Getting Back to the Basics in 2006
(January 15, 2006)
Dear Subscribers and Readers,
Now that Guidant has accepted Johnson & Johnson's acquisition offer of $24.2 billion, is it time to take a hard look at Boston Scientific? One of my concerns about investing in Boston Scientific had been that it may be overpaying for Guidant – and while BSX can still come back with a higher bid next week, my guess is that this is not very likely to happen. While its trailing P/E of 36 would scare any value investor away, readers should keep in mind that the calculation of this P/E consists of many non-recurring charges. The forward P/E of slightly over 13 gives investors a better picture of BSX's true valuation. Given that Boston Scientific is one of the better companies in the healthcare/medical devices field (an industry which this author likes in both the short and the long-run) – it is definitely a company to keep track of in the weeks ahead.
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. As of Sunday, January 15th, this market is now becoming very overbought. Readers who have not gone long should refrain from entering the market at this point – especially in light of the fact that we are only two weeks away from the January 31st Fed meeting and in the beginning of earnings reporting season. Our position on the DJIA does not change from last week. Should the market continue to rally into the January 31st Fed meeting (our target is the 11,200 to 11,300 level), there is a good chance we will go 50% short in our DJIA Timing System (our maximum allowable short position) sometime in the next few weeks. Like we have mentioned before, history suggests that the stock market tends to underperform (on average) during the year after the peak in short-term interest rates compared to the year leading up to the peak in short-term interest rates. That is, if history holds true and if the Fed stops hiking right after the January 31st or the March 28th meeting, then the performance of the S&P 500 in 2006 should end up faring worse than 2005. This should not come as a surprise, as the Fed has historically tended to stop hiking only after the economy is showing signs of a slowdown. For now, we remain completely neutral in our DJIA Timing System.
One of our themes for 2006 is “getting back to the basics.” In other words, all our predictive models and sentiment indicators are fine – but ultimately, our mission is not only to help our readers make outsized returns in the stock market – but to do that in the least stressful way and in to help our readers in their financial educations and to keep tabs on upcoming economic and social trends. Over the long-run, having a basic idea of where the global and U.S. economy is heading and which individual industries and stocks to invest (or to avoid) is the key to long-term success.
So what are you saying, Henry? Are you saying that you won't give us a week-to-week run-down of sentiment indicators anymore?
No, that is not the case at all. Over the last two years, our most popular sentiment indicators (such as the AAII, Investors Intelligence, and the Market Vane's Bullish Consensus) have been immensely useful in helping us navigate this range-bound market. But while these indicators (just like other overbought/oversold indicators such as the NYSE ARMS Index, the equity put/call ratio, etc.) can be very useful in timing entry points for individual stock purchases – it is essential to keep in mind that the key to long-term success in the stock market is to selectively purchase undervalued equities (whatever your metrics may be) and to hold them for the long-run. Moreover, there have been many periods in the stock market when using overbought/oversold indicators to call tops/bottoms just plainly did not work, such as during sustained bear markets and the great bull market of the late 1990s. In other words, this author is not going to kid himself – and I want to let our readers know now: There will come a time when tracking the sentiment indicators on a consistent basis will be a fruitless task.
Look – the greatest investor in the world did not make his fortune by trying to forecast where the markets are heading next year. Nor did he ever try to “outwit” the stock market by getting out of stocks ahead of everyone else just because he thought the stock market was getting overbought or because he foresaw a recession ahead of time. No, Warren Buffett did all this by sticking to the basics – by studying companies and their businesses – and buying their stocks when their share prices were undervalued or when the general market sold off. The only time he liquidated his entire portfolio was in 1969 – and that was only because he could not find any undervalued stocks to buy at that time. Sure, Buffett made other plays as well, such as equity arbitrage during the 1980s and buying junk bonds in 2002 – but those were mainly one-time plays (during those times when he actually took advantage of extreme investors' sentiment or inefficiencies in the financial markets). At the core, Buffett remains a value investor. More importantly, he also tried to make sure that all the businesses that he owns are run as efficiently and as low-cost as possible.
And this is the second part of our “getting back to the basics” theme that we want to touch on further. In other words, it is not sufficient to be a good stock-picker or good investor (note that being a good investor also means knowing which stocks or industries to avoid). It is also not sufficient to “merely” be able to pick the right career for yourself or hoping your kids will pick the right careers for themselves. Being able to do well financially in the long-run basically means that you need to have some kind or organization when it comes to running your own finances or your family's finances. A company cannot be successful if all it can do is increase its revenues without controlling its costs. Studies have shown that the profession with the least ability to retire comfortably is doctors. Now, that is definitely saying something.
