Could This Market “Die of Old Age”?

I was struck the other day by an article by Byron Wien, vice chairman of Blackstone Advisory Partners. He recently wrote that in his view, the market could keep going for some time – perhaps into 2019 – because the usual factors that warn of impending bear markets are simply not in evidence at this time, and that markets do not die of old age. There is no inverted yield curve, he observes that retail investors are not euphoric about equities as they were in 2000 and 2007 for instance, hedge fund net exposure shows a mood of caution, the leading indicator index has been climbing steadily since 2016, corporate earnings have been increasing, and he asserts that strong business activity exists in the US, Europe, Japan, China and India. There is a lot of investor complacency, as evidenced by the very low VIX index readings, but as long as the economy continues to grow, he thinks that maybe that is not all that negative. Under those circumstances, a major crash-and-burn kind of stock market outcome seems to be unlikely in the near or even intermediate future. Since I myself have been cautious about the markets, and continue to be so, it struck me that I am either too pessimistic or Wein is too optimistic – and which is the more likely outcome? I do agree with Wein that the usual indications of a bull market peak are not present. That does not mean that strong bear market indications are absent, however, nor that this market is not very long in the tooth.

At the top of that list of bear market indicators is the lack of intrinsic value as we at my company, Strategic Analysis Corporation, measure it, notably in the S&P 500 and the NASDAQ 100. I recall that early in the year 2000, the S&P reached a valuation in which our Fair Market Value (FMV – our intrinsic value upside/downside determination) fell to zero. It actually bumped against that zero value level three times early in that year before the market finally slipped into the bear market mode that prevailed for the next 2 years into mid-2002. While the clear signs of rampant speculation in the dot-coms may be what most investors and commentators remember about 2000, for me it was the zero FMV potential which is what I recalled most vividly, and which – in my view – was what caused the market to run out of gas. Speculative excess, yes! But I said then and I would say again, I do not think that markets can run on negative energy – which is what they are trying to do now. Wein, of course, has no measure that matches our FMV and is therefore entitled to ignore it (at his peril, perhaps).

A second enormous issue is the massive and continuous efforts by the central banks to prop up markets through Quantitative Easing (QE) which they have been hard at work in executing since the horrific lows of 2008-9. Investors now expect that the central banks will maintain their programmes of stimulation – even if, for a moment or two in time, they falter at this task, or decide to end their current QE programme and replace it with some Quantitative Tightening (“Tapering” or QT) in order to wean the markets and the economy off all of that stimulus. That is thought to be a ‘temporary measure’ at worst, to be repealed at the first sign of serious market weakness. QE, in all of known market history, has never been tried before, and the comforting notion that the Fed will always be protecting the backs of investors is certainly a driving force behind steadily rising market values. I do not know what will happen when the Fed actually tries QT instead, and, as reassuring as their words may be that QT carries ‘no adverse consequences’, “tapering” definitely can not have the same positive effects as “easing” has had (although this proposition has yet to be tested).

Chief among those who claim that they cannot see any market tops in sight are those who observe that there does not seem to be any visibly obvious valuation excesses such as the Nifty-Fifty stocks of the early 1970s, the dot-com stocks in 2000, and the housing bubble which peaked in 2007-8. In some ways, this is the easiest claim to refute because the valuations (in price/book terms) of today of some of the very largest of stock market capitalizations easily match the extremes of the dot-com stocks in 2000. The measured downside risk of most of the FANGS are enough – if they were experienced (again!) – to cause massive losses of investment capital, and the investor pain that goes with it. Facebook carries a forward PE Ratio of a mere 28, while Invidia has a 50x PE Ratio for 2018, Netflix has a 106x PE Ratio, with Amazon being the champion at 138. Amazon, Invidia, and Netflix have all had histories of stunning percentage price declines in weak markets. Apple, another market favourite, is also not immune to huge price declines. The problem with such massively capitalized stocks suffering price declines in line with their own historical magnitude is that they drag down more stocks with them the further that they fall.

