Category: Stocks

A Fundamental Approach to Technical Analysis

A Fundamental Approach to Technical Analysis

This was an article that I submitted to RealMoney, but was rejected because it was not relevant enough to “retail investors.” I offer it to you for your consideration. It was the follow-up piece to this article: The Long and Short of Trend Investing.

Throw in the Short Run

But now let?s move to the technicals of the situation. Given that I am a longer-term investor, this doesn?t play as great a role for me as other investors at RealMoney, but I don?t ignore it entirely. I simply view technicals through a fundamental framework. I have described this in the following articles, which still have value today, in my opinion:

1. Managing Liability Affects Stocks, Pt. 1

2. Separating Weak Holders From the Strong

3. Get to Know the Holders’ Hands, Part 1

4. Get to Know the Holders’ Hands, Part 2

(As an aside, I would simply say that technical analysis, as construed by most technicians, does not work on average. Most technicians die the ?death of a thousand cuts,? as they take multiple small losses. Successful technicians have something fundamental going on, whether they realize it or not.)

Institutional investors run most of the money in the market. Most of them have been trained to think in valuation terms exclusively, and so they set buy and sell prices for their positions. This influences even small investors, because of the impact of sell-side research. Almost every buy or sell recommendation comes with a price target. The sell side analysts often issue new buy or sell when a price target they have been looking for occurs.

But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, ?It takes two to make a market.? Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually ?no,? but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.

As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you?d be amazed what they will tell you?. Here?s a stylized example.

Broker: ?You sure you want to buy that Washington Mutual bond??

Me: ?Yes, why??

Broker: ?Uh, there?s someone with size selling the name.?

Me: ?How much size??

Broker: ?Best indications are eight times your order size.?

Me: ?I can?t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I?ll take the tail [everything that?s left].?

Broker: ?You got it.?

But suppose we don?t have any idea what the intentions of the seller are. We would have to be more humble, and try to infer from the chart what his methods are. Does he put a ceiling over the stock price, and only sell when it gets to a certain level? Or is he a ?mad bomber? that keeps selling regardless of the price level? Looking down the holders list, can I figure out anyone who might be incented to sell so much, and so aggressively? Who is disappointed at present that has a trading style like the group that is selling the stock?

Does he sell in dribs and drabs, scaling over time? Does he do a series of block trades? Is he using some sort of quantitative selling strategy that incorporates both time and price? These are the questions that I try to answer as I strategize my trading. It doesn?t give me perfect information, but it aids me at the margins.

So, say after your analysis of the technicals, you think the stock will continue to go down for a while, or won?t rise because the seller is big, seemingly larger than you can take down. Still, you like the company at the present valuation levels. What do you do?

You could sit on your hands, and wait out the seller. But what if you?re wrong about the size of the seller? The stock could move higher before you get a position on if the seller is smaller than you anticipated. Remember, other traders are watching the big seller also, and they will be waiting for him to be done as well.

You also could buy your full position immediately. After all, you have firm convictions about the secular trends and the stock?s valuation. Timing is for losers, and we are fundamental investors. Well, okay, but what if you are wrong, and the seller is right? Or, what if you like the idea here for the long run, but you would buy even more at lower prices? As Bill Miller has put it, ?Lowest average cost wins.?

Again, we could put on half the position and wait for the seller to be done. I like that, but are there alternatives? We could estimate the size of the seller (imperfectly), try to figure out how long he will be around and do a time-based scale where we put on 80-90% of a full position over that estimated time period. We also could do a price-based scale, and try to estimate (even more imperfectly) how much the seller will drive down the price before he is done. Buy 25% of a full position now, and then scale the remainder of what would be 80-90% of a full position down at the price you the seller gets exhausted at.

These strategies are illustrative, and meant to show the range of ways that one can balance off fundamental conviction versus the technicals of the market. In general, price scales work better when you think the seller is valuation sensitive, or other buyers are showing up in size to gobble up the seller?s supply at a given level. In the absence of that, time-based scales are the proper strategy if you have some confidence in the timing of the seller. Failing all of that, my humble strategy is to buy half and wait. It will never be perfect, but if I am right on the fundamentals, the results will be good enough.

