire could unravel

Josh Brown had a terrific comment about the secret of Warren Buffett's success. Buffett is unabashedly "permabullish" on America:

One of the hallmarks of Berkshire’s success has been its willingness to raise or lower its formidable cash hoard in response to the presence (or lack thereof) of viable investing opportunities. One of the other hallmarks of Buffett’s approach has been to tune out forecasts and de-emphasize the importance of them in general.

The one thing Buffett has never given up on is the idea that American productivity, innovation and economic dynamism will always lead to substantially greater prosperity in the future. And he’s been right for decades, through all sorts of setbacks, crises and challenges for the nation.

So if the choice is to be in the Buffett camp vs the David Stockman camp or the Peter Schiff camp, well, I regard that as no real choice at all.

Lastly, permabulls need not be blind to the possibility of market declines, economic catastrophes (real or imagined) and other momentary trials and tribulations. Buffett’s got these possibilities built right into his manifesto:

Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

That formula has worked out well. Stay bullish on the belief of the dynamism of America, and buy good businesses when they become cheap. In a post-election interview with CNN, Buffett expressed confidence in the supremacy of the American businesses (click on this link if the video is unavailable).

There is much to be said about the Buffett formula. According to Credit Suisse, US real equity returns has been the highest in the world. Though the stock market has experienced serious losses, prices have always come back.

A value orientation, as proxied by a high price to book, outperforms the market. Buffett then couples the value discipline by buying companies with a moat, or a sustainable competitive advantage. The combination of buying value companies with a moat has been the secret of success.

However, we may be reaching an inflection point for Buffett`s brand of investing. In the Age of Trump, the tailwinds on Buffett`s value approach may be coming to an end.

The full post can be found at our new site here.

Is Warren Buffett losing his touch?

How would you evaluate a manager with this kind of 10-year investment performance? Terrific? Or Meh!

It depends on when you got in. Sure, the 10 year numbers look terrific, but he is roughly flat with the benchmark over five years and he had a difficult 2015.

What if I told you this track record was none other than the legendary Warren Buffett? The chart represents the relative performance of Berkshire Hathaway B (BRKb) against the market.

The full post is at our new website here.



Site Notice
If you signed up for the notification of our Early Bird Special Offer but did not receive it, I have had some reports that they got classified as spam so please check your spam folder. Otherwise you can email me at cam at humblestudentofthemarkets dot com and I will send you the link.

The right way to ride Buffett's coattails

It isn't often that we get to participate in buying stocks at the levels that Warren Buffett's Berkshire Hathaway bought them at. Most of the time, the public finds out in regulatory filings after the fact and the stocks have already moved up. Here is one exception that I discovered.

In August 2013, Berkshire disclosed that it had invested about $500 million in Suncor Energy (SU) (CNN). The Street got excited because it had also made an investment in ExxonMobil (XOM). Fast forward to February 2015. Berkshire sold its XOM stake but added to its SU position (via CBC).

In the chart below, I have marked the zones when Berkshire bought its SU stake below. Last night`s closing price of USD 27.66 is right about where Buffett had bought his positions. In other words, you and I can buy SU now at roughly the same price as Buffet bought his stake.

Last week, Suncor Energy report its financial results and earnings were above Street expectations. Not only that, it raised its dividend and reinstated its share buyback program. The company has a healthy balance sheet and it is one of the more conservatively capitalized companies in the Canadian oil patch. The dividend yield is just slightly north of 3%.

While I recognize that oil and oil stocks are nosediving, this is the chance to pick up a stock at a level that Buffett bought in at. Opportunities like that don't come around too often.

Is this investment idea contrarian enough for you?


Disclosure: I have no positions in Suncor, but I may initiate a position depending on how negative the feedback is. So please, either comment at the end of this post, email me at cam at hbhinvestments dot com or tweet me at @humblestudent. Tell me what a stupid idea this is, how SU is a value trap and what an idiot Warren Buffett is to be holding energy stocks when it was obvious that oil prices would be tanking.

Calling all contrarians: What would Warren do?

About three weeks ago, I wrote about possible contrarian plays in the oil patch (see Do you have what it takes to be a contrarian investor?). I had pointed out that Warren Buffett had taken large stakes in Suncor (SU) and ExxonMobil (XOM) in Q2 2013 and the closing price of those stocks are approaching the top of the zone where Buffett made his purchases. For contrarian value investors, this could be a rare opportunity to step up and buy at depressed prices. Here is the chart of SU

Here is XOM:

$80 oil?
On the bottom panel of each chart, I have shown the ratio of each stock to the WTI oil price. Given how oil prices have cratered in the last couple of days, the SU/oil and XOM/oil are at considerably higher valuations than the Buffett buy zone, which indicates that the price of these two stocks are nowhere near valuation levels where Buffett would buy again.

As the oil market is in turmoil, the price of crude is likely to be volatile and current prices is unlikely to be the long-term equilibrium price. One sensible comment that I saw today came from Neil Irwin, who tweeted that the futures curve was discounting a 5-year price of roughly $80:

$80 is certainly a better level than the closing price Friday and about $10 below where Buffett made his SU and XOM purchases.


