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Tom Armistead
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I'm a well-informed retail investor and post on SA in order to expose my thought process to critical examination and comment from readers. It makes me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that encouraged me to... More
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  • Is The Market Safe At Current Levels?  7 comments
    Jan 28, 2013 8:19 AM | about stocks: SPY

    For many years, I've tracked the level of the S&P 500 as a proxy for the market, using a ratio between the index and GDP as a measuring tool. Last week, the market crossed a brightly painted line - 1,498 on the S&P 500, which is the midpoint value by my methods.

    Measuring Market Level

    For an explanation of this line of thinking, here's a link to an article I wrote in October 2011. Here's the current output of this model:

    (click to enlarge)

    From a common sense point of view, with the market at its 50th percentile, there is no compelling reason to invest in stocks - nor is there any compelling reason to avoid them. For long term investors, it's constructive to look at expected returns, and weigh them against the risk of loss. For the purposes of this article, I'm thinking in terms of expected one year returns.

    When the market is between 10 and 50 (out of 100) in terms of market level, capital appreciation for the next year averages 10.5%. From 50 to 90, it averages 3.5%, to which one could add the dividends. So we have now crossed the threshold into an area of lower expected returns, something on the order of 5.5% to 6.0%. There is no market level that doesn't have a positive expected one year return.

    Measuring Risk

    A primary cause of negative equity investment returns is financial stress. Here is financial stress, as measured by the STLFSI:

    (click to enlarge)

    I did a study on this topic, and published the results here on Seeking Alpha. Here's a table, relating stress level to forward returns, again for one year:

    (click to enlarge)

    Briefly, when financial stress is between 0 and -1, forward returns are very attractive at 11.8%, and positive 85.7% of the time. That's the power of the Fed. By way of a cautionary statement, when financial stress is extremely low, forward returns are negative. That's the Fed for you, or lack of prudential regulation of financial services.

    Business Conditions

    Let's take a look at business conditions, as measured by the Philly Fed.

    (click to enlarge)

    Conditions are positive. As a practical matter, one year forward returns are not as sensitive to business conditions as one would imagine. They are better when conditions are above average, 0 to 1, and poorer when below average, 0 to -1, but nothing to hang your hat on for investment decision making. Again, a cautionary statement: when business conditions are extremely good, one year forward returns are poor.

    Investment Implications

    Financial Stress and Business Conditions portray relatively low risk, and are at levels associated with acceptable one year forward returns. Market level is at the midpoint, and at a level associated with relatively weak forward returns.

    I've been transitioning my portfolio from an emphasis on Deep Value toward a strategy based on selecting from among stocks with Dividend Growth credentials. Based on my interpretation of the information discussed above, I expect to have time to make the transition in an orderly fashion. Meanwhile, I'm building a hedge with deep in the money S&P 500 puts, while volatility is low and premiums are affordable. I add to the hedge each time SPY advances by $1.

    Themes: Market Outlook, Risk Stocks: SPY
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Comments (7)
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  • Robin Heiderscheit
    , contributor
    Comments (1875) | Send Message
     
    Thanks for the update Tom. There hasn't been a better time since early 2007, based on volatility prices anyway, to build a cheap multi month duration hedge through out of the money puts.
    28 Jan 2013, 02:29 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5308) | Send Message
     
    Author’s reply » Robin, glad you liked the update.

     

    I haven't done out of the money puts to hedge for some time, mostly on affordability grounds. As you say, with VIX where it is, that type of hedging is less expensive than it has been.
    28 Jan 2013, 02:43 PM Reply Like
  • jimmy46
    , contributor
    Comments (1804) | Send Message
     
    Hello Tom,
    Thanks for an interesting overview of the market as a whole,
    the thing I find most interesting/curious,
    is that from table 1,
    the market doesn't spend much time in the middle range,
    investors seem to be manic depressives pushing the S&P average
    to one extreme or the other.

     

    But there does seem to be a paradox here,
    with the market in the 50-60 range,
    the expected 1 year return is only 3.7%,
    BUT, the market only stays in this range 4.43% of the time,
    less than 1 year in 20,
    which would make me think the market WILL bolt one way or the other.