The “Fed Model”

The “Fed Model”

Recently there has been a discussion of the so-called ?Fed Model,? with some questioning the validity of model, and others affirming it. Even the venerable John Hussman has commented on models akin to the Fed Model that he dislikes. This piece aims at taking a middle view of the debate, and explain where the Fed Model has validity, and where it does not.

What is the Fed Model?

The Fed Model is a reasonable but imperfect means of comparing the desirability of investing in stocks versus bonds. It can be considered a huge simplification of the dividend discount model, applied to the market as a whole, rather than an individual stock. The dividend discount model states that the value of the stock is equal to the future stream of dividends discounted at the corporation?s cost of equity capital.

What simplifying assumptions get applied to the dividend discount model to create the Fed Model?

  1. The market as a whole is considered rather than individual stocks.
  2. A constant ratio of earnings is paid out as dividends.
  3. The growth rate of earnings is made constant.
  4. A Treasury yield (or high/moderate quality corporate bond yield) is substituted for the cost of equity capital.
  5. Instead of following a strict discounting method, the equation is rearranged to make an explicit comparison between bond yields and equity yields.

Assuming that the dividend discount model is valid, or at least approximately so, what do these simplifying assumptions do to the accuracy of valuing the market as a whole? The first assumption is more procedural in nature, and does no major harm. The fifth assumption simply reorganizes the equation, and doesn?t affect the outcome, but only the presentation. The real changes come from assumptions 2-4.

Dividends are more stable than earnings, so the payout ratio certainly varies over time. Additionally, corporations have shown less willingness to pay dividends, and investors have shown less inclination to demand dividends, to the payout ratio today is roughly half of what it was in the early 60s.

Fed Model Chart 3

Earnings don?t grow at a constant rate, either. Over the last 53 years, earnings have grown at a 6.7% rate, but that has included times of shrinkage, and boom times as well.

Fed Model Chart 4

As for the cost of capital to a corporation, I believe that the Capital Asset Pricing Model is genuinely wrong, and I refer you to Roll?s famous critique for what should have been its burial. Academics need risk to be something simple though, with risk being the same for all investors (not true), so that they can easily calculate their models, and publish. The CAPM provides useful, if mistaken, simplification to financial economists. It is not going away anytime soon.

One day I will write an article to explain my cost of equity capital methods in more depth, which derive corporate bonds and option pricing theory. In basic, for any corporation, the basic idea is to compare the riskiness of the equity to that of a bond. Look at the yield on juniormost debt security of the firm, the cost of equity is higher than that. Examine the implied volatility [IV] on the longest dated at the money options for the firm. How do those implied volatilities compare with other firms? In general the higher the IV, the higher the cost of equity capital.

Practically, when looking at the capital structure of the firms in the S&P 500, I think that the yield on a BBB bond plus a spread could be a good proxy for the weighted average cost of capital for the firms as a group. I?ll get to what that spread might be in a bit. We have BBB yield series going back a long way. Equity risk for the S&P 500 (a high credit quality group) is probably akin to the risk of owning weak BB or strong single-B bonds on average. (My rule of thumb for cost of equity capital in an individual corporation is take the juniormost debt yield and add 3%. For those with access to RealMoney, I have written more on this here.)

To summarize then: there?s not much I can do about assumptions 2 and 3. The only thing I might say is that earnings are a better proxy for value creation than dividends, and that expectations for longer-term earnings growth do not change nearly as much as actual earnings growth does. On assumption 4, a BBB bond yield plus a spread will be a reasonable, though not perfectly accurate proxy for the cost of equity. My view is that spread should be between 2.5%-3.0%.

The Results

With that, the ?Fed Model? boils down to a comparison of BBB bond yields less a spread versus earnings yields. Wait, ?less? a spread? Didn?t I say ?plus? above?

Let?s consider how a stock differs from a bond. With a bond, all that you can hope to get is your principal and interest paid on a timely basis. With equity, particularly in a diversified portfolio, one can expect over the long term growth in the value of the business from a growing dividend stream, and reinvestment of retained earnings. As I mentioned above, that has averaged 6.7%/year earnings growth over the past 53 years.

If I were trying to balance the yield needed from bonds to compete with equities, it would look like this, then:

Earnings Yield + 6.7% = BBB bond yield plus 2.5-3.0%

Or,

Earnings Yield = BBB bond yield – 4% (or so)

Here is how earnings yields and BBB bond yields have compared over the years.