A near-term bottom for oil?
Indeed, the market psychology may be getting close to a temporary bottom, when I saw Ian Bremmer, who is a political analyst, tweet the following comment on a topic outside his area of specialization:

These kinds of sarcastic comments are closely related to the magazine covers effect, where the general public seizes on a market condition when it`s very late in the game - and they mark a market turning point. Most recently, well-known investment professional and blogger Josh Brown tweeted this irreverent comment

...right before the market open on October 15, the day of the most recent market bottom.

It is said that value-oriented contrarians buy when blood is running in the streets. Is there enough blood in the streets yet?

What would Warren Buffett do?

Rethinking Buffett's "favorite" valuation metric

I have written about this topic before (see He who solves this puzzle shall be King), but in his weekly commentary, John Mauldin wrote about developing bubbles. Mauldin referenced the following chart (from Doug Short) of market cap to GDP as Warren Buffett's favorite valuation metric to show that stock market valuations are stretched.

I have called this same indicator as Buffett's favorite valuation metric before. However, I have not seen him publicly reference this ratio in interviews in the last 10 years. I am therefore re-considering the validity of this valuation measure.

The market cap to GDP ratio is really shorthand for an aggregate price to sales ratio. Recall that the price to earnings ratio is price to sales divided by net margin - and corporate net margins have risen considerably over the past few years and created distortions in both the P/E and P/S ratios. This chart from Goldman Sachs (via Business Insider) shows how corporate net margins have reached new highs.

The rapid expansion in net margins suggests that they are at risk of mean reverting and falling at some point in the future. However, analysts like Dan Suzuki of BoAML have shown before that net margins have mainly been rising for financial reasons, namely lower interest expense and lower tax rates, rather than an increase in operating margins (via Business Insider).

So, if P/E = P/S/(Net margins), then how valid is the price to sales metric if net margins are distorted by these factors?

This analysis doesn't mean that equity valuations aren't stretched. I wrote before that stock prices appear to be elevated based on a combination of PE, PB and dividend yield (see More evidence of a low-return equity outlook). However, price to sales may have outlived its usefulness as a valuation metric given the current net margin environment and, by extension, to call market cap to GDP Warren Buffett`s favorite valuation indicator may be a label that`s well past its "best use" date.

My plan for 2014

Blogging will be light until the New Year, but I wanted to share my investment plan for 2014. Here is how I see US equity market conditions right now.


A sweet spot for equities?
Current macro conditions indicate that we are in a sweet spot for equity returns. The US economy continues to revive and it is starting to show signs of growth acceleration.

As New Deal Democrat puts it, short-term and coincidental indicators are all pointing up but he is concerned about the rise in mortgage rates, a key element of his longer dated indicators that raise concerns about late 2014 and early 2015:

Coincident indicators were generally positive, but less strongly so. Steel production is positive albeit more muted. Bank lending rates remain at or near record lows. House prices remain strongly positive. Tax withholding retreated after an excellent November. Gallup consumer spending remained quite positive, despite challenging YoY comparisons, Johnson Redbook was moderately positive, but the ICSC index less so.

My mantra remains the same. The economy has bounced back in the second half of this year, and all looks well for the next 3 to 6 months. Housing and especially interest rates must be watched carefully, however, as to the end of 2014 and 2015.

In particular, the bond market's reaction to the inevitable Fed tapering, whenever that occurs, has to be watched very carefully. Will long rates start to back up and push up mortgage rates and dampen growth in the cyclically sensitive housing sector?

Meanwhile, European leading indicators are still pointing up, though coincidental indicators still look punk. The ECB has made it clear that it is prepared to give the market a Draghi Put, which is supportive of growth. China is growing, albeit in an unbalanced fashion.

Simply put, global growth is continuing and there is little or no tail risk in the immediate future. It's time to get long equities. What could possibly go wrong?


Too good to be true?
Maybe it's because I apprenticed under people who lived through the terrible bear market of 1974-75 that I worry so much, but I have this nagging feeling that these market conditions are too good to be true.

If you look, there are a number of technical and fundamental clouds on the horizon. John Murphy (subscription required) pointed out that 2014 is the second year of the Presidential Cycle, which is usually not equity friendly [emphasis added]:

According to the Stock Traders Almanac, the two first years of the four-year cycle are usually the worst with the last two usually the best. Bear markets usually occur during the first two years. Since 2013 (the first year of this term) was so strong, historical odds for 2014 (the second year) to suffer a downside correction are pretty high.

Chart 1 overlays four-year cycle lows on the SP 500 going back to 1990. The vertical bars show the last six bottoms occurring in 1990, 1994, 1998, 2002, 2006, and 2010. Earlier four-year patterns (not shown here) occurred in 1970, 1974, 1982, and 1987 (the cycle skipped 1978 while 1987 was a year late). Most of those bottoms took place during the second half of those years (mainly around October), and have coincided with midterm congressional elections. Assuming the four-year pattern repeats, the next bottom is due in 2014 and most likely during the fourth quarter. That carries both good and bad news. While the second year of a presidential term (like 2014) is usually the weakest, the third year (2015) is usually the strongest. The bad news is that 2014 is likely to experience a major stock correction. The good news is that correction should lead to a major buying buying opportunity later in the year.