Now that we have that out of the way, I want to reiterate that our mid-cycle slowdown scenario remains in play for 2006. How this will affect the S&P 500 specifically, however, I am not going to say – but it is important to keep in mind what I have previously mentioned. At this stage of the bull market, a mid-cycle slowdown will affect the most cyclical industries – along with the industries that have witnessed the most speculation. Going into 2006 and 2007, this author is bearish on (in no particular order) energy (including natural gas), homebuilding, steel, copper, precious metals, along with emerging market stocks. Remember, it is crucial to keep in mind that avoiding the worst stocks is as important (if not more important) than finding the right stocks to invest in. Such a mid-cycle slowdown may or may not lead to a general sell-off in the non-cyclical shares of the S&P 500 – stocks such as WMT, MSFT, DELL, KO, C, MCD, IBM, HPQ, AMGN, and so forth. In fact, history suggests that anytime we have a peak in short-term interest rates, industries such as financials, healthcare, and consumer discretionary tend to outperform the market significantly.
It is also important to keep in mind that some of the large cap brand names such as KO, BUD, WMT, etc., are now trading at valuations not seen in over ten years. While we may not be at an optimal buying point yet – given all the risks that I see in 2006 which I outlined in last weekend's commentary – we are definitely getting pretty close. Case in point: At the beginning of 2005, Berkshire Hathaway was sitting on $43 billion of cash – equivalent to 46% of shareholders' equity – which is historically unprecedented for Warren Buffett unless you go back to 1969 when he liquidated all his portfolio holdings and returned all the money to his shareholders. During the first three quarters of 2005, Buffett actually found some equities to buy, including a $900 million stake in WMT, a $2 billion stake in BUD, and additional stakes in Wells Fargo as well as a stake in a European liquor company called Diageo PLC. All in all, Berkshire Hathaway spent $5.7 billion on equities in the first three quarters of 2005. Should the market suffer a general sell-off sometime in 2006, then there could be a huge buying opportunity in large cap, brand name stocks.
But Henry, isn't the S&P 500 still trading at a historically high valuation as indicated by the P/E and price-to-dividend ratios? Yes, and that is why it is so important to look at specific individual stocks and asset classes. Readers who have kept track with our commentaries should know that this author is a cautious optimist at heart. While I have outlined and acknowledged the significant amount of economic risks that we should experience in 2006, I am also optimistic that any subsequent market sell-off will lead to a buying opportunity in many of the large cap, brand name stocks that I like. As I have outlined in many of our previous commentaries, not only have domestic investors been shunning U.S. large cap stocks since 2000, international investors have been doing the same as well – even as large cap stocks in Europe and most of Asia continued to rally in 2005. At the same time, equities and mutual funds held by U.S. households as a percentage of their total assets is now at a low (excluding the 2002 and early 2003 bear market bottom) not seen since the second quarter of 1995, as shown by the following chart:
Please note that as of the end of the third quarter of 2005, the percentage of household assets that are invested in equities “only” stood at 15.34% - approximately 0.9% above the 50-year historical mean of 15.43%. While this percentage could of course decline further, it is important to keep in mind that as a percentage of market capitalization, the U.S. large cap, brand name stocks have been declining on a relative basis since 2000 – relative to mid caps, small caps, and international equities in general. Moreover, much of the rise in the market in the past couple of years could be attributed to the rise in cyclical stocks such as energy, steel, and precious metals. Case in point: Six of the top ten best-performing stocks in the S&P during 2005 are in the energy sector. Bottom line: Unless investors believe U.S. households are entering a prolonged period of balance sheet recession, any general market sell-off this year could lead to a huge buying opportunity for some of the large cap, brand name companies.
And while the expected decline in mortgage equity withdrawal could be significant (as I have discussed in our January 2nd ad hoc commentary), it is important to keep in mind that while a significant amount of mortgage equity withdrawal have directly gone into consumer spending over the last few years (as much as one-half to two-thirds), general consumer credit growth over the same period had also declined significantly – as exemplified by the following monthly chart showing the annualized growth of consumer credit (both on a revolving and non-revolving basis) from January 1989 to November 2005:
More importantly, it should be noted that consumer credit growth has been less than nominal GDP growth since the middle of 2002. This has two immediate implications:
- A significant number of households have been using their mortgage equity withdrawals to pay down their debts – especially debts that have historically had the highest carrying costs (e.g. revolving debt such as credit card debt).
- Given that 70% of American households did not experience a boom in housing prices and given that 30% of households still do not own their own homes, this lackluster growth in consumer credit suggests that many households have been “saving for a rainy day” in the aftermath of the March to November 2001 recession and the stock market crash of March 2000 to October 2002.
