InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
MAY 9, 2018
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
We close out the recent thread on near-term prospects for The Economy and Markets in this issue of IntelDigest.
As we have written in recent weeks, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years.
But, we believe that the next recession is inevitable, not imminent.
Last week, we listed a number of factors which Investment Analyst Louis Navallier has set out to support the proposition that stocks will continue to “Melt Up” for the next few months.
Today, we will discuss valuations and yields, and begin to lay the groundwork for “transitioning” our portfolios to an era of high risk.
Valuations
Stock prices have, generally, been on an upward path for nine years. This has been an unusually long bull market. And, stock valuations have become unusually pricey … at least, based on historical measures of value.
However, as we have posited in prior issues of IntelDigest, stocks have NOT been overvalued or overly expensive when Interest Rates are taken into account. This nine-year time period has been characterized by an ultra-low Interest Rate environment which is totally unprecedented.
Therefore, we are not deterred by the perceived-high valuations as stock prices “Melt Up” in the coming months.
Earnings Yield
Yield is an important component in measuring the valuation of an asset. Calculating the Earnings Yield on a variety of investments allows us to easily compare them.
As an example … if your bank were paying you a yield of 5% on your cash on deposit, you would keep your money in the bank unless riskier assets … such as stocks and bonds … could top that rate of return. We calculate the Earnings Yield on equities investments by comparing Earnings-per-Share to the Price of a share of the stock.
Looking at the markets at the turn of this century, one could earn a yield of 6-7% on a U.S. Treasury bond. Meanwhile, the Earnings Yield in the stock market was around 4%. As a result, many investors in the year 2000 were happy to earn 6% safely in bonds, which was better than a 4% return in riskier stocks
What is the best choice here in 2018, as we near the end of a nine-year bull market? The Earnings Yield on stocks (around 6%) is double that of Treasury bonds (just under 3%). Stocks have been a “no-brainer” for several years.
By the beginning of next year, most investors will be jumping to the safety of Treasuries.
Near-Term Markets
First Quarter earnings of the largest corporations have been better than expected; indeed, companies have had an historic 1Q, based on earnings. However, the response in the markets has been tepid, as the prospect of a recession over the horizon constrains investors.
A few trends can be gleaned from the numbers. First, the markets are favoring those companies which have posted strong sales and earnings, with strong positive guidance. Strong earnings aren’t enough. The forward guidance has had to signal strength in 2Q or 3Q.
Second, companies which have not provided strong forward guidance have seen their stock prices slide for a few days. But, typically, strong companies saw their stock prices rebound thereafter.
The market actions/reactions illustrate that so much of trading these days is computer-centric, and highly reactive. As many human market-makers have been replaced by computer algorithms, stock price moves in reaction to news and earnings reports are immediate. Computers don’t think, they react.
So, investors would be wise to stay calm in the face of frantic market moves, and allow a few days for prices to revert to mean. If some of your stocks are becoming too volatile, it is worth staying calm, and waiting for opportunities to sell into strength.
Where To Go Next
We are making plans for the transition from bull market to bear market. As we wrote last week:
The next few months will likely be the last opportunity for growth in equities for the next several years. So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.
One indicator which we are studying is The Wedge Pattern. Trading ranges in the equities markets have been getting tighter … as the prices of stocks go up and down over time, the highs are getting progressively lower, and the lows are higher.
On a stock chart, this creates a wedge-shaped pattern. When the point of the wedge becomes evident, there can be a steep run up in stocks, or a steep dive. Because economic conditions are currently at the best level in years, and there are still many Billions of Dollars on the sidelines (held by U.S. and foreign investors), we interpret the wedge as pointing to a final blow-out higher in the equities markets this year.
We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August. As we expect the markets to stay strong in the next few weeks, we’ll try to sell into strength before mid-Summer.
This doesn’t mean that we are leaving equities entirely. We expect that strong, “boring,” income-yielding companies can form the basis of one’s portfolio in the coming bear market.
Exit Strategy
However, it is important to devise an Exit Strategy for each and every asset in your portfolio. We recommend establishing a Stop Loss level for each asset; the Stop Loss is the exit price where you will sell your position if the price drops that low. The Stop Loss can be a specific dollar price, or a percentage loss from the highest price which a stock has attained.
By setting Stop Losses and executing them without emotion, one can methodically cut losses, while allowing winners to ride.
Later in the Spring, we will devote an issue of IntelDigest to the subject of Income Investing in the coming bear market.