Growth and Value bears come out of the closet
Besides the technical headwinds posed by the Presidential Cycle, a couple of well-respect growth and value oriented investors are turning bearish. Mark Hulbert pointed out last week that the Value Line Median Appreciation Potential, which has a growth tilt, hasn't been this bearish since 1969:

To be sure, the market may resolve its current critical juncture by headed higher rather than turning down. Yet Aronson notes that other indicators are also flashing caution.

One to which he draws special attention is known as the Value Line Median Appreciation Potential, or VLMAP, for short. This represents the median of the projections made by Value Line’s analysts of where the 1,700 widely followed stocks they closely monitor will be trading in three to five years’ time. But for brief exceptions, the VLMAP currently is lower than it’s been in many decades.

For example, the VLMAP today stands at 30%, where it’s been for seven straight weeks. Prior to the October 2007 peak, it got this low for just one week. And it never got this low in the months leading up to the 2000 market top.( Read a column I devoted earlier this year to the VLMAP. )

In fact, you have to go all the way back to early 1969 to find another time in which the VLMAP spent as long a period at 30% or below. From then until the market’s December 1974 low, of course, the Dow fell more than 40%.

As well, legendary value investor Warren Buffett has stated while equities look fairly valued, he can't find anything to buy, though he did allow that

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

This is a case of watching what Buffett does, not just what he says. When he says that he can't find anything to buy, you have to start getting cautious. When both Growth (VLMAP) and Value (Buffett) are cautious, then investors have to get especially wary.


Positive momentum, long term caution
The combination of positive short-term indicators and analysis from Value Line, Buffett et al point to the same thing. Short term momentum remains positive and stocks remain in a multi-year uptrend...

...but longer term indicators, such as valuation (VLMAP and Buffett) and longer dated economic indicators (New Deal Democrat), are flashing caution signs. So markets rally for now, but watch out as we approach late 2014.

My base case scenario calls for stock prices to continue to grind upwards until mid-2014, at which point some unknown catalyst is likely send equities downwards. Some time during Q2 and Q3, I would have to re-evaluate the macro conditions and re-position portfolios accordingly.

Today, the VIX at levels that are low by historical standards, indicating that the price of downside put protection are relatively cheap. Investors should consider staying long equities today but starting to accumulate cheap put protection into mid-year.

2014 is sounding like a good year to be selling in May and go away.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is this end of the line for energy bulls?

Ah, those unfortunate energy bulls. Their returns over the last few years have been nothing to write home about.

As shown by the chart below, the relative performance of the energy sector against the market has been topping out for the last few years (blue line), though bulls can be console by the fact that the long-term relative uptrend that began in 1999 remains intact. From a technical perspective, there is a decent chance that the relative decline could be halted at the 50% Fibonacci retracement level, which roughly coincides with the long relative uptrend that began in 1999.

What's more depressing for energy bulls, the press and blogosphere has been full of bearish stories about oil prices, largely because of the shale boom seen in the US:

• Recalling the false messiah of peak oil (FT Alphaville)
• For Oil, Conventional Wisdom No Longer Applies (WSJ)

Is this the end of the line for secular bulls on energy?


Watch the smart money
Before getting overly bearish on the long-term outlook for the energy sector, consider this. Warren Buffett was interviewed recently and said that he thought stock prices were fairly valued and he couldn't find much to buy (via Business Insider, emphasis added):

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

If Warren Buffett is having such a difficult time finding values in the market, then why did he put $3.5 billion into Exxon Mobil and $500 million into Suncor Energy?

Just asking...

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

How to forecast stock prices

Further to my recent post (see The ABCs of financial planning), I promised that I would write about how to forecast stock prices. First, let me outline my analytical framework. In awarding this year's Nobel Prize for economics, the Royal Swedish Academy of Sciences noted the following in its press release:

There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

In other words, trying to call the stock market in the short term is very hard work, but calling it long term is relatively easy. However, there is a right way and a wrong way to forecast long run equity market returns.


The wrong way
Robert Shiller is well-known for his analysis showing that long-term stock real returns, i.e. after inflation, to be 7%. With CPI at 1.5%, the long term stock returns should be 8.5%, right?

There are a number of problems with that approach. First of all, will you live long enough or be patient enough to see those kinds of returns? The long-term chart below shows periods when the stock market has been in multi-decade range-bound episodes. If you are in one of those periods, your returns may be subpar for a very long, long time. Can you be that patient?

Dow Jones Industrials Average (from 1900)

Lancer Roberts, writing at Pragmatic Capitalism, made the same point. Stock returns depend on when you start. As the chart below shows, there are wild variations in equity price returns, though an upward long term trend is discernible.

Here is Roberts' analysis of 40-year stock returns by starting decade. Do you want to roll the dice on what you get?

Most analysis of stock returns have focused on US equities - which suffers from a survivorship bias because the US market is not the only market in the world. Imagine that you wanted to invest in the capital markets in the year 1900. The stock market was nascent and undeveloped, the major markets where most of the the global capital was invested was the bond market. Consider what the developed and emerging markets were in 1900.