In other words, any upcoming decline in Mortgage Equity Withdrawal on GDP growth may be muted simply because U.S. households – in recent years – have improved their balance sheets and should subsequently have a better ability to take on debt in order to support consumer spending going forward. This is a major reason why this author is only calling for a mid-cycle slowdown sometime in 2006; and not a major recession.
But Henry, isn't the savings rate in negative territory right now?
Good catch; but as always, what you see in economic statistics is not usually what you get. According to the Federal Reserve's Flow of Funds data, U.S. households' net worth has continued to grow, and is now at a level much higher than it was at the previous peak in 2000. Moreover, Americans contributed approximately $650 billion into savings products in 2005. Money market assets also grew from $4.9 trillion to $5.3 trillion in the same year. And all this in the face of historically high oil and natural gas prices!
Obviously, the current measurement of the U.S. savings rate is fundamentally flawed. The bears would argue that the U.S. savings rate was hugely positive 20 years ago, but what they fail to catch is that the dynamics of the U.S. economy have changed significantly over the last 20 years. For example, in the last 20 years, the number of small businesses has gone on a dramatic rise – rising more than three-fold during that time. While it is straightforward to measure the savings for employees in a typical Fortune 1000 corporation (purchases of equity funds, contributions to pension plan, etc.), it is not so straightforward for entrepreneurs that start their own businesses, since much of their savings are deployed back into their own businesses. Think about the two co-founders of Google – Larry Page and Sergey Brin – who worked day and night at the Stanford campus to develop the ground-breaking search engine that we call Google today. Today, their combined net worth is approximately $20 billion, but virtually none of their working hours over the last seven years are counted as savings according to the official definition – even though they have managed to build Google from the ground-up into a $130 billion company today. To add salt to the wound – whenever one of them (or another insider) sell their shares on the open market, the capital gains taxes are treated as an expense, and therefore is counted as an offset against savings. That is, there is no corresponding entry on the income side even though there is an entry on the expense side! This scenario is consistent with the secular decline in the savings rate since the early 1980s. For folks who would like to see a rising “savings rate” in the U.S., I suggest a simple solution: Just close down Google or force them to relocate the Google campus (along with some of the best IT talent in the world) to Europe or Asia. Finally, if one takes the sum of private savings and change in net worth as a percentage of GDP today, that rate is on the order of 10 to 15% - which is within the historical range of the “true U.S. savings rate.”
Please keep in mind that I am not trying to be a “Pollyanna” here. All I am saying is that the U.S. economy should be relatively insulated from any “economic shocks” going forward, including any adverse effects on consumer spending caused by an upcoming decline in Mortgage Equity Withdrawal. That being said, this author is still calling for a mid-cycle slowdown in 2006, which happens to be slightly more bearish than what most economists are currently looking for in 2006 and beyond (and just slightly more bullish than George Soros – who is calling for a full-blown recession to start in 2007).
In the meantime, the market is starting to become very overbought – as illustrated by our most popular sentiment indicators and by a ten-day equity put/call ratio of 0.53 (just marginally lower than the readings we saw during December 2004 and July 2005). In addition, the market is also becoming very overbought on a breadth basis, as illustrated by the following long-term chart (courtesy of Decisionpoint.com) showing the percentage of NYSE stocks above their 200 exponential moving averages from 1987 to the present:
While this latest rise in breadth should be healthy for the markets in the longer-term, it should be noted that the percentage of NYSE stocks above their 200 EMAs are now hitting its resistance line going back to the beginning of 2004. That is, while the major market indices should continue its uptrend from current levels, folks that are invested in individual stocks should now be very vigilant as any upcoming rally in the stock market should now be more selective.
Again, I will definitely let our readers know once we believe that the major market indices are overbought enough to short. For now, we are not there yet – although we are now starting to get very close according to our most popular sentiment indicators. The only remaining exception is the NYSE ARMS Index – as the ten-day moving average is still at a relatively oversold level of 1.12. Again, before this author is willing to go short in our DJIA Timing System, one of our first criteria is to see this reading drop to the 0.90 to 0.95 level.
Let's now end with a discussion of the most recent action in the stock market. Over the last week, the stock market continued to digest its recent gains – with the Dow Industrials rising a mere 0.56 point while the Dow Transports declined 67 points. The action will come in the form of earnings reports this week, with Intel, IBM, Wells Fargo, and Yahoo leading the charge on Tuesday at the close. Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:
Looking at the above chart, probability still calls for a continuation of the uptrend in both the Dow Industrials and the Dow Transports in the coming days – even as the stock market is currently getting very overbought. The real test of the markets will come after the official appointment of Ben Bernanke as the new Chairman of the Federal Reserve on January 31st, although we should also see some action as companies start reporting their earnings this Tuesday.
