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Category: Market Commentary

Will You Be Able to Break the Cycle?

Hey John,

“This time is different.”

We hear that a lot in the financial markets. Today, that means the notion that the New Economy is resistant to recessions.

That was right before technology stocks lost nearly 80% of their value.

Green Shoots are growing, and the economy is like Goldilocks… not too hot, not too cold.

Not sure if you remember… this view predominated just months before the biggest financial crisis in modern history.

Well, there is one thing that will be different this time.

In the next crisis, there will be nowhere to hide.

A decade of bailouts and easy credit has the markets awash with cash. And this record bull market has brought everyone along for the ride. That means everyone has a long way to fall.

Consider the differences between prior market tops and today’s highs.

Back in the early 1970s, the top 10 stocks represented 34% of the S&P 500. That remains the highest level in 46 years.

By far.

This was a period coming off the “Nifty 50” phase of dominant, must-own growth stocks. These were stocks you could buy and hold forever – in theory. Those unfortunate to have a portfolio of Nifty 50 stocks got decimated in 1973-74.

They never recovered.

Then, energy stocks blew up when they represented nearly 30% of the S&P 500 by the early 1980s. An oil glut saw the price of oil shaved by about two-thirds in real dollars.

Investors bet wrong again.

By the late 1990s, the Nifty 50 was a distant memory. So, like humans typically do, they failed to learn from the past and subsequently worked themselves into a lather over Internet and technology stocks, which represented 33% of the S&P 500.

That was over four standard deviations from the norm.

You don’t need to be a math major to know that is way outside what could be reasonably expected or sustained.

The dominance of technology stocks hid the fact the bear market lurked in other sectors. By the time the tech sector crashed, many stocks were rebounding. If you avoided technology stocks in 2002, you likely did quite well. You might’ve eked out a positive return despite the market taking a beating.

By the time the financial crisis unfolded, banks were in the limelight and represented over 20% of the index, nearly double the historical average.

Once again, many stocks bottomed before the indexes, setting up a powerful rally in 2009 and beyond.

So, where are we today?

Well, the top 10 stocks don’t dominate the market.

At 20%, they’re below the long-term average of 22%. The technology sector is back up there at 26%, driven by a few companies leading the way. Financials have reverted to the mean.

Lastly, energy is nowhere to be found. The hard-hit sector ranks seventh out of 11 sectors.

The big difference today is just how high the entire market is priced.

The median price-to-sales ratio of the S&P 500 is 2.48x.

Simply put: We’re sitting near all-time highs. And, again with the fancy math, that’s about three standard deviations above normal.

Everything is overvalued.

A little-know indicator confirms this.

When the price of the lowest 25 stocks in the S&P 500 is low in dollar terms, it’s time to snap them up as bargains.

Think about it: In a bear market, many stocks get brutalized that don’t deserve it. Their stock prices fall $3 to $4 or more – only to rebound when the “All Clear!” siren sounds.

This is how John Templeton made his first fortune. Today, the 25th-cheapest stock in the market is $22.60, an all-time high. When these stocks trade below $6 a share, the annual returns are over 25%.

Always remember that the market is inherently speculative. Now, everything has been bid up to nosebleed levels.

When (not if) things turn, it’s highly likely that the vast majority of stocks will take a beating, unlike the last several bear markets.

Good luck out there,

Originally appeared in The Rich Investor

Earnings Are Not What You Think

Earnings season is underway, and the path to quick profits (or losses) is right in front of us.

Expectations are high because of tax reform and solid trends in earnings growth. Sales are trending up, and operating profits are on the rebound. Meanwhile, profit margins are high, with Wall Street analysts projecting more of the same.

All this should propel the market higher.

However, there’s a disconnect between the market and the typical company.

Government statistics compiled from all corporations show that not only did profit margins peak years ago, but that the trend has deteriorated further over the last 12 months.

The differences likely come down to one thing that public companies can do that private companies can’t that can make a big impact on its profits.

That one thing? Buying back stock.

When companies buy back stock or pay a dividend, it’s called “shareholder yield.” Returning capital to shareholders is great, right? Possibly, but…

Not all shareholder yield is created equal.

At Hidden Profits, I focus on a version of my forensic accounting stock tracker called “Show Me the Money.”

I overweight the shareholder-yield component while also keeping the earnings-quality factors in the model so that, when I make a stock recommendation to my readers, we can have more confidence that management isn’t pulling the wool over our eyes by returning capital to shareholders.