The bluest of the blue chips was the British bond market. Other developed markets included France and Germany. Oh, yeah, don't forget the Austro-Hungarian Empire. If you wanted to take more risk, you could have looked at emerging markets such as Russia, the US, Canada, Argentina and Japan.

Fast forward 113 years, how did that portfolio work out? Now you understand what I mean by survivorship bias. Global Financial Data went all the way back to 1800 and reported the instances of government bond defaults:

1. Germany 1938,1948
2. Japan 1942, 1946-1952
3. France 8 times between 1558-1788. Last one in 1812
4. Italy 1940. Almost daily speculation of another default since 2008
5. Spain 1809, 1820, 1931, 1834, 1851, 1867, 1872, 1882 and 1936-1939. Since 2008, Spanish yields spiked considerably and have been volatile on the back of another default
6. Austria 1938, 1940, 1945
7. United Kingdom 1822, 1834, 1888, 1932

The point I am trying to make here is we have no idea who the winners and losers will be in the future, so if you step back in time and only considered the returns of the winner (US equities) in your study, you will have overstated returns by a huge margin.


How much would Dracula be worth?
Think about it this way, let's take Robert Shiller's assertion that equity real returns of 7% to be correct. Supposing that a hypothetical immortal like Count Dracula (hey, vampires are rich - they have castles and other stuff, right?) invested $10,000 into the stock market 500 years ago. Assuming 3% inflation over the 500 years, Dracula's wealth he would have today would have 24 zeros after it. Is that plausible?

To put the problem of estimating long term equity returns into perspective, Morningstar broke down risk into three categories:

1. Destruction: The reason why Dracula might not be a super-tycoon is that in the last 500 years, a lot of empires went down and a lot of people got killed in some very nasty ways. Wealth was destroyed during those episodes.
2. Volatility: This is the "conventional" risk that most academics focus on, but it's not the only source of risk.
3. Uncertainty:: Uncertainty can be best described as the risk of fraud or poor governance. Morningstar described it as: "The simplest species of uncertainty is not knowing when writing a check whether the other party is a crook."

In summary, using these very long term estimates of equity returns are problematical at many levels. Even if we were to assume away the risks of destruction and uncertainty, there are huge variations in stock returns and you may not live long enough to see the 7% real return postulated by Shiller.


A more realistic approach
I prefer a more realistic approach. Instead of using multi-decade long time horizons, a more realistic forecast horizon is 3-7 years. As the Royal Swedish Academy of Sciences noted, "It is quite possible to foresee the broad course of [stock] prices over longer periods, such as the next three to five years."

My principal approach to 3-7 year equity return forecast is based on two elements, valuation and demographics. In the short run, valuation doesn't matter much to the direction of stock prices. In the 3-7 year time frame, valuations matter a lot. The simplest way to forecast prices is to watch stock market.valuation.

The long-term chart of the Dow at the beginning of this post shows that the stock market has moved to new all-time highs, indicating that equities may have broken out of a range-bound period. I am skeptical of that view because of valuations. Consider this chart of market cap to GDP that goes back to 1927 as a proxy for price to sales for the US stock market. Does this look cheap to you? Past secular bulls have not begun with valuations at such elevated levels.

For another perspective, Ed Easterling analyzed historical P/E ratios and concluded that the current secular bear market, which has been associated with range-bound markets, has only just begun. He charted the normalized P/E ratio progression of secular bulls, where stocks have gone to multi-year and multi-decade new highs:

...and he did the same for the secular bears where the market stayed range-bound. The current bear, shown in dark blue, began at stratospheric normalized P/E levels and the normalized P/Es have only descended to readings that can be best described as elevated:

What are smart investors doing?
If you don't want to do the work to judge whether the stock market is over or undervalued based on P/E and other valuation measures, one simple way is to watch what smart investors are doing. Here, the signals for long term returns are ominous.

Consider the Bloomberg report that private equity funds are selling via the IPO process:

Private-equity managers from Fortress Investment Group LLC (FIG) to Blackstone Group LP (BX), which made billions by buying low and selling high, say now is the time to exit investments as stocks rally and interest rates start to rise...

“It’s almost biblical: there is a time to reap and there’s a time to sow,” Apollo’s Black said at a conference in April. “We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.” 

Black’s New York-based firm, which oversees assets worth $114 billion, generated $14 billion in proceeds from the sale of holdings between the first quarter of 2012 and the first quarter this year.

Simply put, they can't find anything to buy [emphasis added]:

The industry’s focus on exits has reduced volumes of leveraged buyouts this year, with the number of private-equity deals announced declining 20 percent to 3,047 worldwide from the same period last year, according to data compiled by Bloomberg.

“It’s a difficult environment to find really attractive things when the markets are robust as they are,” Fortress’s Edens said yesterday.