     

    Is the 3.7% return an average of extreme numbers,
    or more or less ordinary distribution?
    ie does the SD indicate it's a meaningful average?

     

    Or could we have the choice of either up 33.7% or down 30%?

     

    Given that the market has been climbing a wall of worry for the last 4 years, and the FED still has the pedal to the metal,
    I'd be inclined to think up is more likely than down.

     

    You don't mention level of volatility,
    what correlation if any is there to the market levels you present in table 1?

     

    Would the present low volatility be indicative of a move in one direction or the other?

     

    Cheers
    jimmy
    29 Jan 2013, 05:39 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5308) | Send Message
     
    Author’s reply » jimmy, the 50-60 has the highest standard deviation of all the deciles. It seems like the market motors on through, in either direction, or at least that's what happened in the past.

     

    I didn't have to think about what to do when the market would go past the midpoint, at least not until lately, for the fact we haven't been there for a long time. So this article is me thinking out loud, what now?

     

    I feel as if the low financial stress, and the Fed with the pedal to the metal, sets the stage for further market advances.

     

    Just speaking for myself I played the market to get past the fiscal cliff smoothly, so results last year and so far this year have me to a point where I'm starting to play defense. At the same time, I regret not being more aggressive as the rally continues, so I'm sort of hoping for some sort of correction.

     

    I don't have as many covered calls sold as usual at this kind of market level, but I am getting tempted.

     

    Never a dull moment,

     

    Tom
    29 Jan 2013, 06:04 PM Reply Like
  • Freekizh
    , contributor
    Comments (182) | Send Message
     
    Tom, your articles are very thought provoking and practitioner orientated! I follow you and somehow missed this article. Just spent the last hour running your numbers on Market Levels, and got stuck replicating them.

     

    Then I realized you must be using nominal GDP instead of real GDP: was expecting to write a critique on you using RGDP, but shame on me instead :) This is a nice long-term line to consider, and am still analyzing the basic idea.

     

    Initially I think it will provide a good BUY signal, but maybe not a timely sell signal on its own because inherently you are relying on low frequency economic data unless you are willing to sit out of the market for long periods of time. Also GDP is not trade-able, so you cannot arb the conditions explicitly according to that ratio. The return characteristics within each market level need to be better understood since you have a classic non-linear "smile" there, making the strategies from this signal a little more complicated.
    9 Feb 2013, 07:54 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5308) | Send Message
     
    Author’s reply » Freekizh,

     

    You are correct that I'm using nominal GDP. I was just looking back at an earlier article I did using this methodology, "Market Level vs. Market Timing" and I noticed that I haven't been consistent in using the same time period to look back for the mean and standard deviation. In the earlier article, I used 10 years, in the current one I used 20 years for market level.

     

    The indicator is sensitive to the length of the look-back period, a short-coming.

     

    I'm a relatively long-term investor so while this indicator had the market level at less than the 50th percentile my thinking was simple enough, expected returns are good and I can just hold through the soft spots and lean against the wind a bit with hedging.

     

    I didn't work dividends into the return calculation, which would have been helpful. Particularly at the lower market levels dividends are a meaningful increment of performance. Also, when averaging returns there are several ways to do it.

     

    For market timing, I'm hypothetically not a timer, I maintain to work off level. As a practical matter if I have an opinion on short-term direction I feather my positions accordingly.

     

    One idea I've played with off and on is to make market participation proportionate to market level, ie if the market was at the 10th percentile I would be 90% invested in equities, etc. The problem is, you could sit out several years of a bull market, very frustrating.

     

    I lean toward staying invested most of the time, on the grounds returns are positive most of the time. I suspect that knowing when to just get out of the market is more a question of street smarts than anything a nice tidy logical model like this can develop.
    9 Feb 2013, 08:44 PM Reply Like
  • Freekizh
    , contributor
    Comments (182) | Send Message
     
    Tom, I had similar conceptual problems a few months ago as you regarding whether you could correlate market participation with "market level". That's why the return characteristics of your model output need to be analyzed. I especially agree with your last paragraph - to stay vested most of the time, especially clear if you look at nominal values, unless something tells you very explicitly to get out.
    9 Feb 2013, 10:04 PM Reply Like
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