IBM (NYSE: IBM) is a great example of a company that loaded up with tens of billions in debt to buy back stock and dish out dividends. Meanwhile, revenues were slowing (down quarter after quarter for about five years), and cash flow performance was dismal.

Propping up earnings by buying back stock is not good shareholder yield. While we can simply avoid investing in specific companies that do this, what’s scary is the market as a whole is flashing a huge red flag… marked “shareholder yield.”

Companies are using their tax windfalls to goose the numbers. Financial engineering is reaching new heights. In the past five years, companies have spent $4.9 trillion in mergers and share repurchases. In the first quarter of 2018, that trend actually accelerated, with $305 billion spent on takeovers and buybacks.

This has been going on for a while. When it ends, it will expose the market for what it is: financially engineered without sustainable profits to support stock prices.

Look out below.

 

This post was originally published on Economy & Markets and can be seen here.

Is It Time to Take Profits?

There’s an old market axiom that goes something like this: You can’t go broke taking a profit.

Of course, for every piece of a conventional wisdom, there’s usually a piece of counter-wisdom, such as “let your winners run and cut your losses short.”

Both can be useful, depending on the circumstances.

In this space in recent months I’ve highlighted rich market valuations and overly optimistic investor sentiment. As both of these conditions persist, I’m very concerned that any gains in the market would only be erased entirely and then some at a later date.

After the shellacking many retail investors suffered in early February,, their views of the market changed. Realizing that stocks can actually go down will do that! We’ve since seen investor sentiment normalizing a bit, as record amounts have been pulled from exchange traded funds. But sentiment has not swung to the other side of too much pessimism.

Which is to say, the risks are still present and dangerous.

As a result, in Hidden Profits this month, I followed the first maxim and booked some large profits in three of my recommendations, all around 50%.

Not bad!

Earnings season is upon us, and, with the recent uptick in market volatility, anything can happen going forward. While tax reform generated some market tailwinds, my view is that any company that whiffs even a little bit on their earnings release or guidance will face the wrath on unrelenting selling by investors.

We’re now longer at the stage of the market cycle where free hall passes are being given out.

It’s like the old mafia members in the movie Casino trying to figure out who to whack to save their own hides. Alas, they  wipe everyone out: “Why take a chance?”

Interestingly, while I’ve been cautious on the market, two of my biggest winners were conservative investments. One is in the unloved refining business. Far from sexy, Valero (NYSE: VLO) has solid operating performance and earnings quality. In fact, it’s at the top the rankings in my forensic accounting software.

Our biggest winner, Wyndam Worldwide (NYSE: WYN), is a hotel and vacation operator that had taking a beating just prior to my recommendation to buy the stock. What we viewed as the “Apple of hospitality” has had an unrelenting move to higher prices. I have no doubt the business is well managed and operating performance has been strong, but the stock is ahead of itself, in my opinion.

Finally, we booked a profit in QVC (NYSE: QRTEA), which is led by industry veteran John Malone, who sports a track record that rivals the legendary Warren Buffett. It’s a solid business that we also recommended after a short-term decline. Great managers and loads of cash flow are a wonderful combination, as the pick has proven.

During the exercise of reviewing all of the positions very closely, I made another observation…

A couple of the very best opportunities in the portfolio are trading a touch below my ideal buy-up-to price, but nothing has changed to alter my opinion of these stocks. In fact, the fundamentals have improved. That just hasn’t been recognized by the market.

That’s the hidden profit: well-run companies with good operating performance but a misunderstood opportunity.

If the investment thesis plays out as expected, that only means even bigger returns. They’re out there, even in this up-and-down market.

You just have to know where to look.

Good luck,

John

 

This post was originally published on Economy & Markets and can be seen here.

Be Fearful When Others are Greedy

Consumers are confident.

That has me nervous.

In fact, they’re the most confident they’ve been in more than a decade. The Reuters/University of Michigan Consumer Sentiment Index just registered its highest reading since 2004.

That should be good for the economy, right?

Well, consumers are people, and people as a whole are terrible at predicting much of anything. They’re even worse when it comes to financial matters.

For example, consider some consensus views of the stock market.

Individual investors held the highest allocation to stocks ever in 2000, at 77%. That was also the lowest cash position ever, at 7%, leaving no cushion to soften a major blow. For you history buffs, that wasn’t too long before the market cracked and many technology stocks fell over 90% as the Internet Bubble popped and deflated.

Then, in 2009, individual investors held just 41% in stocks at the market lows in March 2009. That represented the lowest equity allocation ever – right in front of one of the most monstrous bull markets in history.