As well, legendary investors like Warren Buffett, Stan Druckenmiller and Carl Icahn have recently come out with cautious statements on the stock market (via Business Insider). Buffett echoed the views of private equity investors that he can't find much value in the market. However, he did allow that the underlying businesses of Berkshire Hathaway was doing well:

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

Stan Druckenmiller believes that stock prices are artificially buoyed by Fed policy. He has no idea of when this stops, but such a few does not bode well for long-term stock returns:

Druckemiller elaborated “My first mentor and boss, Dr. Ellis in Pittsburgh, used to tell me it takes hundreds of millions of dollars to manipulate a stock up, but the minute you have this phony buying stop, it can go down on no volume and it can just reprice immediately. I personally think as long as this game goes on, assets will stay elevated. But when you remove that prop - and let's face it, the Fed has said they're targeting those asset prices - those prices can adjust immediately.”

One common thread of these smart investors is that their belief that stock prices are fairly or over-valued, but there is no imminent risk that the market goes over a cliff.


Demographics is destiny
Another way of forecasting stock prices is to study the demographics of equity supply and demand. I have written about the demographics issue before (see Demographics and stock returns and A stock market bottom at the end of this decade). For stocks to go up, there has to be more buyers than sellers at a given price. The propensity of Baby Boomers, as they move into retirement, is to take money out of stocks. In order for equities to rise, those negative fund flows have to be met by the retirement savings of their children, the Echo Boomers. Two research groups looked into this topic (see papers here and here). Their conclusion - the inflection point at which the fund flows of Echo Boomers moving into stocks start to overwhelm the Baby Boomers taking money out is somewhere between 2017 and 2021.

Niels Jensen at Pragmatic Capitalism summarized the issues much better than I ever could:

Given the large number of boomers knocking on the 70+ door, these findings should not be ignored. In another study from 2012, McKinsey Global Institute found that U.S. households reduce their exposure to equities in a meaningful way as they grow older, supporting Arnott’s and Chaves’ conclusion that large cohorts of 70+ year olds is bad news for equity returns (chart 3). We know that U.S. baby boomers own 60% of the nation’s wealth and account for 40% of its consumer spending, so their effect on the economy and financial markets shouldn’t come as a surprise.

US household asset allocation by cohort 

Jensen pointed to the San Francisco Fed paper that suggested a stock market bottom in 2021:

The most likely stock market trajectory
Putting the valuation and demographics forecasts together, the 3-7 year equity market forecast is for further subdued returns. Under these circumstances, the GMO forecast -2% real return for large cap US equities appears to be in the right ballpark:

I am also in the same camp as John Hussman in his long-term return forecast:

However, the comments from Buffett et al are also revealing. While equity valuations appear to be elevated, there is underlying momentum in Berkshire's businesses so there doesn't seem to be any imminent risk of a bear market.

So should you be bullish or bearish? That depends on your time horizon. The best perspective is one chart produced by Steve Suttmeier of BoAML. The firm's official view is that the major stock averages have convincingly broken out to new highs and we are seeing the start of a new secular bull. However, Suttmeier found parallels between the current range-bound market with the 1966-1982 period and did allow for a final bearish relapse before the market blasts off to new highs as they did in the mid-1980's.

In summary, I remain long term cautious on equity returns. It seems that with the market trading at such lofty multiples, we only need to see a negative catalyst to send stock prices tumbling. By their very nature, negative catalysts are unpredictable and can come out of left field. As I have pointed out before (see The sun will come out tomorrow), I am therefore watching the following three tripwires on a tactical basis for a bearish signal:

• Earnings
• Signs of economic slowdown
• Monetary policy

In the meantime, my inner trader is staying long this market and enjoying the ride.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

How cheap are stocks? (Two views)

In the current low-yield environment, money has been piling into the income investment theme by driving down the yields on anything that has a yield. In particular, dividend paying stocks have been a major beneficiary of this trend. Recently, Morgan Stanley highlighted how far this investment mania has run in their 2013 investment outlook document by pointing out the earnings yield on stocks is now higher than high-yield bonds (via Business Insider).

Stocks are cheap and junk bonds are expensive. Right?

My view is that. on a relative valuation basis, that view is correct. Stocks are cheap compared to high-yield bonds, but they aren't screamingly cheap on an absolute basis. Consider this chart of the market cap to GDP ratio (via VectorGrader), which is a proxy for the Price to Sales ratio. (A related ratio, namely the market cap to GNP, is one of Warren Buffett's favorite valuation metrics.) Note how the ratio, shown on the top panel, is falling and still hasn't gotten back to its long term average and it is nowhere near levels where secular bull markets tend to begin. As well, falling market cap to GDP eras tend to be associated with secular bear markets, where stock prices (bottom panel) tend to be range-bound.

These conditions suggest that the income theme is overdone, but stocks aren't terribly cheap. Investors should adjust their return expectations accordingly.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.


None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

What next for US homebuilders?

Several weeks ago, I identified the homebuilding stocks as a possible leadership candidate out of several (see Suggestions for bulls and bears). For once, it seems that I was ahead of the curve instead of behind the curve in my market calls as Warren Buffett announced last week that Berkshire Hathaway was getting into the business of being realtors. This represents an enormous vote of confidence for the housing sector in America, as per this story from Bloomberg:

Warren Buffett’s Berkshire Hathaway Inc. (BRK/A) is extending its bet on the U.S. housing market by forming a venture with Brookfield Asset Management Inc. (BAM/A) as low interest rates, inventory and prices spur a real-estate rebound.

