June 19, 2017
The S&P 500 is pushing new all-time records, while market volatility is at historic lows.
Here’s the most recent CAPE ratio chart, showing how highly valued the U.S. market currently is compared to historical norms:
For more information on the cyclically-adjusted price-to-earnings (CAPE) ratio, and market valuation techniques in general, click here.
Although I don’t respond to every email due to the volume, I read every single one, and probably the most common question that readers ask via email is what my thoughts are on the possibility of a 20% or more market correction in the near future.
Of course I don’t claim to know something like that, but this issue will examine some of the facts about what signs we have that we may or may not be near the top of the market cycle.
A short answer is this:
An economic recession is most commonly defined as two consecutive quarters of GDP shrinkage, with everything else being considered an economic expansion.
We’re currently 8 years into a market expansion, from June 2009 to June 2017, which is the third longest market expansion in U.S. history dating back to 1776. The longest ever market expansion was exactly 10 years, from March 1991 to March 2001.
So, if we manage to go 2 more years without a recession, we’ll have a new record in the nearly 250 year history of our country.
As shown by the high CAPE ratio, as well as a high Cap/GDP ratio, stock prices are broadly expensive, which is another indicator of being late into the market cycle; towards the peak of an expansion. If we were to encounter a recession, or some other negative catalyst, stock prices have plenty of room to fall before they’d be clearly undervalued.
Whenever I analyze an individual company, the majority of the time I find that it is noticeably overvalued, based on discounted cash flow analysis.
In other words, the market is expensive, and we’re pushing the historical limits on how long a market expansion can last.
I still have the majority of my net worth in equities, but the clear rule of thumb is this: don’t invest in equities unless you can financially and emotionally withstand a 20% or more market decline within the next few years. Equities are one of the best long-term investments, but they are indeed expensive right now, and we are getting close to the historical maximum length of a market expansion.
Long answer: Let’s dig deeper into the facts
Nobody can tell you what the market will do, especially in the short term.
Analyzing the CAPE ratio and Cap/GDP ratio, and applying discounted cash flow analysis directly to individual companies, gives us a very strong idea of how expensive the market is and whether the long-term expected rate of return for the market will likely be good or bad.
But over the next 6-12 months? Who knows. Short-term movements are more emotional, compared to long-term movements that are more mathematical.
I am a bear, at the moment. With stock prices so expensive, and us being so far into a market expansion, I believe our portfolios should be prepared for a downturn, and mine is. But I don’t time the market; that correction could come in a couple months, or a few years. All I can say with relative confidence is that there’s more downside potential than upside potential in the market.
But for a change of pace, I’ll put my bull cap on for a bit.
One argument in favor of a prolonged expansion is that the severity of the 2007-2009 recession, and the tepid recovery thereafter, will probably lengthen the duration of the current market expansion that follows it. Like, a long and weak expansion, rather than a short and strong expansion.
Prior to the 2001 recession, people were ecstatic about the state of the economy and the tech bubble. Prior to the 2007 recession, people were buying far larger homes than they could afford, feeling prosperous. But now, in 2017, the economy still feels pretty “meh” to a lot of people. It has definitely recovered, but it never seemed to truly shine. People haven’t hit a feeling of exuberance. We might still have room to grow further, for longer.
Here, for example, is the long-term unemployment rate for people 20 years and older, according to the St. Louis Federal Reserve:
At under 4%, we’re in the range of the historic bottom, and comparable to 2007 levels, and less than a percentage point away from 2001 dotcom bubble levels. It’s almost as good as it gets.
The problem is, most measures of the unemployment rate, including this one, don’t take into account people that are underemployed, like people that want to work full time but can only find part time work, and are not technically unemployed. Or people that gave up searching for a job entirely, and perhaps retired early in bad economic conditions.
So, here’s a chart from the Bureau of Labor Statistics, that shows a far broader figure. It’s the percentage of the population of people over 16 that are employed, period:
As we can see, the percentage of the population employed never fully recovered to 2007 levels. We’re still in a period of lower employment.
And here’s a second chart from the BLS, showing the same broad percentage of the population that is employed, but restricting the age to between 25 and 54 to exclude college-age folks and retirees:
This confirms the previous chart; the percentage of the working age population that is employed, period, is still not quite up to 2007 levels.
These last two charts are only useful for the last few decades, because if you go back farther than that, the broad upward trend is due to the cultural shift of women entering the workforce in greater numbers. So, I would just compare the current state of employment to 2007 and 2001, the previous two peaks. And that comparison implies that we still haven’t fully recovered in terms of the employment/population ratio, even if we’ve about fully recovered in terms of the official unemployment rate.
Maybe we’ll enter a “new normal”, where automation and e-commerce reduces employment over the long-term, in a similar way that greater gender equality increased employment long-term. But for now, we can compare 2017 to 2007 and 2001, and the evidence is that there’s potentially still some room to run. There’s no guarantee that we’ll hit employment levels equal to 2007 before experiencing another recession, but it at least gives us a water market to compare to.