Fed Model Chart 5

Thus my criteria for investing would be under the ?Fed Model,? when the earnings yield is more than 4% less than the BBB bond yield, invest in bonds. Otherwise, invest in stocks. Following this method, how would a portfolio have done since 1954?

Fed Model Chart 1

Wow. Pretty good rule, in hindsight. Is the spread of 4% the best spread for simulation purposes?

Fed Model Chart 2

Pretty close. The optimum value is 3.9%. This chart uses an actuarial smoothing method to give a fairer view of noisy historical results. (Life actuaries use this smoothing method in cash flow testing to calculate required capital, because sometimes small changes in spread produce large differences in the results for a particular scenario.)

The strategy produces a return roughly 2.0%/year higher than investing in stocks only, with a standard deviation roughly 1.5%/year lower. At least in a backtest, my version of the ?Fed Model? works.

Limitations

Okay, given the above, I endorse my version of the ?Fed Model? as being useful, but with five caveats:

The first thing to remember is that the ?Fed Model? doesn?t tell you whether stocks are absolutely cheap, but whether they are cheap versus bonds. There may be other more desirable asset classes to choose from: cash, commodities, international bonds or equities, etc.

The second thing to remember is that when interest rates get low, yields do not reflect the true riskiness of bonds ? a slightly superior model would be 107% of BBB yields less 4.7%. But that could just be an artifact of backtesting. To its credit though, the slightly superior model behaves the way that it should in theory, in term of how credit spreads move.

Number three, ideally, all models would not use trailing earnings yields, but expected earnings yields. That said, trailing yields are objective, and expected yields have often proiven wrong at turning points.

The fourth limitation: a high earnings yield might reflect low earnings quality or profit margins higher than sustainable. No doubt that is possible, and particularly in the current era. On the flip side, there may be times when a low earnings yield might reflect high earnings quality or profit margins lower than sustainable. A rule is a rule, and a model is only a model; they don?t reflect all aspects of reality, they are just tools to guide us.

What P/E ratio would the current BBB bond yield (6.74%) support? I am surprised to say that it would support a P/E in the high 30s; 39.8 for the simple model, and 35.2 for the ?slightly superior? one. With the current trailing P/E at 18.1, that would indicate that on an unadjusted basis, the market could be twice as high as it is presently.

That thought makes me queasy, but here three other ways to look at it:

  • How inflated are profit margins? If they are going to regress by less than half, then stocks are still a bargain.
  • Are bond yields/spreads too low? The recycling of the current account deficit into US debt instruments keeps yields low, and the speculation in the credit markets keeps spreads low. What should be the normalized BBB yield?
  • Will earnings growth slow beneath the 6.7% average? If so, the spread needs to come down.

Fifth, this is simply a backtest, albeit one that conforms to my theories. The future may not resemble the past.

Conclusion

My version of the Fed Model provides us with a way of comparing corporate bond yields with earnings yields, giving credit for growth that happens in capitalist economies that are free from war on their home soil. There are reasons to think that current profit margins are overstated, and perhaps that corporate bond yields will rise. All of that said, there is a large provision for adverse deviation in the present environment.

I would rather be a moderate bull on stocks versus bonds in this environment as a result. Don?t go hog wild, but current bond yields are no competition for stocks at present. If you think bond yields will normalize higher, perhaps cash is the place you would rather be for now.

Portfolio Reshaping Mid-Year 2007, Part 3

Portfolio Reshaping Mid-Year 2007, Part 3

Time for my most recent portfolio changes. The reshaping is complete, here is the data file and here are the qualitative details:

 

Buys

 

  1. Arkansas Best [ABFS] — Inexpensive, and trucking is out of favor. Trucking should pick up with the economy in the second half of 2007, and as the dollar cheapens, trucking is needed to get the exports to the ports.
  2. Deutsche Bank [DB] — Cheap major European bank. I’m light on financials (though if I lost my restrictions you would see a lot of insurance in my portfolio). 9-10x earnings for the next two years seems too cheap for me. Can they have that much exposure to the same problems faced by Bear Stearns? Maybe, but the valuation compensates for that.
  3. Gruma SA [GMK] — Inexpensive, and a play on the growing middle class in Mexico. Also a play on the growing popularity of Mexican food in the world. I don’t have a lot in consumer staples, so this helps.
  4. Mylan Labs [MYL] — returning to a name I last owned in 1988. Inexpensive generic drugmaker. I have nothing in healthcare, so this diversifies me a little. Generics are unlikely to fare badly as the branded pharmaceuticals should the Democrats win in 2008.