Berkshire’s HomeServices of America Inc. unit will be the majority owner of the venture to manage a U.S. residential real- estate affiliate network, according to a statement on the new company’s website. The firms plan to offer a new franchise brand, Berkshire Hathaway Home Services, starting next year. Brookfield’s network has operated under the Prudential Real Estate and Real Living Real Estate brands.

Positive demographics = More demand
The demographic tea leaves are also lining up bullishly for housing. Walter Kurtz highlighted a report from Moody's indicating that housing demand is about to turn up as the Echo Boomers reach the age where they want more housing as they begin families:

It is a well known fact that homeownership in the US has been on a decline, a trend that started even before the financial crisis. Now Moody’s predicts this trend will begin reversing next year.

Their explanation has to do with demographics. Baby boomers are moving into the highest homeownership group by age, while “echo boomers” (children of baby boomers) are getting to the age at which they are significantly more likely to own a home than the younger age group.

Rising construction employment
What's more, last Friday's NFP report showed that the construction sector showed healthy employment gains. Despite being only 4.1% of the workforce, the sector showed 9.1% of the gains of 171K jobs.

On a longer term perspective, however, construction employment is still relatively flat and has potential to go quite a bit higher especially when I looked at this graph from Ed Yardeni:

Should construction continue to recover, then it would indeed be good news for the US economy and has the potential to feed through into a virtuous cycle of better employment and higher consumer spending.


What's next?
So what's next for the investors in homebuilding stocks?

In the short term, there could be some turbulence. Despite what some of the polls say, the latest figures from intrade.com shows Obama solidly in the lead for the big showdown on Tuesday. If Obama were to win re-election, which is my base case scenario, then you can expect that capital gains tax rates will rise. In response, expect investors to harvest their capital gains this year instead of waiting to take them next year and get hit with a higher tax bill.

What stocks have had the most gains this year? You guessed it, it's the homebuilders. Therefore, in the near term, don't be surprised to see some softness in these stocks as investors take their capital gains in 2012.
Longer term, the technical picture looks promising. The relative performance chart below of XHB against SPY shows that the homebuilding ETF to be in a well-defined relative uptrend (red channel) but testing a relative resistance level that dates back to 2007. A breakout out of such a long base suggest a technical target that is well above the relative highs set before the Lehman Crisis of 2007. Should tax-related profit taking occur, don't be surprised if these stocks pull back and test the bottom of the relative uptrend.

Bottom line: Short-term cautious, but long-term bullish on the sector. Expect some weakness until year-end, but any weakness could be a great opportunity to buy.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.   None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Apple after Jobs

I don't often write about individual stocks, largely because I haven't done much fundamental analysis in years, but that doesn't mean that I don't have any skills in that area. In the aftermath of the news about Steve Jobs' unfortunate demise, there has been a lot of chatter about the fate of Apple in the post-Jobs era.


What's Apple's economic moat?
I would analyze the issue by asking, "What's Apple's economic moat?" Warren Buffett has effectively used the concept of "economic moat" as a way of analyzing companies. Here is one good explanation of a moat [emphasis added]:

What does the term economic moat mean? An economic moat is a competitive advantage that is difficult to copy or emulate, which provides a significant barrier to competition from other firms. Buffett has often referred to an economic moat as being similar to a fortress or a medieval castle that one can not penetrate.

There is no question that Steve Jobs contributed a great deal to Apple's success. Apple holds over 300 patents by Steve Jobs, which is an astounding number for a founder and chief executive. If that is Apple's economic moat, then the company is indeed in trouble.

Jobs was known to be an intensely detailed focused micro-manager. If Jobs was the main reason why Apple was propelled to success, then the company is indeed in trouble.


iTunes Store is the key to Apple's current success
My personal belief is that Apple is more than Steve Jobs. The company has many other talented people working for it. I believe that Apple's economic moat was not just the coolness of its products (which Jobs contributed to), but the iTunes platform.

Apple has always embraced a closed architecture for its product lines. The way it made money, and lots of it, was to get people to come inside its walled garden and play. That walled garden is called iTunes. It is Apple's platform to sell its customers music and software content. Wall Street may be focused on how much of a hit the latest iPhone is, but all these gadgets are designed to drive the user to iTunes - which is the key to Apple's long-term cashflow.

Speaking as an iPhone user, I opted for the iPhone over the Blackberry or Android platform was because of the combination of the utility of the device over the Blackberry and the advantages of Apple's closed architecture compared to the Android open architecture. (I am by no means an early adopter of technology - I tend to go with the crowd. As an example, my computers run Windows because of legacy software issues.)

Take the issue of device security as an example. There will be no doubt a lot of malware written for mobile devices. If an Android device got infected, it is unclear who will be responsible for fixing it because responsibility is diffuse. By contrast, if software from an authorized iTunes dealer infected millions of iPhones and iPads, then I think that you can expect that Apple will move heaven and earth to remedy the problem - because that's their economic moat.