It’s a bull market we’re still living through, in fact.

It might be a bit old and tired, but this baby has legs!

I subscribe to my own theory of wealth management,  the “George Costanza Theory of Money.” You may remember George from the iconic 1990s sitcom Seinfeld. He gets into all sorts of trouble from episode to episode, brightening my day with plenty of laughter an untold number of times.

Here’s just one “George” story.

One day, fed up with all his continued misfortune, George decides to do the exact opposite of everything he thinks he should do. Throughout his life, his gut instinct has caused him nothing but problems.

But when he starts doing the exact opposite of what he thinks he should do, life starts going his way.

First, he lands a beautiful girlfriend. Then, he gets a job offer with the New York Yankees. Finally, he snags an apartment that allows him to finally move out of his parents’ house.

Life is grand for George!

The average investor or consumer is the typical George – before he decides to do the exact opposite of what he thinks he should do.

Collectively, we make bad decisions because we’re driven by emotion. And, at best, all we can get is “average.” Otherwise, we’d all be sitting rich on a beautiful sandy beach, drinking Bahama Mamas, and watching our online trading account balances soar.

That’s why when folks are incredibly optimistic, I get nervous. When they’re spending money hand over fist, I’m squirreling it away for a rainy day. When they’re pessimistic about the economy and their own prospects, I’m looking to spend money to obtain the best deals in years.

In the short term, these might be good indicators of economic growth – for a quarter or two. But there’s no greater contrary indicator than when masses of people are at multi-year highs in optimism. Any short-term benefit will be wiped out when the pendulum swings the other way.

So, while the popular media might cheer the 14-year high in confidence, please remember George.

And proceed with caution.

Good luck out there,

John

This post was originally published on Economy & Markets and can be seen here.

Bitcoin’s Crazy Ride Brings in the Regulators

Bitcoin has bounced back off its lows after getting absolutely smashed earlier this year. After nearly topping  $20,000 in 2017, the price of bitcoin fell back to $7,000 before rebounding to about $11,000.

And, wouldn’t you know it, high-flying prices and insane volatility have caught the interest of regulators.

That’s a good thing.

Wait, wait. Hear me out.

I’m pretty libertarian about things, which means I’m not usually a big fan of regulation. But a space like bitcoin is ripe for ordinary folks getting taken advantage of. You can see it coming a mile away. Recently, the Securities and Exchange Commission (SEC) issued dozens of subpoenas to crypto-issuers and are warning that these offering should be treated like securities.

I have no doubt there are illegal securities offerings. The market is growing exponentially, with 50% growth over all of 2017 in just the first two months of the year. With bitcoin looking like the Wild West, I keep picturing a guy with a desk, a fax machine, and a pager lighting up the phones to sell some sort of crypto-related investment. Formerly, these people were junior gold miner prospectors.

It always ends badly.

With the request for information, the regulators are clearly trying to get ahead of the curve and nip the illegal activity in the bud. This might also make life difficult for legitimate operators, but, hopefully, that’ll only be short-lived. Once the smoke clears, legitimate companies have a better chance to prosper without being dragged through the mud with the frauds.

The other area where the SEC has flexed its muscle is in the exchange-traded fund (ETF) space. The SEC had blocked bitcoin ETFs in the past, but once futures started trading on bitcoin, several ETF sponsors filed to list their funds on exchanges. They could price the ETF based on the futures contracts traded on bitcoin. Previously, it would’ve been impossible for an ETF based on bitcoin to function properly.

I have no doubt that these bitcoin ETFs would’ve garnered billions of dollars in assets quickly after their respective launches. These would be the most successful ETF launches in recent history, if not all-time. What’s more is that if normal bitcoin volatility, which is like a death-defying roller-coaster ride, didn’t whet your appetite, you’d also have been able to purchase ETFs with added leverage designed to juice the returns.

Fortunately, regulators stepped in and expressed deep concern with how these ETFs would function. In short order, the ETF sponsors withdrew their filings. Tons of money in future management fees also went up in smoke.

Our last Hidden Profits stock pick is engaged in blockchain technology. But, instead of changing its name to Sock Puppet Blockchain to capitalize on a trend, it’s actually operating real blockchain businesses. I remain quite skeptical on the currencies themselves, but blockchain technology is real and here to stay.

Even if I’m wrong and bitcoin goes to $100,000, bigger gains will be made in the winners of the blockchain battle.

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.

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