 

Sales

 

  1. Sold Komag [KOMG] because of the merger, and the arb premium (amount of incremental gains from holding on until deal consummation) was less than what I could earn in cash.
  2. Sold St. Joe [JOE], and I wish I had sold when one of my colleagues explained their likely troubles to me one month ago. St. Joe is going to have it tough for a while because they don’t have a lot of ways to generate cash, without selling property, and the land market is not as good as it was two years ago.
  3. Sold Sappi [SPP]. The glossy paper market, like other fiber markets faces their share of challenges. Demand is sluggish, and likely to stay that way for a while.
  4. Sold a little of Lafarge [LR]. Still have a position there. It’s had a nice run, so I rebalanced down to my normal target weight.

 

With these moves, I am back to 35 positions, up from 34. I am running with 16% cash, which is high for me. At the beginning of the year, I reinvested and brought cash down to 5% of the portfolio, but good investment results, combined with rebalancing has brought the cash back, and then some. If the cash hits 20%, I will raise my normal portfolio position size, and move cash to 10% or so. Maybe we get a pullback?

 

What I did not sell

 

  1. SPX Corp — the turnaround continues. For now, honor the momentum.
  2. Noble Corp — Hey, I just bought this last during the reshaping; I am not kicking it out so soon, no matter how well it has done.
  3. Sara Lee — the turnaround continues. No momentum here; maybe management will succeed. A few of their ideas seem to be on target.

 

What I did not buy

 

Many more entries here. As I worked down my list, I kept saying, “Cheap for a reason… cheap for a reason…”

 

  1. Too small: Charles and Colvard, PAM Transportation
  2. Don’t care for the industry: Chipmos Technologies, Finish Line, Foot Locker, Encore Wire, First Consulting, Freightcar America, Korea Electric, and Metrogas
  3. Already own something that I like better in its industry, and don’t want to increase exposure: Crystal River and MVC Capital (both interesting, though I like Deerfield better)
  4. Irregular operating history: Optimal Group and Northgate Minerals
  5. Tyco International is not as cheap as the data would indicate because of the recent spinoffs.

 

After I finish this, I will adjust the portfolio over at Stockpickr.com.
Full Disclosure: Long SPW NE SLE LR GMK DB ABFS MYL

Reasons For Short-Term Optimism

Reasons For Short-Term Optimism

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn?t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.

So with that, here?s my quick list on what is going right in this environment:

  1. Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
  2. The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn?t happened in size yet.
  3. ECRI?s weekly leading index continues to make new highs.
  4. Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
  5. Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
  6. Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
  7. Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don?t involve too much of a haircut. (I?m not talking about subprime here.)
  8. On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
  9. Sell-side analysts are more bearish than they ever have been.
  10. Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
  11. The FOMC is unlikely to tighten before it loosens.
  12. Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
  13. DB Pension plans and endowments are still willing to make allocations to private equity.
  14. The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
  15. Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
  16. The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven?t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Editing note — my apologies.? The second paragraph omitted the word “not” in the original publication.? What a word to omit, not. ??

Efficient Markets Versus Adaptive Markets

Efficient Markets Versus Adaptive Markets

The Efficient Markets Hypothesis in its semi-strong form says that the current market price of an asset incorporates all available information about the security in question. Coming from a family where my Mom was a successful investor, I had an impossible time swallowing the EMH, except perhaps as a limiting concept — i.e., the markets tend to be that way, but never get there fully.

I’m a value investor, and generally, over the past fourteen years, my value investing has enabled me to earn superior returns than the indexes. A large part of that is being willing to run a portfolio that differs significantly from the indexes. Now, not everyone can do that; in aggregate, we all earn the market return, less fees. The market is definitely efficient for all of us as a group. But how can you explain persistently clever subgroups?

