Blind Squirrels And A Nuts Investment Environment

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Includes: DIA, IWM, QQQ, SPY
by: Andre Weisbrod

Summary

Multiple unsuccessful attempts to forge new highs over the past year indicate that an aging bull may be at or near its end.

Economic conditions are mixed and at times data is confusing or contradictory.

Three of the forces holding up stocks up are suspect.

There may be nuts out there, but they might not be ones even a seeing squirrel might like.

ADDITIONAL SUMMARY POINTS

· After a fearful swoon at the beginning of the year, most stock markets are back in positive territory.

· While we did some buying and increased equity exposure during the dip, we were not confident enough to be aggressive.

· Overall market valuations are above average and possibly in warning territory.

· Large volume computer-generated trading has turned the stock market into a rigged casino that is against traditional fundamental investing.

· The huge expansion of ETFs and the trend toward "robo" investing create new market influences that could actually increase risk and hurt investors.

· Three of the forces holding up stocks up are suspect. One could evaporate with a negative event or a funky algorithm gone haywire. The second compounds the first and creates greater future risk. The third is a ruse, plain and simple.

· This is a time to err on the conservative side.

[I'll try to not be too long and analytical in this article. Extensive back-up (and disagreement) for my thoughts can be found by conducting Internet searches for other articles and data.]

Market Behavior, Last 20 Months: The behavior of the stock markets has been at best fickle over the past 20 months. Consider this chart of the S&P 500 since it hit a low on October 15, 2014 and up to June 6, 2016.S&P 500 Daily Oct. 15, 2014-June 6, 2016

Note the sideways trading range. There are two major bottoms with a third in the middle. These would normally be called corrections in a bull market, and the two bottoms do form a good support line. But the more telling part of the chart is the series of tops showing that new highs are a struggle. Technically, if the market fails here, it will likely fall again and test the previous lows. If it can break through, another leg up becomes more likely, but one has to wonder how far up it could go before creating a dangerous bubble.

Economic Conditions: This economy is hard to evaluate. Statistics can be confusing and even misleading. The official jobless rate looks excellent, but doesn't tell the real story. The labor participation rate is terrible. Mean wages have not been increasing adequately, but if you factor in an influx of younger workers into the labor force, it isn't so bad. United States GDP growth is modest, but still positive in a 2.0-2.7% range. 3-4% is needed to even come close to keeping pace with increasing debt. Growth and financial health of many countries is teetering or already recessionary. A few countries, such as Venezuela, are imploding. Puerto Rico is bankrupt and they are our territory under our supervision. Burgeoning debt threatens U.S. national financial integrity, especially as the government continues to favor printing more money out of thin air than doing the harder things to get back to more "normal" balances between interest rates, inflation and business activity, as well as stimulating true business growth. "Easy money" usually results in greater borrowing and increased risk. Increased systemic risks are also present in the high ratios of derivative "values" to actual values of the assets upon which they are based. A run on the derivatives markets could cause a chain reaction that could make 2008-09 look like a picnic. There are other areas not addressed here where data and ramifications are confusing and sometimes at odds. Simply, I would submit that we are at best in an "in between" economy with greater than normal risk factors.

Stock Market Valuations: Determining whether stocks are overvalued, undervalued or just right is at best a debatable subject. But there are ways to approach valuation using some historical guidelines, correctly evaluating trends and a dose of common sense. The historical average trailing 12 months (TTM) Price/Earnings ratio (PE) is around 16.7. According to Standard & Poor's May 31 fact sheet, the current ratio is 23.62 and if calculated today is about 24.4. Being somewhat optimistic about earnings, S&P projects a future ratio of 17.26. We are not as positive. We are seeing a trend toward companies reporting that they met or even beat earnings estimates, but missed revenue projections. If revenues slow, it will be harder to maintain earnings going forward. Other measures such as price to book ratios (2.75 now vs. 2.73 historical) tell us that the large company U.S. stock market is somewhat overvalued, though not at "bubble" levels. Small companies are another matter. TTM PE for the S&P Small Cap 600 is 68.62, but their forward projection is 18.83. That seems very optimistic to us. The key here is our view of future revenues and earrings as they are impacted by economic growth, technology and other factors. Our common sense tells us that risks are probably higher than potential rewards over the near future.

Large Computer-Generated Trading and Other Games Large Firms Play: Here's a question. How can the stock price of a good company vary 20% in an hour or two when there has been no news or any fundamental changes in the company? Or how can similar price changes occur with an indexed ETF? This is not investing; it is a game played by well-heeled traders who are able to move prices by high frequency trading, often using computer algorithms. Such games are destabilizing markets and hurting traditional investors and managers. It is both unfair and poorly regulated. And it increases risks. If I were a benevolent dictator I would remove a huge part of market risk by instituting one rule: Whatever you buy you must own it for 24 hours. There could be some exceptions, perhaps, but they should be indeed exceptional. If you can't own it for 24 hours you are not an investor. Investment markets are supposed to exist for the orderly capitalization of and ownership transfers within the economy. They need to be level playing fields and work for the overall good. They should not be a private casino for a privileged few. And one more part of my rant: The very term "dark pool" should cause concern. For a good and revealing read, I recommend the book "Flash Boys" by Michael Lewis.

