Brand Name Large Caps Still a Buy
(March 25, 2007)
Dear Subscribers and Readers,
Just like in the stock market, if one wants to panic in everything else in life, the best time to do it would be to do it early, or ahead of almost everyone else. Worried about a mass layoff at your company? Declining morale? No problem – get a job somewhere else, and do it quickly. Once your coworkers have done the same, the supply/demand pendulum would have already shifted to the side of other employers in the same industry, and you will no longer have bargaining power in terms of your salary, benefits, job position, etc. If you had waited that long, you may as well stay with your company and hope or try to go for a raise or promotion, as many of your peers and talent would longer be there to compete with you. The best scenario is if your boss has also left the company. Assuming you don't get laid off (in stock market lingo, this would mean either 1) you are not leveraged or that you are not leveraged enough to get a margin call during a crash, or 2) the companies that you are holding don't go bankrupt during an economic recession), this would probably be your best chance to get promoted, as it is always much easier to promote within, especially for a company that is unattractive to many others in the same labor pool.
Bottom line: The “deer in the headlights and then panic” approach does not work in the stock market, and neither does it work anywhere else in life. It is amazing how much trading or investing in the stock market can teach you about life in general.
Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,096.01 points
2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 976.01 points
In the short-run, the market is still relatively overbought – as both the Dow Industrials and the S&P 500 are still approximately 5% higher than their respective 200-day moving averages. Given this short-term overbought condition, any further upside in the market during this upcoming week is probably not sustainable in nature, and should not be chased. That being said, I am still bullish on the U.S. stock market in the longer-term, and after a brief consolidation phase (and hopefully more pessimistic sentiment readings and some kind of washout in margin debt levels), I expect the U.S. stock market to be higher three to six months from now.
Over the weekend, I reviewed the August 2006 edition of Outstanding Investor Digest featuring an interview with Arnold Van Den Berg of Century Management – a value investor who have strung together an annualized return (after fees) of 15.6% for his clients over the last 30 years (as of mid 2006) vs. an annualized return of 13.5% for the S&P 500. Moreover, this performance was achieved while his clients were holding cash and bonds in their portfolios. If we count the equities portion of his clients' portfolio, the annualized return (after fees) would have jumped to 19.9% instead, an enviable record by any measure. I highly recommend the interview with Mr. Van Den Berg. It is available for free on the Outstanding Investor Digest website, if you are interested.
In his August 2006 interview, Mr. Van Den Berg recommends a buy-and-hold strategy in many of the U.S. mega-cap stocks, such as WMT, MSFT, and PFE. Just for the record, this author has been doing the same thing over the last six to nine months, and I continue to recommend such a strategy going forward. Quoting Arnold: “… today, the average P/E of the biggest of big-cap stocks has fallen from 25.5 to 18.6. But that's not the whole story. And here's why I say that: Since 2000, the yield on the 10-year Treasury has declined from an average of 6.03% to 4.29% [Henry's note: It closed at 4.61% last Friday]. So the average P/E should actually be higher. However, there's always a psychological reason why valuations temporarily get out of line – and this time is no different. Only in the stock market does the best merchandise occasionally sell cheaper than the lower-grade merchandise. And it just so happens that we're at one of those points in history right now. In fact, I'd say that such an opportunity only comes along about once every 10 or 12 years – in fact, it may come along only once every 20 years. It's very, very rare…”
The discount of U.S. large caps vs. U.S. small caps can also be witnessed in the following chart showing the relative P/E ratio (12-week moving average) of the S&P 500 vs. the S&P 600 from April 1993 to the present:
As Arnold discussed in his August 2006 interview – not only is U.S. large caps trading at a discount to U.S. small caps, but also to U.S. treasury notes and bonds as well. More importantly, the discount gets wider as one move further up the market cap spectrum. According to Yahoo Finance, WMT is now trading at a P/E of 17.7, PFE 9.7, HD 13.7, MO 15.0, MCD 15.9, GE 17.9, DELL 17.8, and so forth. This discount is even more pronounced if one compares the valuation of U.S. mega-caps with the valuation of REITs, the popular emerging market securities, and so forth.
Over the long-run, I sincerely believe that the only way an individual investor can beat the professionals (including guys like Bill Miller, hedge funds, private equity funds, etc.) is to employ a buy-and-hold strategy and only buy on 1) valuations, and 2) fundamentals. When buying individual stocks, capital preservation is the game, and buying based on valuations can cover a lot of mistakes. In fact, I would go one step further: Buying U.S. large caps such as WMT at good prices is close to a no-brainer, as companies like WMT usually come with high-quality management and a brand name that attracts the best talent – luxuries that many small cap and mid cap companies do not typically have. Finally, as the U.S. economy continues to grow below its potential (this is short-term in nature) and as the U.S. Dollar continues its secular decline against many of the Asian currencies (this is more secular in nature) – U.S. large caps, with its much more geographically diversified earnings stream – should experience higher earnings growth than U.S. small caps going forward.