Behavioral finance has been the leading challenger to the efficient markets hypothesis, but the academics reply that behavioral anomalies are not an integrated theory that can explain everything, like the EMH, and its offspring like mean variance analysis, the capital asset pricing model, and their cousins.

Though it is kind of a hodgepodge, the adaptive markets hypothesis offers an opportunity for behavioral finance to become an integrated theory. First, behavioral finance is a series of observations about how most investors systemically misinterpret investment data, allowing for value investors and momentum investors to make money, among others. The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

Consider risk arbitrage strategies for a moment. Arbitrage strategies earned superior returns through 2001 or so, until a combination of deals falling through, and too much money chasing the space (powered by hedge fund of funds wanting smooth returns) made it less worthwhile to be a risk arb. It is like there were too many fishermen in that part of the investment ocean, and the fish were depleted. After years of poor returns money exited the space. Today with more deals to go around, and fewer players, risk arbitrage is attractive again. No good strategy is ever permanently out of favor; after a strategy is overplayed to where the prospects of the assets are overdiscounted, a period of underperformance ensues, and it gets exacerbated by money leaving the strategy. Eventually, enough money leaves the the strategy is attractive again, but market players are slow to react to that, becaue they have been burned recently.

Strategies go in and out of favor, competing for scarce above-market returns in much the same way that ordinary businesses try to achieve above market ROEs. Nothing works permanently in the short run, though as a friend of mine is prone to say, “There’s always a bull market somewhere.” Trouble is, it is often hard to find, so I stick with the one anomaly that usually works, the value anomaly, and augment it with sector rotation and the remainder of my eight rules.

Now, I’m not a funny guy, so my kids tell me, but I’ll try to end this piece with an illustration. Here goes:

Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.
Scene Two — Adaptive Markets Hypothesis, Part 1
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.
Scene Four — Adaptive Markets Hypothesis, Part 3
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.
Scene Five — Adaptive Markets Hypothesis, Part 4
An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

It was a Good Quarter; Also, my Favorite Managers

It was a Good Quarter; Also, my Favorite Managers

It’s good to be back home with my wife and kids. There truly is no place like home, particularly when things seem to be working well with my wife and kids.

Two quick notes, because I’m kind of tired:

  1. I wondered at many points this quarter whether I would beat the S&P 500 or not. Not counting my unpaid dividends and interest, I can say that I was ahead by 110 basis points for the quarter, bringing the year-to-date figure to 590 basis points. I don’t expect to win every quarter, and not every year either, but the streak is at six years now, and I hope to prolong it. Let’s see how I do at the next portfolio reshaping, which should come this week.
  2. One of my readers asked for my favorite mutual fund managers. Here they are: Marty Whitman at Third Avenue, Ron Muhlenkamp at the Muhlenkamp Fund, Don and Craig Hodges at the Hodges Fund, Ken Heebner at CGM, and Bob Rodriguez at FPA. (There are other value managers I like as well, Tweedy Browne, and Heartland Value, to name a few. I am a value guy, but I like rotating sectors.)

All of these managers are willing to look for cheap assets, and sectors that are undervalued. That’s what I do, and my record is comparable to theirs, though I run a lot less money.
Here’s to a great second half of the year. Let’s make some money together, or, at least not lose more than the market.

Another Win for the Broad Market Portfolio

Another Win for the Broad Market Portfolio

Well, score one more for my portfolios, Komag is being bought by Western Digital for $32.25/share. This was a remarkably quick win, given the initial purchase back in late March, and a rebalancing buy in late May.

Investments rarely work this quickly, but I am grateful when they do. In the last portfolio reshaping back in March, I put more weight on EV/EBITDA, and Komag scored well there. I’ll be selling Komag at the portfolio reshaping, which should take place in the next two weeks.

I sometimes mention that my investment methods allow me to be away without worrying too much; this closing week of the quarter is one more example of that, at least, so far.

PS — On another note, wasn’t it interesting today to see the market get excited about the supposedly dovish FOMC language, and then sell into the reality that nothing had changed?? I chuckled; people expect too much of the FOMC…

Full disclosure: long KOMG

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

As part of my 2-part project on the Fed Model, I want to give you the results of my recent investigation. This is the simpler of the two projects. A little while ago, Bespoke Investment Group published two little pieces on the relationship between the yield curve and the absolute level of the S&P 500 over short time periods. (You can see my comments below what they wrote.)