Plus, the European Union has had an even more tepid recovery than the United States, and that has an impact on the rest of the global economy:
Here’s their unemployment rate over time, compared to the US and UK:
(Automated chart from Google, using Eurostat and BLS statistics as data sources)
Since the year 2000, the lowest the unemployment rate has been in the EU is 6.8%, in March 2008. It increased to a peak of nearly 11% in 2013, and has now decreased to under 8%, and still declining.
Lastly, there’s a case to be made that the current expansion is far more reliant on low interest rates than previous expansions were.
Here’s the historical federal funds rate, courtesy of the St. Louis Federal Reserve, with recessions highlighted in gray:
During this latest recovery/expansion, interest rates have been kept lower for longer than ever before, which makes it easier for companies to borrow money, and makes companies more likely to buy back shares to boost EPS on the back of low-interest corporate debt.
The same is true for European and Asian banks- markets are currently propped up on low interest rates. Interest rates continue to be kept fairly low, because inflation has stayed low and hasn’t forced their hand to push interest rates up.
And a main concern with interest rates being so low, is that whenever we do have the next recession, the Fed won’t have as many tools to boost the economy, because interest rates will already be low during a time that a recession begins.
However, with interest rates being kept low for long, it’s not out of the question that this could be a longer, more tepid U.S. expansion, hitting 10+ years. If inflation remains low, and the Fed keeps interest rates low, who is to say how long an expansion could last?
That’s why my portfolio, using a lot of cash-secured puts, is positioned to continue to benefit from growth, while also being prepared for a correction. It’s designed to make decent money in an upward or flat market, and to protect some capital should stocks fall quite a bit.
I’m less concerned about how far we are into the expansion, than I am about the high CAPE ratio of the market itself; that’s a far more reliable indicator of long-term market performance.
Four Things that Are Suddenly Cheaper
With the macroeconomic ponderings out of the way, here are some noteworthy events recently that made some investments become cheap.
In February, silver was at over $18.50/ounce. Today, it’s down to about $16.70. That’s a pretty nice 10% dip.
Of course, it was over $50/ounce back in 2011, when precious metals were in a bubble.
Gold, meanwhile, has been relatively flat between February and today.
Long story short, I’m a buyer of silver at these prices, and I’ll buy more if it falls more. For more detail, see my portfolio below.
Grocery Store Stocks
This past Friday, it was announced that Amazon agreed to buy Whole Foods, the large chain of supermarkets that sells organic and natural products.
The result is that the following stocks, and other grocers, were crushed in the course of a few hours:
- Walmart down almost 5%
- Target down over 5%
- Costco down over 7%
- Kroger down over 9%
- Supervalue down over 14%
When this happens, my natural inclination is to look to see if there are bargains to be found amidst the rubble.
Does the event of Amazon buying Whole Foods truly justify the loss in billions of dollars in market capitalization from those other companies, just because investors were spooked by the possibilities? Amazon hasn’t even announced what their plan is here.
Walmart, Target, and Costco are diverse store chains that happen to also be large grocers, with Walmart in particular being the largest grocer in the United States.
Costco continues to be a growth story and a very well-run business, but it’s very expensive in terms of price-to-earnings, so I won’t focus on that one. It became cheaper on Friday, but it’s still a very highly-valued stock.
Target and Walmart are the ones running into some growth issues, as Amazon and other online retailers eat away at their market shares. Amazon buying a large high-end physical grocery chain, and becoming an even more direct competitor to these two companies, is a shot across the bow.
However, even troubled companies can become attractive investments if bought at the right price. Of all of these names, Target appears the most interesting.
- Target has grown its dividend for 49 consecutive years without fail, straight through 7 recessions.
- The company remains profitable, and the dividend payout ratio remains under 50%.
- The current dividend yield is now around 4.7%.
- The balance sheet is moderately strong, with reasonable debt levels and good credit ratings.
- Their online sales are growing. The same is even more true for Walmart- they’re entering the digital space while Amazon is entering the physical space.
- Target is now trading for a price-to-earnings ratio of 11x, and a price-to-free-cash ratio of about 7x.
- The company is aggressively buying back its own shares, meaning the lower the stock price, the more shares they can buy for the same amount of money, which directly boosts EPS.
- By selling cash-secured puts and covered calls, Target stock can make you a lot of money even if it stays flat or continues a downward trend, as long as their earnings don’t truly fall apart.
Over the last 12 months, Target made $2.7 billion in net profit, and $4.7 billion in free cash flow, and yet it only has a market capitalization of $27 billion, because the valuation is so cheap. Amazon, meanwhile, made $2.5 billion in net income and $9.4 billion in free cash flow over the same period, but has a market capitalization of $480 billion.
I don’t necessarily view Target as an underdog success story here, and do not advocate investing heavily in the mess that is retail at the moment. I used to shop at Target for years, but haven’t set foot inside one of their stores for a long time, since I get many of my goods now from Amazon and Amazon’s subsidiary Zappos. Whether it’s organic matcha tea, sardines in a can, summer sandals, or rented movies, I buy just about everything via Amazon. And that’s the story for millions of people.
However, a cheap, profitable company, buying back its own shares, with high-priced options available for sale, is something to consider. It’s hard to say if Target is a value trap or a value play, but I lean towards the latter. Walmart is a bit safer, due to its wider moat and greater online success thus far, but at less deep of a discount.