In short, I would be less concerned about the apparent tepid reception for the iPhone 4S. Don't forget that the reception for the iPhone 3GS was less than enthusiastic but they still sold a lot of those devices.

As long as the iTunes franchise is intact, Apple should continue to be successful, even without Steve Jobs.

Disclaimer: I don't have any position in AAPL and this is not a recommendation to buy or sell the stock.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Too many bullets for stocks to dodge

Admit it. We are in a cyclical bear market. The stock market has too many bullets to dodge. Despite the ugly returns seen the 3Q, there is more downside potential from current levels. Here are the big macro risks that I remain concerned about:

• Europe:  The market is still expecting either that Greek default will somehow be avoided or a TARP-like rescue of the banking system. Neither is going to happen. Add to the mix of a looming recession and you have the precursors of a market meltdown.
• US: ECRI was out publicly with their recession call last week. As we approach 3Q Earnings Season, what happens when the equity markets start to price in a recession?
• China: The fears of a hard landing are rising. As the markets move the consensus view of a soft landing to the possibility of a hard landing, it will put downward pressure on the price of risky assets.

A soft landing in Europe? Not!
I wrote last week to remember that the endgame is a Greek default. That is the bond market's consensus, but the stock market seems to hope against hope that there will be an orderly resolution of the crisis. I don't mean to pick on STRATFOR, but their analysis is one example of conventional thinking. STRATFOR believes that Greece needs to leave the eurozone, though that's not necessarily the consensus. What is consensus is what needs to happen afterwards:

And so to prepare for a Greek ejection, you have to prepare a fund that can handle three things more or less simultaneously. First, you need about 400 billion euro to firebreak Greece off from the rest of eurozone. Second, you need about 800 billion euro in order to prevent a wide-scale banking meltdown, because the day that Greece defaults on that debt, the day that it’s ejected from eurozone, there will be catastrophic banking collapses in Portugal, Italy, Spain and France, probably in that order.

In other words, the European authorities need to come up with funds (and a lot of it) to make bond holders whole. Otherwise we will be risking a banking catastrophe.

When analyzing Europe, it's important to remember these principles:

1. Greece is going to default. It's just a question of when and how.
2. The EU can't afford to bail out the peripheral countries. What makes you think that they can bail out their banking system?

In this week's commentary, John Hussman gave some perspective on the scale of the problem facing Europe if the authorities were to decide to make bondholders whole [emphasis added]:

As background, the EFSF represents a fiscal commitment of European countries to a fund intended to stabilize the European financial system. It is not, however, money that these governments have eagerly decided to simply flush down the toilet - the intent is to use it for stabilization, but also to get most of it back, as the overall commitment represents about 6% of the GDP of the European union. Notably, the total amount of Greek debt alone represents nearly 80% of the size of the EFSF, which would leave only 20% of the commitment available to other states if the EFSF was to buy it up, as some have suggested.

In other words, don't expect the EU or ECB to bail out the European banking system. They can't afford it.

Warren Buffett was interviewed on CNBC last Friday and he says that European banks shouldn't expect help from Berkshire. By contrast, he did buy into Bank of America. That's a signal of how deep in doo-doo the European banks are.

What's more, there is no one in charge in Europe. Leadership is sorely lacking. As the Economist points out, the European politicians' plan is to have a plan.  Attila Szalay-Berzeviczy, who is the current Head of Global Securities at Unicredit (speaking personally as the former head of the Hungarian Stock Exchange), wrote about the level of cognitive dissonance among Eurocrats (translated from Hungarian from Google Translate):

The American politicians, at least it has always been understood that the money and capital markets are efficient economic policy allies of the investor for the company are responsible for. In contrast, their counterparts in Europe, unfortunately, still do not understand the nature of markets, most of them think that the financial system, the ancient enemy, because it does not work the way it is dictated by their own political interests.

Even worse, there have been multiple forecasts of a European recession that begins in 4Q (see examples here and here). Such a slowdown is coming at an inopportune time when the financial system is especially fragile.
 
American investors start to price in a recession
Across the Atlantic in America, ECRI went public last week with their recession call which they provided clients with the previous week. They wrote:

ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down – before the Arab Spring and Japanese earthquake – to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”

ECRI has had no false positives in their recession calls, though, as their detractors point out, they have been late on occasion.

In an interview with Bloomberg Television, Lakshman Achuthan used the word "wildfire" in characterizing the downturn in all of their indicators, which was "pronounced, pervasive and persistent". These are all hallmarks of recession. Moreover, their recession call was not based on events in Europe. "If there's an 'event'", Achuthan said, "I don't know where this is going to go."



What's the downside risk in US equities?
I wrote here back in August that US equities were trading at 14x trailing earnings, which appear to be reasonable value given level of 10-year Treasury yields. However, recessions have a nasty habit of taking earnings down 20-30%, which would mean that the market may not be so cheap anymore. By contrast, James Bianco thinks that earnings may be 20-40% too high if we were to encounter a recession.