My data went from April 1954 to the present on a monthly basis. I regressed the yields on the three and ten-year treasuries, and a triple-B corporate bond spread series on twelve month trailing earnings yields for the S&P 500. The regression as a whole is highly statistically significant. Except for the t-statistic on the 10-year Treasury yield, the other regressors have t-statistics that are significant at a 95% level. I only did two passes on the data, because I didn’t realize until later that I had the spread series… in the first pass that did not have the spread series, the ten-year yield was significant.

Anyway, here are the statistics. What this says is that in the past trailing earnings yields tended to:

  1. decline when BBB spreads rose
  2. rise when three-year treasury yields rose
  3. rise when parallel shifts of the yield curve up
  4. rise when the yield curve flattens, with no adjustment in the overall height of the curve

The last three observations make sense, while the first one does not, at least not on first blush. Typically, I associate higher credit spreads with higher E/Ps, and thus lower P/Es, because tighter financing is associated with a lower willingness for equity investments to receive high valuations. I’m not sure what to do with that last observation; perhaps it is that my practical experience exists over the last 20 years which have been different than the whole data sample. Or, perhaps my readers will have a few ideas? 🙂

As for the main current upshot from this admittedly limited model is that current trailing E/Ps, and thus P/Es, are fairly valued against current treasury yields and bond spreads. Here are two graphs that illustrate this:

Clean yield slope graph

messy yield slope graph

The nice thing about these graphs is that they easily point out the stock market undervaluation relative to bonds in 1954, 1958, 1962, 1974, 1980, 1982, and September 2002, and overvaluation relative to bonds in 1969, early 1973, 1987, and March 2000 and March 2002. Now this model might have suggested staying in bonds for most of the 90s, but the 90s were a relatively good decade to be in bonds, though not as good as equities.

This is the first time I have done a post like this, and so I put it out for your consideration. Comments?

Portfolio Reshaping Mid-Year 2007, Part 2

Portfolio Reshaping Mid-Year 2007, Part 2

Here are my current industry ratings.? Using my Bloomberg Terminal, I? ran a screen looking for cheap companies in those industries.? The result yielded eight tickers:

ACO CONN GMRK HES NSIT PDE SMRT SSI

I also added in the top 12 tickers from the last time that didn’t make it into my portfolio, and aren’t on the current list.? Here are the tickers:

ABFS [DBK GR] FINL FL GGC HERO [NGX CN] PTSI RADN SNSA URI WIRE

If you have other stock ideas for me, let me know (post a comment!).? Remember that I am a value investor.? I like them cheap.

Aside from any names that readers might give me, my list of possible replacements is done.? All that is left is to run my valuations/technicals model, and think about what to but and sell.? Early next week, I will run those models, and make the decisions by Independence Day.

Portfolio Reshaping Mid-Year 2007, Part 1

Portfolio Reshaping Mid-Year 2007, Part 1

Well, the second portfolio reshaping of the year has begun. To refresh your memory on what I do here, you can review this short post. Here are the tickers from my initial stack, candidates to replace my current portfolio:

ABY ACI ACTU AFN APA ARLP ASEI BBG BHP BLX BMI BOW BTU BVN C CBE [CMB PE] CMC CNX CQB [CRY CN] CRZ CTHR CTL CVX CWEI CY DELL DNR DVN DVR EMR EOG EPEX EPL ERF ESV FCGI FCX FRD FRO FRX FSS FST FTO GIFI GMK GMR GSF GVHR GW GYI HHGP HNR IDCC IMMR IMOS INTX IO IR ITW IVAC KAR KEP LRCX LRW [LUN CN] MEOH MGS MKSI MLR MRO MTL MVC NAT NBL NBR NFX NR NRP OMM OPMR PCZ PH PRKR PTEN PVX PWE R RDC RDS RGS RIG RIO ROK RRC RSH S SHOO SPH SPI STZ SU SWKS TAP TLM TPL TSO TX TXI TYC UNT UNTD UPL WCC WDC WFC WIN XTO

If you have ideas, post them in the comment section of this post.? I’ll be running my industry model and an additional screen to generate a few more tickers, and then the comparison to my current portfolio. I should have more later today. Till then.

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