As I am writing this article, the Dow Jones Industrial Index has marched over 17,000 points for the first time in history, 7 months after the index closed above 16,000 for the first time. While this is a widely celebrated event on Wall Street, this question still remains - where are we standing now?
The market has been going up and up and up since March of 2009. It can be frustrating for U.S value investors who have witnessed a run up of valuation of a great many of public companies and a shrinking level margin of safety as a consequence. It’s easy to form an opinion based on perception and intuition. But the fact that the market has advanced for 5 years in a row is not a compelling reason to stay on the sideline. In order to come up with a logical and reasonable answer as to what we should do in the current environment, we should follow the wisdom of Howard Marks (Trades, Portfolio),
“The Most Important Thing Is... Having a Sense for Where We Stand”
Obviously, we have to come up with some sort of system in order to gauge where we stand now. Fortunately, in Chapter 15 of “The Most Important Thing,” Howard Marks (Trades, Portfolio) has provided us with a great framework in terms of assessing the current market environment. Marks’ list includes the following indicators:
Economy: Vibrant Neutral Sluggish
Outlook: Positive Neutral Negative
Lenders: Eager Neutral Reticent
Capital markets: Loose Neutral Tight
Terms: Easy Neutral Restrictive
Interest Rates: Low Moderate High
Spreads: Narrow Moderate Wide
Investors: Optimistic Neutral Pessimistic
Equity Owners: Happy to hold Neutral Rushing for the exits
Equity Sellers: Few Moderate Many
Markets: Crowded Neutral Starved for attention
Funds: New Ones Daily Neutral Only the best can raise money
Recent Performance: Strong Moderate Weak
Equity Prices: High Moderate Low
Respective Returns: Low Moderate High
Risk: High Moderate Low
Popular Qualities: Aggressiveness Neutral Caution and discipline
- Economy: The U.S economy is neither vibrant nor sluggish. 2013’s real GDP growth was 1.9%, a level that is still considered slow. On the other hand, the most recent unemployment rate has dropped to approximately 6% from more than 7% in 2013. This is an encouraging sign.
- Outlook: Here I’ll use IBD/TIPP economic optimism index as a proxy. The latest IBD/TIPP economic optimism index stood at 45.6, which is 3.7 points below the long time average of 49.3. A reading above 50 indicates optimism and a reading below 50 indicate pessimism.
- Lenders and Capital Markets: I think Thomson Reuters' PayNet Small Business Lending Index is a good proxy to use. The latest reading of the Index is 127, almost back to the pre-crisis level of 130. This means the lenders are becoming more eager and the capital market is becoming looser.
- Terms: Mortgage terms and bank loan terms are still restrictive. Banks are still very selective when initiating mortgages and loans. For instance, JP Morgan rejected more than 30% of mortgage applications and Bank of America rejected more than 25% of mortgage applications.
- Interest rates and spreads: Low.
- Investors: American Association of Individual Investors publishes survey result of individual investors on a regular basis on its website (http://www.aaii.com/sentimentsurvey). The latest result shows that 38.5% of investors are bullish, 39.1% are neutral and only 22.4 % are bearish. Overall, individual investors are neutral.
- Equity Owners and Equity Sellers: I am not sure what is the best way to gauge the happiness of equity owners or the number of equity sellers. But my observation, which you should take with a grain of salt, indicates a neutral rating.
- Markets and Funds: ”According to Hedge Fund Research, "Hedge fund launches rose through early 2014 as new launches in Equity Hedge and Event Driven continued to attract new investors, and total hedge fund capital rose globally to a record $2.7 trillion at the end of the first quarter. New hedge fund launches totaled 289 in 1Q14, up from 244 in the prior quarter, and the highest total since 297 funds launched in 1Q13, as reported in the latest HFR® Market Microstructure Industry Report, released today by HFR, the established global leader in the indexation, analysis and research of the global hedge fund industry.” This indicates an increasing level of crowdedness in the market as well as an increasing level of easiness in raising money in the hedge fund industry.
- Recent performance: The Dow, S&P 500 and the Nasdaq have all experienced strong performances since March of 2009.
- Assets prices, respective returns, and risk: Buffett’s favorite indicator total market cap as % of GDP stands at 123% today, which indicates a significantly overvalued market. The Shiller P/E is also significantly higher than historical mean. Both indicators imply lower returns, and relatively high risk levels.
- Popular qualities: According to TD Ameritrade’s data release. TD Ameritrade clients were net buyers of many names that saw drops in price during the May IMX period. In the technology sector Twitter (TWTR) and Yahoo (YHOO) both saw dips and were net buys. Net buys in the services sector included Whole Foods (WFM) and Amazon (AMZN). Clients were net buyers of the financial sector overall, with Bank of America (BAC) and Prospect Capital (PSEC) the most popular purchases in the group. Additional popular names bought included Berkshire Hathaway (BRKB), AT&T (T), and Pfizer (PFE).Apple (AAPL) ended May over 20% above its April 2014 low and was the largest net sell as clients seemed to be lightening positions and taking profits. Clients were net sellers of Coca Cola (KO) as the stock was range bound in May after spiking higher in April 2014. Additional securities that saw pops in their price during the period and were popular net sells include Cisco (CSCO), Intel (INTC), and JC Penney (JCP). Several services sector issuers were also net sold, including Sirius (SIRI), McDonalds (MCD), and American Airlines (AAL). My take is that the momentum stocks such as Twitter, after a selloff earlier this year, has come back strongly but at the same time, investors have also been buying blue chip safe stocks such as Berkshire and AT&T. Therefore, a rating of neutral seems appropriate.
Ok, I have tried my best to provide an analysis that might be helpful in terms of measuring where we are in the equity market. While everyone can have different interpretations or different methods in gauging each indicator, I think by and large, we can get the feeling that a cautionary approach seems to be prudent going forward. I don’t think we are going through a round of “irrational exuberance” as we have seen in the tech bubble or the housing bubble and I certainly don’t think we will have a crash in the market as bad as 2008 and 2009. Investors are not that bullish.
Given what we know and given where we are, I think the appropriate thing to do is to apply a higher level of prudence in today’s market, by which I mean we should not lower our standards in order not to feel left out. I also think we should not be afraid to hold cash when we can’t find enough compelling ideas. Someday the pendulum will swing to another direction and when that day comes, you should be prepared and your opportunities will come.