- Not every stock is going to do what you think it'll do during the next correction.
- Many "high quality, large cap, blue chips" are 30-50% more expensive than they were during the last cyclical peak.
- There's significant downside if the economy slows down and the earnings supporting these valuations weaken.
- The best places to hide during the next market correction are generally less popular right now.
The market is headed for a nasty correction.
I haven't a clue when it'll happen, of course. It could happen later this summer or it could happen in the year 2017. Or 2027! It may have already started. Who knows.
Corrections and bear markets are perfectly normal. They happen all the time. They're unavoidable and a natural side effect of the way that markets work.
While we can't predict with much accuracy when these will happen, we can develop strategies to deal with them in advance. Good risk managers always identify the emergency exits before the building catches on fire.
In the equity world, I think we'd all agree that the single dominant approach since 2011 has been "Buy the Dip." We've had an environment of relative economic stability, powerful stimulus tailwinds, and little competition from other asset classes. Most importantly, it's been one of the friendliest environments in history for corporations to grow profits. This has been an era to be long and to get longer when the market drops.
The good news is that that's an easy strategy that anybody can employ. Anybody who's not afraid to get into the market, that is. If you're not in the market now, it's hard to imagine what will bring you back -- another crash in gold or an explosion from 2.6% to 4% on the 10yr? Who knows. The best argument that we're still a ways from the cyclical market top is that psychology still hasn't peaked.
The bad news is that the "buy the dip" strategy isn't going to work forever. And the longer it keeps working, the tougher it is to try something else. Nevermind the fact that sideways and bear markets require a whole lot more skill to manage as it is.
This is what I want to talk about today. When the correction does come, what strategies will we need to lean on? How can we prepare ourselves in advance?
While the "NO DUH, DUMMY" solution is obviously to adopt some sort of asset allocation approach to keep your portfolio from totally blowing up, I want to focus strictly on the world of stocks. It's a different market than it was in 2007 or 2001 and I'm not sure everyone understands or appreciates that.
Here's our action plan:
- We'll start by looking at the basic backdrop for stocks.
- Then we'll look at some individual names.
- Then we'll design some simple strategies to keep our profits rolling but insulate us from the biggest losses.
Let's get to it.
Part One: Setting the Stage
It isn't just prices that are much higher today than they were after the last washout, it's valuations.
Today, though, let's think about this in terms of earnings yield. This is a more intuitive way of understanding what kind of long-term risk/reward proposition stocks are at any point in time. It also makes it easier to contrast them with other asset classes like real estate or bonds.
For context, let's start with a look at the general environment:
The earnings yield today is pretty good! Or rather, it's good relative to the last couple of decades. It's around 5%.
You'll notice the funky skew, I'm sure. This is the "Fed Model" that we've all heard about and was popularized in the 90's. Something happened a while ago, and this model sorta broke down. Turns out, other factors influence our appetite for various assets aside from just yield.
This isn't tremendously useful, but if we look at forward earnings yields, we can make the concept slightly more relevant to an investor. This is assuming that analysts get it right with their forward estimates.
This chart explains much of the action we've seen in the market the last few years.
The reason why the market keeps going up and up and up isn't because of the "money-printing" or the "rigging" or whatever meme is popular at any given moment. Stocks keep going up because the forward earnings yield has been consistently awesome.
You can also see that bonds aren't much competition to stocks in terms of yield. But that trend is changing somewhat. Interest rates have risen, and the forward yield on stocks is contracting ever slightly.
It's the absolute reading that matters, though. If you buy into S&P's estimate that earnings will be $124 next March, it's a forward yield of 6.6%. That's pretty darn good.
There are a few problems with this perspective. The first is the "if you can predict forward earnings" argument. For the most part, analysts do an OK job with this, at least for the market as a whole. But things can change quickly, and when recessions strike earnings disappear and the earnings yield collapses.
That's why there are big troughs in 2001 and 2008. If you can see those coming, you can avoid a lot of losses. And if you know when the recoveries will happen and how big they'll be, you can catch some huge gains. There might not be a single more valuable piece of market knowledge than knowing what reported earnings will be for the S&P 500 one year from today.
Investors have made two gigantic mistakes in the last decade. Everyone talks about the first mistake -- we were far too enthusiastic in 2007, far too leveraged, and not fully appreciative of the systemic risks.
The second epic mistake gets less attention. Investors didn't believe that corporate earnings could recover. The forward yield on stocks in the summer of 2009 was 7.6%. In the August 2010, it was over 8%. Just as we were too caught up in the enthusiasm of 2007, we were too caught up in the pessimism of 2009.
In the next chart, we'll normalize the earnings yield by averaging the next three years of earnings. That will smooth things out a bit. For the most recent three year period we'll use a blend of actual earnings and projected earnings from S&P.
Now this chart is how you make money! This is the cyclic indicator we care about, the one that gets us into stocks in '95 and out in 2000. It tells us to go long in 2003 and pull the plug in 2007.
It's telling you to be long stocks right now.
As of today, the forward three year normalized earnings yield on the stock market is around 8%. That's pretty darn good, as high as we've seen since the 1980's which was an environment where investors simply abhorred stocks (and crazy-high inflation had a huge influence on nominal earnings). Those were also the days when bonds gave equities pretty stiff competition in terms of yield.