Let's now move on to a discussion of margin debt. We last discussed margin debt in our February 22, 2007 commentary (“Is the Rise of Margin Debt a Danger?”) and concluded that while rising margin debt in bull market is very normal, the fact that it was rising so quickly signaled a red flag nonetheless. In retrospect, however, I was wrong nonetheless as I also stated: “That being said – for those that are already long and are in stocks that have good fundamentals and earning power – I would not consider selling here. Records are meant to be broken, especially during a bull market. Moreover, many things I have read suggest that most of the increase in margin debt has been due to speculation in foreign stocks and ETFs – as opposed to the concentration in domestic technology stocks back in late 1999 and early 2000. In past times, I would have slapped an emphatic “sell” on international stocks and on emerging markets – but given the much cleaner balance sheets and economic/earnings growth in emerging markets in recent years, I now believe margin debt can continue to increase from current levels before we see any kind of significant correction. Readers please stay tuned.” Five short days later, the Dow Industrials would decline over 500 points in an intraday swoon resulting in a NYSE Arms Index reading not seen since the aftermath of the Eisenhower heart attack in late September 1955.
Given the February 27, 2007 decline, one would think that the amount of margin debt outstanding on both the NYSE and the NASD would have experienced some kind of washout, but alas, it was not to be. Margin debt outstanding actually increased again (for the sixth consecutive month) during the month of February. In fact, the rate of ascent in the margin debt outstanding has been nothing short of phenomenal over the last six months – as shown on the following chart showing the Wilshire 5000 vs. the 3, 6, and 12-month changes in margin debt from January 1998 to February 2007:
The total amount of margin debt outstanding on both the NYSE and the NASD increased $10.3 billion (assuming that NASD margin debt remained the same, as February NASD data isn't released until the end of this month) to $321.8 billion – a new record high. As mentioned on the above chart, both the 6-month ($72.4 billion) and 12-month ($72.2 billion) change in margin debt are now at their highest levels since April 2000! Because of this latest increase, margin debt continues to be a red flag. While I believe the U.S. stock market is still in a long-term uptrend, investors who want to go long should generally adopt a “wait and see” approach before buying. This is also one reason why I believe the U.S. stock market should experience a further consolidation period before we see higher highs over the next three to six months.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:
For the week ending March 23, 2007, the Dow Industrials rallied 370.60 points while the Dow Transports rallied 191.64 points – resulting in the highest close of both of the popular Dow indices since the close on February 26th. More importantly, the internals of the stock market continued to improve, as the A/D lines of the NYSE Common Stocks only Index, the S&P 500, the S&P 400, and the S&P 600 all made all-time highs last week. Given that the stock market does not typically top out until four to six months after a peak in the NYSE A/D line (although there are exceptions, such as during June 1946 when the NYSE A/D line and the Dow Industrials topped out at the same time), we are definitely still not close to the end of this cyclical bull market, just yet. For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators declined from last week's 19.5% to 16.3% for the week ending March 23, 2007. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
As mentioned on the above chart, the four-week MA of this indicator is now at its most pessimistic since September 8th of last year. I also expect this reading to decline slightly in the coming week, although I don't expect to see the kind of oversold readings that we witnessed during either October 2005 or June 2006. The best scenario for the bulls would be to see a further consolidation period in the stock market – and accompanied by more pessimistic readings in the Market Vane, the AAII, and the Investors Intelligence Surveys. For now, investors should not indiscriminately buy – as any upcoming rally this week is probably not sustainable in the short-run. Moreover, there is a good chance that any upcoming rally would most probably be more selective than what we have witnessed from June 2006 to February 2007.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
As one can see from the above chart, the 20-day moving average of the ISE Sentiment dropped to a reading of 98.5 last Wednesday – representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002. While the indices can and should consolidate over the coming weeks, the pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” basis the Dow Industrials or the S&P 500.
Conclusion: While the amount of margin debt outstanding on both the NYSE and NASD still represents a “red flag,” this author believes that the stock market should continue to rise over the longer-term – and that the U.S. “mega caps” continue to represent one of the most attractive value plays anywhere in the world today. I will also emphasize this again: Over the long-run, the best and probably the only way for individual investors to beat the “pros” at their own game is to adopt a much longer-term view and to not “look at the rear view mirror” – and given that U.S. large caps represent one of the best buys out there today, I encourage our readers to think hard about buying some of these companies.
Probability also suggests that the intermediate term trend remains up, for now. Should market internals or valuations deteriorate substantially over the next couple of weeks, we will definitely trim down on our 100% long position in our DJIA Timing System – but as of Sunday evening, we will remain 100% long. We also believe that the deterioration of the subprime industry will not “spill over” into the rest of the U.S. economy. We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System in the upcoming weeks (this will depend on new information such as technicals, liquidity, mutual fund inflows/outflows, sentiment, and so forth).
Henry To, CFA