Exchange Traded Funds and "Robo" Managers: If you haven't guessed by now, I am a traditionally oriented investment advisor. Mutual funds used to be a slow moving long term way for smaller investors to accumulate wealth. It required discipline and patience, but over the long haul it paid off. The traditional mutual fund was one of the greatest investment inventions. Traditional separately managed accounts allowed managers to create long-term portfolios of good individual stocks according to clients' objectives. This also worked well. Here's the problem: With thousands of ETFs and more hitting the markets almost every week, the index funds must invest in the stocks of the indexes. When there is high trading volume of ETFs, that creates higher trading in the underlying stocks. The math surrounding all these ETFs is staggering and it could adversely affect the overall markets and economy. Add the "Robo" managers, which are the lazy person's solution and introduce a new set of risks. Let's say the day traders' algorithms and the Robo algorithms happen to create the same "sell" signal at the same moment for large blocks of stocks or ETFs. The force of all those trades hitting at once could create the Armageddon of market crashes. This stuff may look brilliant and even work for a season, but in a crisis I would much rather have my own hands on the wheel of my car than in the control of a faceless machine that could be corrupted by any number of unforeseen occurrences. The broker-dealers are promoting these because they won't have to think much and the machines will create income via the promised simplification to investors. We'll see how they do when the next crash hits. Of course that crash might just take all the hands-on drivers with it, too. I think it is past time for the government to take a serious look at this. I'm generally a proponent of minimal government, but when the entire game is threatened, the refs and the rule makers better step in, call the fouls and consider rule changes.

Three Suspect Forces Buttressing Stock Prices: 1. Lack of Alternatives. The first is simple - there aren't many other places to put your money right now. Interest rates assure you a negative real return after inflation and taxes in money markets, CDs, bonds and fixed annuities. Gold and silver have been volatile and big losers since 2011 before the recent rally, and that seems to be hitting resistance along with stocks. Real estate is the best other alternative and there are signs that prices are getting relatively high also. 2. Increased leverage. Artificially low interest rates and massive government borrowing have created stimulus but it is likely to cost us down the road. Not only has the government mortgaged the future, but companies have increased their debt ratios in recent years. Private sector debt, especially in the real estate sector is not as bad as in 2007 but it is significant. There are indications that some companies are using creative debt and fancy accounting to buttress short-term appearances rather than focus on reality.Stock Buy-Backs Simplified 3. Stock Buy-backs. Consider the accompanying chart. What has changed? Only that the company is actually less valuable than if it kept the cash. Here's a stupid idea: USE THE CASH TO CREATE MORE GOODS AND SERVICES TO INCREASE REAL VALUE! If you think most of these stock buy-backs are great ideas, then I might be able sell you some ocean front property in Arizona.

Blind Squirrels: It is said that even a blind squirrel sometimes finds a nut. But what if it isn't a walnut, but a hex nut? On a short-term basis, trying to beat the big computers without a big or bigger computer is tough. In the end, a company's or property's worth in three years, five years or ten years will be based on its success in delivering goods and services and usefulness with profitable results. Focusing on the last quarter, week, day or hour is a trend that forces investors to often look at the wrong information. Day traders aren't helpful. Stock buybacks don't create real value or growth. Increased debt creates more risk.

Success is not based on short-term whims and random emotions or even artificial intelligence. Companies are valuable because people work hard and think hard to create value over years, not seconds. Forget that and we could lose everything because of short-term fascinations and machinations.

The Caution Flag is Up: Sometimes you feel like a nut, especially when you suspect the nuts seem to be in charge. Government policies and growing leverage are increasing risks. Stock valuations seem high, especially if revenue growth stalls. Against these factors the U.S. stock markets will find greater resistance to gains. We think another short-term correction is likely, and if economic growth forecasts prove overly optimistic, a new bear market is possible. Therefore we have increased our cash positions. As Will Rogers put it, "I am less concerned about the return on my money than I am about the return of my money."

(Note regarding foreign stocks: We think many foreign markets and stocks are better values than U.S. and if the dollar falls over time, foreign stocks could more attractive. But overall they are likely to follow the U.S directional lead short term. On a long term basis we will not ignore healthy country indexes and stocks in those countries since they may have a better upside potential than U.S. stocks.)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I did not mention any particular positions. There is nothing to disclose except that we own a wide variety of stocks, ETFs and mutual funds and that we have recently raised our cash positions.