Let's now discuss our most popular sentiment indicators. Let me try to sum it up in one sentence: Things are not looking so great for the bulls right now. Just as the latest weekly readings in the American Association of Individual Investors Survey were starting to become oversold, the Bulls-Bears% Differential in the AAII survey unexpectedly jumped up again in the latest week – from a very benign reading of negative 1% all the way to positive 40%! This latest jump represents the largest weekly rise since March 2004. We are also now getting highly overbought readings in both the Investors Intelligence Survey and in the Market Vane's Bullish Consensus. For now, however, the trend of the broad market remains up (although the bulls should now be very careful here) – that is, this author will not go short in our DJIA Timing System (or the major market indices in his own portfolio) until we see more overbought readings in the NYSE ARMS Index or at a DJIA level in the range of 11,200 to 11,300:
Meanwhile, the ten-week moving average increased from a still-neutral reading of 22.0% to finally an overbought reading of 24.5% in the latest week – still not at a point which this author will start to “panic” although we are definitely getting pretty close. Like I have been saying for the last few weeks, however, this author would not call an imminent top in the stock market until we see at least a 30%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey – preferably accompanied by a weekly reading of 40% or higher.
At the same time, the Bulls-Bears% Differential in the Investors Intelligence Survey remains overbought – as the weekly reading rose from 32.0% to 34.7% in the latest week. Meanwhile, the ten-week moving average increased from 31.8% to 33.3% - which is now officially in the “danger zone.” While this author would like to see a 40%+ reading in this survey before going 50% short in our DJIA Timing System, that is no longer the necessary condition.
Over the next week, the probability still favors a continuation of the intermediate uptrend at least until right before the January 31st Fed meeting – especially since company insiders are not allowed by the SEC to sell any shares because of the beginning of the quarterly earnings season. After the January 31st Fed meeting, however, anything goes. Given these highly overbought readings we are currently experiencing, and given that equity issuance is set to heat up in the next few weeks, this author is definitely not too bullish on the stock market right now. Once we approach the 11,200 to 11,300 level, there is a good chance that this author would go 50% short (our maximum allowable short position) in our DJIA Timing System, assuming the current conditions in our popular sentiment indicators remain highly overbought.
Last week, I had mentioned that “the Market Vane's Bullish Consensus continues to surprise on the upside…” Well, the latest weekly reading proved to be a surprise once again, as the Market Vane's Bullish Consensus jumped from a reading of 70% last week to 73% in the latest week – the highest reading that we have registered thus far in this cyclical bull market. This also represents the highest weekly reading since November 1998. Based on the history of the Market Vane's Bullish Consensus, such high readings (over 70%) can only mean two things: That we are in the midst of a significant top or that the bull market will now reassert itself in a powerful way. Since this author is very cautious in nature and since I believe 2006 will be a year fraught with risks, probability suggests to me that it is the former rather than the later:
Meanwhile, the ten-week moving average increased from 67.3% to 68.5% - which is now extremely overbought. Given that all three of our popular sentiment indicators are now very or extremely overbought, chances we will be shorting the major market indices at that time (both in our DJIA Timing System and in our personal portfolio for hedging purposes) – in the days leading up to the January 31st meeting or immediately after. At this point, this author is still targeting a DJIA level of 11,200 to 11,300 for short purposes but we may short at a lower level should the market remain overbought but fail to rally to that level in the days ahead.
Conclusion: For now, our mid-cycle slowdown scenario remains in play for 2006. Even as 2006 promises to be a year fraught with both political and economic risks, it is important to keep in mind that these risks affect different industries in disproportional ways – as I have emphasized in many of our commentaries over the last few weeks. For longer-term investors, this author is suggesting you to “go back to basics” in 2006, and to focus on valuations and researching businesses instead, as many of the most valuable, large cap brand names are now selling at valuations not seen in over ten years. Any market sell-off that we see in 2006 due to a mid-cycle slowdown or some other economic shock should provide a great opportunity to load up on those shares and hold them for the long-run. Please keep in mind, however, that this author is a cautious optimist at heart and is thus not looking for a full-blown recession, although the situation continues to remain very much in flux. Given the relatively benign consumer credit growth of the last few years and given the fact that the U.S. “savings rate” is not painting a complete picture, there is no reason to believe we will experience a recession during 2006 or 2007 at this time.
In the meantime, the intermediate uptrend in the stock market still remains intact, although it is now getting very fragile. Investors should keep a keen eye on the upcoming earnings reports as well as the January 31st Fed meeting. For now, we will remain completely neutral in our DJIA Timing System, and if all goes according to plan, we will establish a short position towards the last few trading days of this month. Over the long-run, however, the road to successful long-term investing is still having the ability and the patience to study and pick individual stocks and hold them for the long-run – while constantly re-evaluating their fundamentals at all times.
Henry K. To, CFA