This 8% forward yield requires you to believe the following things:
- Earnings for 2014 will be $114 as S&P currently projects
- Earnings for 2015 will be $139 as S&P currently projects
- Earnings for 2016 will experience a similar rate of growth.
In other words, the stock market is a really good buy right now if the economy never slows down and earnings keep growing at a 10-15% clip. You might think that a PE of 17x is a bit rich, but it isn't. Not if earnings grow at the rate that analysts currently project.
This is all just another way of re-stating the same thing I've been saying ad infinitum for the last couple of years. The only risk that really matters is recession. (Technically, the end of negative real rates is another significant risk, as is sweeping policy change impacting the corporate landscape.)
But that's it. As long as there's no recession on the horizon and real interest rates are negative at the front and middle of the curve, investors need to be long stocks. Don't make this more complicated than it needs to be. Short-term crises of confidence need to be aggressively bought, as long as the first two factors remain intact. None of this other mumbo jumbo makes much difference in the grand scheme of things.
So, this is where you can stop reading.
If you believe the S&P projections and believe the current Fed rate hike schedule, you can stop right here. Just keep owning the market. Keep buying stocks indiscriminately, especially the cyclical names and higher growth names.
But if you don't buy into those assumptions, or you're seriously interested in the art & science of managing risk, read on.
Part 2: Places to Hide
In the abstract, establishing a defense for this type of risk is relatively simple. If you are concerned about the future earnings power of the market -- whether that's due to a recession, changes in policy, or knock-on effects from higher interest rates -- all you have to do is shift your focus to individual stocks.
All you have to do is choose stocks whose earnings power will be less impacted by those macro-economic factors or select stocks whose earnings yield is currently high i.e. their valuation is low. Ideally, investors should blend those two objectives. The best companies to own during bear markets are those whose earnings power stays relatively intact and who weren't trading at a high valuation in the first place. It ain't rocket science.
In practice, this is much tougher than it sounds. It's always a little tougher to find those types of companies than you'd think. Plus, the market has been partying pretty hard for the last few years and it's psychologically challenging to be sitting in defensive laggards while the rest of the market soars. It's really hard not to chase beta right now, even if it just means adopting a passive strategy like buying the whole S&P or the (NYSEARCA:VTI) and forgetting about everything else.
Don't forget, though, that's also like driving with the rear view mirror. Just because the growthier, higher-multiple section of the market has performed the best during the last few years doesn't mean it will over the next few. What does past performance have to do with anything?
Isn't it the future we care about?
Now, I know what you're saying. You're saying this is happening already.
And you're right. This is happening. Since March, "Value" has handily outperformed "Growth".
That may be indicative of some meaningful risk on the horizon. It might mean that the market is rejecting forward earnings forecasts and getting more defensive. Or this may just be a short-term thing. It may be just because a handful of the growthiest stocks have been obliterated in the last few months.
It goes without saying that super high multiple stocks like Netflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA), Amazon (NASDAQ:AMZN), and the like will be terrible places to store value in a correction. If you're skeptical about the earnings trajectory for the economy, you simply cannot own stocks like this. (Conversely, if you buy into long term 15% earnings growth, giddyup. You probably should own these names.)
But these aren't the only stocks that are trading at strangely high multiples. Plenty of "blue chip" equities feature really low earnings yields.
|Company||Current PE||Current EY||2006-2007 EY|
|Johnson &Johnson (NYSE:JNJ)||19.2||5.2%||6.8%|
|Proctor & Gamble (NYSE:PG)||21.8||4.6%||6.1%|
|Coca Cola (NYSE:KO)||21.8||4.7%||5.6%|
The list goes on and on. These have been the most popular stocks in the market, and with good reason.
This isn't arbitrary date picking, either. 2006-2007 represented a cyclical peak. That's as expensive (or low yielding) as those stocks got before the market corrected.
We think of companies like this as places to hide during bear markets. We shouldn't. Not now.
Yes, they were a great place to hide during the last bear market:
But I'm not convinced they will be during the next.
The constellation of fundamental and macro-psychological factors are totally different than they were in 2007. Before the last bear market, these blue chips all traded at meaningful discounts to the market. Today they all carry startling premiums.
Every major bear market in history was feature a few really important events and factors that nobody saw coming. Perhaps this is it. Perhaps nobody sees just how vulnerable these large cap blue chips are.
If the market drops 30%, these companies could get cut in half.
Ready for the first strategy that'll knock you off your rocker? I'd rather own the whole market than a select basket of "large cap blue chips" during the next major bear cycle.
Seriously. That might be one of the most contrarian things an analyst could possibly say right now.
The fact that it might just be fundamentally correct as well means that this is the type of situation where outsized alpha is possible.
This is the secret macro equation for mega-profits:
Contrarian + Fundamentally Correct = Huge Success
The "large cap blue chip" trade is also super crowded right now. A lot of that has to do with past performance. Investors -- particularly institutional investors -- are more gun shy in the post-crisis days. They all studied past performance and came to the conclusion that large cap blue chips were the best way to protect capital in equities (and also happened to be easy stories to sell to their clients).