If you were to apply a 10x stock market panic P/E multiple observed in 2008-9 to depressed earnings levels, US equities could very well revisit the lows seen in the bottom set in 2009. In that case, investors could have a very nasty surprise. I plan to keep a close eye on company guidance during 3Q Earnings Season. Unexpected negative guidance may the catalyst for another downdraft in equity prices.


No help from Helicopter Ben
The bulls can't expect any help in the near term from the Fed. I was of the opinion that, when things got bad enough, that the Fed would come to the bulls' rescue with QE3. Ben Bernanke gave a speech entitled Lessons from emerging market economies on the sources of sustained growth last week and gave a press conference afterwards. If the Fed were to move forward with further stimulus, that press conference would have been the perfect venue to signal such a move. Instead, we got the Fed-has-done-all-it-can-and-it's-up-to-fiscal-policy lecture:

“Monetary policy can do a lot, but monetary policy is not a panacea,” Bernanke said.

 
A Chinese hard landing?
As the American and European economies slow and prices of cyclically sensitive commodities such as copper tank, investors will no doubt start to wonder about the fate of China. As the chart below shows, should a global recession grip the world, then the copper price decline has much further to go (and the panic will grow).

With copper prices crashing, what are the implications of the Chinese copper collateral trade on the informal banking system? Already, we are seeing signs of credit stress among Chinese property developers.

Ambrose Evans-Pritchard, writing in the Telegraph, observes that the financial contagion from the West is already showing up on Chinese shores:

Contagion has spread to Chinese "Dim Sum" bonds issued in yuan on the offshore market in Hong Kong, where companies linked to China's property market and building sectors have taken a beating. Yields on Dim Sum bonds jumped by 105 basis points to 5.85pc in August, the worst month since the instruments were created.

China and other emerging market could face a credit crunch because of Europe's unfolding financial crisis [emphasis added]:

Most developing countries lack a proper bond market so firms rely on global finance to raise capital. Almost 80pc of the money come from European banks, which have lent $3.4 trillion to emerging markets. Part of the funding comes from US money markets – which have effectively pulled the plug on Europe. This adds a nasty twist to what is already a very twisted nexus.

BCA Research echoes Evans-Pritchard's concerns about the vulnerabilities of the emerging market economies to the problems in Europe [emphasis added]:

[S]ome developing nations have received massive inflows from G7 banks in general and European banks in particular. These inflows are at risk as European banks freeze their lending activity and repatriate capital. Brazil is the most vulnerable on this front as it has received US$485 billion in inflows from G7 banks, of which US$350 billion is from European institutions. Central and eastern European economies are the most at risk from Europe’s credit crisis, given the heavy involvement of European banks in the region and their trade links with the euro area. Meanwhile, the biggest impact on Asian emerging economies will be via global growth. The share of Chinese exports going to the EU is almost 20%. In fact, the EU is just as important a trade partner for Asia as the U.S., and a renewed contraction in Europe would pose a material risk to Asian exports.

While I am not necessarily in the camp that China will experience a hard landing this cycle, I am of the belief that as the economies of the West slow, investors will begin to price in the possibility of a Chinese hard landing. Already, I am seeing more and more hand-wringing articles and blog posts such as "Whither China?" and "China: The risks of a hard landing are growing".  David Cui, the Bank of America/Merrill Lynch China strategist, has also joined the bandwagon by producing a highly bearish report on China.

Don't say that you weren't warned.


What to do?
Under these circumstances, my inner investor is staying with the long Treasury bond trade, largely because the Asset Inflation-Deflation Timer Model has been signaling deflation for several weeks. He is also depending the Timer Model to maintain a stop-loss risk control discipline for the trade and to sound the all-clear signal to return to risky assets.

My inner trader, for once, is positioned in a similar way by staying long the USD/long Treasury safe haven play and waiting for a rally to short equities.
October is likely to be a good month for the bears.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

What's Warren up to?

In commenting on the Berkshire Hathaway share buyback, David Merkel at Aleph Blog extrapolated the buyback to a more general assessment of the stock market [emphasis added]:

As far as buybacks go, this is a good one, but the question remains, how good is it? If Buffett had better uses for cash, he would not be buying back stock, and this is at a time when all equity valuations are depressed.

To me this indicates that Buffett does not have any large places to deploy cash superior to the cost of capital of Berkshire Hathaway, which is pretty low, aside from investments with an inadequate margin of safety.

That doesn’t mean the whole market is overvalued, but it does mean that a bright guy like Buffett anticipates no more large productive places in the near future to put large amounts money to work than by shrinking his own balance sheet. Not a good sign for the economy.

This makes sense to me. Until I remembered that Buffett was quoted in August as saying that the stock market is cheap compared to bonds and he is buying:

In the meantime, Buffett is looking to buy stocks -- oh, and apparently to sell Berkshire bonds too. Berkshire is reportedly taking advantage of record low rates and issuing bonds to raise dirt-cheap capital. For Buffett right now at least, this is not a time for fear. This is a time for action.

Warren Buffett will be the first one to tell you that he is good at spotting value but terrible at market timing. 

So has he changed his mind? What's going on at BRK?



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.