Tech Stocks (kind of)
Over the last week, tech shares have broadly taken a more modest hit, with no obvious catalyst that analysts can identify.
- Texas Instruments dropped from over $84 to under $80
- Apple dropped about $155 to $142
- Google (Alphabet) dropped from over $980 to under $940
- Microsoft dropped from $72 to $70
- Intel dropped from around $36.50 to $35.20
- Facebook dropped from $155 to $150
Some of them may have had specific catalysts, like Apple had an analyst downgrade their price target from $160 to $150. But overall, there is an unanswered mild tech sell-off, and many of the companies had no fundamental reason. I consider it a good thing, because it relieves some of the high valuations in this sector.
Many of these companies are still not particularly cheap by absolute standards, but the sudden reduction is interesting. If you happened to have any of these stocks on your watchlist, now’s the time to take another look.
I used the dip to go long on Texas Instruments and Microsoft, using options to reduce the cost basis to below current market prices.
I recently had an article published on Seeking Alpha about Texas Instruments here, if you want more detail. The summary is that I believe the company is very well-run, but the valuation is on the high side.
Magellan Midstream Partners LP
Magellan Midstream Partners LP (NYSE: MMP) is a 5%-yielding master limited partnership that transports crude oil and refined products, with 16 consecutive years of higher distributions, and has grown distributions at a compounded 12% annual rate. They have among the least leverage of pipeline companies, and have no incentive distribution rights to pay, meaning up to 100% of cash is available to limited unitholders. This gives them a capital advantage compared to pipeline companies that still pay a lot of their cash as IDRs to their general partner.
I made a lot of money on Magellan back in 2015-2016 during the energy price crash, shortly after their unit prices dropped from $86 to under $60, despite the fact that they had only about 15% of their profits exposed to commodity prices. That’s when I went long, and MMP’s units eventually recovered to back over $80/each, because Magellan was one of the most rock-solid tollbooth-style investments around. They aim for reliability, rather than maximizing everything.
As of early 2017, I no longer had a position in MMP. Now, oil prices are slipping again, and Magellan units have steadily slid from a high of over $81 earlier in 2017, to just under $70 now. The same remains true today- almost all of Magellan’s profits come from transporting and storing oil and refined products, with only about 15% exposure to oil prices.
It’s an MLP I’m keeping my eye on, and may end up initiating another position at some point.
My Portfolio Updates
In addition to having a large portion of my money in broad, low-cost index funds (stocks and bonds), here are my current real-money active investments:
The purpose of my active portfolio is to further diversify into other areas that are not covered by my index funds, such as precious metals and REITs, to maintain positions in certain key companies I’ve followed for many years (like Brookfield Asset Management and Traveler’s Companies), and to have better risk-adjusted returns in an overvalued market with income-generating options and international dividends.
Brookfield Asset Management, Traveler’s Companies, the iShares International Select Dividend ETF, VF Corporation, and Ventas were all positive for the portfolio in recent months.
VanEck Vectors Oil Services ETF has been in the red lately.
HollyFrontier has been a bit of a mixed bag, but the investment remains above my committed cost basis.
Silver is interesting, because I’ve been waiting for a pullback there. I’ve been selling profitable cash-secured puts on the silver trust for quite a while, which were not exercised. Now that silver took a dip, my latest round of options were exercised, so I was assigned shares of SLV. I then sold covered calls on those shares at a higher strike price ($18) than I bought them for, to generate income while I hold them.
Since the previous issue, Qualcomm rose in price a bit, and I rotated capital out of Qualcomm, and into Microsoft and Texas Instruments.
Virtual ETF Portfolio Updates
Each issue, I update a virtual portfolio that focuses on ETFs and options.
Here’s the current portfolio:
For reference, the S&P 500 is at 2,433.15, and the S&P 500 TR is at 4,695.23.
For this issue:
- The SPY position increased in value due to beneficial option price decay.
- The VNQ position expired slightly in the money on Friday, and so the shares were bought for $85/each. Counting the option premium, this was a profitable investment thus far.
- In response to the VNQ position being exercised, I’m selling covered calls at a strike of $88 for January 19, 2018, at the current bid price of $1.75/share.
- The IDV position increased substantially, as shares climbed to $33.45 from $31.16.
- The GLD position slightly improved due to beneficial option decay.
- The SLV position decreased in value mildly due to the fall of silver prices. There’s a decent chance this will expire in the money in July, and in that case, the portfolio will own 400 shares, and I’ll sell covered calls on the position.
Whether you stick to pure index funds, or venture into more active investments, I think diversification is more important than ever, due to the high market valuations in the U.S. economy.
It’s a pretty good idea to own:
- Domestic Stocks
- International Stocks
- Real Estate (direct ownership or REITs)
- Precious Metals
The next newsletter issue will likely be in late July or early August. In the coming weeks I plan to write an article about my specific approach to precious metal investing, because it’s a bit different than how many people do it, and generates a substantial amount of income rather than focusing on capital gains.
Enjoy your summer!