What's happened is that they've bid them up to prices that are now contingent upon extreme, everlasting earnings growth. I love Nike if the corporate world can keep growing the bottom line at 15%. But a stock like that could blow up if factors outside Nike's control come together to eviscerate those earnings the way they were in past recessions.
If you own these stocks or other stocks like them, you really need to ask why.
Do you care only about the long run? Are you in it for the year 2024?
Are you in them because you can't bring yourself to own a mid cap you may never have heard of like Elbit Systems (NASDAQ:ESLT) whose earnings yield today is 7.5% vs. 6.3% in 2006? I know nobody wants to own cyclical retailers during corrections but Kohl's (NYSE:KSS) has an earnings yield of 7.2% today vs. 5.8% in 2006. They arguably have a defensible retail model in environments of macro weakness, too. The fact that they aren't really leveraged to the rest of the economy the way someone Macy's (NYSE:M) is could explain why KSS has gone nowhere and M has bounced back and then some.
Can you think of a tougher trade to sell to your branch manager than Long Kohl's and Short Macy's right now? But during the next major market drawdown or economic rough patch, that trade could knock it out of the park.
These are hugely unpopular ideas right now.
Let's look at some others.
Part 3: How to Find Places to Hide
Under this same framework, here's a sample of some stocks that may be much more effective at preserving capital when it all goes down:
|Company||Current PE||Current EY||2006-2007 EY|
|L3 Communications (L3)||13.8||7.2%||6.2%|
|URS Corporation (NYSE:URS)||14.4||6.9%||4.8%|
That's not an exhaustive list by any means. But that gives you an example of what to look for. Their earnings yields are all superior to the market, and I'd argue these are the types of companies who can still protect that earnings power in adverse climates too.
Seek out specific companies with:
- Above-market earnings yields,
- Whose businesses are also good bets to hang in there during an economic slowdown and,
- Whose earnings also have a high probability of rebounding back to where they were prior to the correction.
That's your strategy. Go forth and manage risk and protect capital.
I think you can do this strategy one better by also focusing on stocks with strong dividend yields. Value plus Dividends gets plenty of play here at Seeking Alpha. But consider AT&T (NYSE:T) as an example. They sport an earnings yield right now of 9.3% to go with a dividend yield of 5.0%. Is T an exciting place for growth? Hardly. Is it a good place to preserve capital? Absolutely.
BP's (NYSE:BP) forward earnings yield is 9.9%. Their dividend is 4.6%. Will their sales stay relatively intact if the economy were to start slowing down tomorrow? I'd make that bet.
Stocks like these are a must in any truly defensive portfolio.
Alternatively you could just hide in the market. Relative to where it was at its last peak, it isn't any worse a place to hide than it was. And it could even be a better place to hide than some of these really expensive blue chips.
But who knows, right? Maybe it's worth it to chase high-priced quality in such a low interest rate environment. Maybe Nike makes sense at a 3.95% earnings yield. With the 10yr Treasury at 2.65%, why not?
Here's another thing: interest rates make these high quality names doubly vulnerable.
As rates rise, the yield on these companies' earnings will become less attractive. That situation can resolve itself the exact same way that bond markets do. Prices drop which makes yield rise.
Their stocks are also more vulnerable to economic hiccups. If the earnings underpinning these historically expensive valuations weaken, there's further to fall than in true value names.
These are two really critical points of risk management that most investors are flat-out ignoring.
How big a a premium are you willing to pay for quality if you can find competitive yields in Treasuries or IG paper?
How invincible are these companies' earnings and will they really grow at a rate over 15% per year?
Whoever has the answer to those questions stands to make a lot of money in the next 3-5 years.
None of this is to say these stocks are no good. To the contrary, these blue chips are the best stocks. These are the companies you really want to own over the long run. They're the ones whose brands dominate the landscape and they're the ones that enjoy advantages of all shapes and sorts.
The problem is that when the correction comes, I don't think they're going to perform the way you think you will. They're not going to preserve capital the way they have in the past.
Blue chips aren't an absolute, perpetual proposition. It matters what you pay for these things. I hate using catch-phrases like "priced to perfection," but these types of stocks really are. They'll be fine if we get a good economic outcome. But most of the upside is priced in and nobody is willing to talk about the risk. We just assume they'll be fine because they were last time. The last time was totally different, though. On the doorstep of the last bear cave we explored, these blue chips really were good values with great earnings yields.
At the very least, ask yourself why you own these stocks. Is it to preserve capital? Is it because they're easy to talk to your clients about? Is it because there's safety in numbers? Is it because you think these historically expensive blue chips represent the best opportunities for growth?
Ask yourself what kind of investor you are. I'm the type of guy who believes it's actually safer and more profitable to be a contrarian. Are you fully prepared to do something unpopular if the data suggests it may be the best way to protect your capital?
There's nothing that'll get more strange or critical looks right now than calling out the "large cap quality" trade. The support for these types of companies is fierce, and with legitimate reason, too. It's been an amazing thing to watch.
Just don't confuse these stocks with value.