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Observing the popular crypto-currency movement as well as the willingness of investors to blindly put their money into vehicles that they don’t understand and can’t measure in any case is to harken back to the Mississippi Bubble era of three centuries ago. As well, with more than 1000 bitcoin issues public right now (and rising steadily), it is looking almost worse than the dot.com market of 2000. Does the world really need all those cryptos and what – if anything – is their intrinsic value in any case? My guess – based on long and sometimes bitter experience – is that most will die in the coming period, the survivors will be seriously tarnished, and the speculators who own them will be severely mauled.

In the meantime, investor expectations appear to be very powerfully optimistic. Merrill Lynch finds that their clients are holding the lowest allocation to cash in the last 13 years. The Market Vane poll show that 71% are bullish and 65% of respondents expect stock market prices to be higher in the next 12 months. There are also a record number of speculator futures contracts which are short the VIX. Technically, at any rate, those numbers are concerning. It is really difficult to assert that investors are anything but rampantly bullish!

Further, I are intrigued by the extremely low VIX levels averaging about 0.3% a day (the measure of volatility of the markets which historically has served to measure the comfort of investors with the valuations in evidence). I vividly recall, for instance, the one-day market crash of 1987 which was preceded by a long period in which the daily fluctuations of the market averaged close to 2%. One day, that 2% change just kept on going – down 28% before finding a bottom (in price/book terms, from about 2 times down to about 1.5 times book in a single day). In other words, that crash was clearly signalled – or perhaps “clearly in retrospect” would be a much more accurate way to put it. Our advice to our clients at the time was “the market is levitating”, although we hardly expected a one-day termination of that condition. Today, there is no obvious parallel between October 1987 and October 2017 in VIX terms, save to observe that an extremely low VIX may be a sign of extreme investor comfort and complacency – for all the reasons that I noted above, especially the promise of Fed intervention should anything untoward occur. Do keep in mind that in 1987 Fed intervention also occurred – vigorously – but not until the day after that market crash. Curiously, the same set of conditions applied then as do now, namely all of those market algorithms that kicked in to sell out investors as the market plunged are alive and well today as trading robots (“bots”), resetting stock allocations on the go, as it were. I am hoping that the automatic stabilizer mechanisms remain in place that were put in place after 1987 – but I doubt it as none have been tested in a real-life meltdown. Simulations, maybe, but reality? Recent one-day “mini-crashes” do not give me confidence that a serious setback will not be exacerbated by all of those bots. And how is one to know when the next “mini-crash” occurs that it is merely an error in someone’s programme or the start of something much more serious? Not that I am expecting anything like another 1987, but current valuations are a sleeping tiger best left unmolested. I do note, however: the market is levitating again.

Evidence that the economy is actually slowing is abundant (although the IMF just raised its 2018 outlook!). Auto sales are long in the tooth and home sales plus auto sales are starting to run in negative territory (below). Like others, I am also wondering if the householder is running out of discretionary spending ability after a 9-year Fed-encouraged spree. However, consumer confidence remains quite positive, thank you very much. The ECRI’s US Weekly Leading Index growth has fallen to a 79 week low, indicating thqt economic growth is as good as it is going to get. (Is this a precursor to much slower conditions – or is this move into negative ground merely a temporary condition?)

picture 2

What about tax reform in the US, however? Surely with corporate taxes coming down, earnings per share would move strongly upwards in 2018-19. That assumes, however, that tax reform is even remotely possible and in the cards. The huge issue with tax reform is how to pay for it – that is to say, what is the offset to slashing taxes for corporations (and the wealthy by inference)? Reforming Obamacare (that is, slashing spending on Obamacare) died aborning, and other alternatives do not seem to appeal much either. Cutting corporate taxes when US corporations are buying back their stock does not really seem to make much sense, and capital spending in the US is quite tepid in any case. I have made the case, complete with the detailed mathematics, in The Limits of Debt (see my blogsite, The Occasional Contrarian) that US GDP cannot grow rapidly because of the very issue that the congressional leaders are concerned about – the size and sheer weight of the US debt on the economy. This would be exacerbated if taxes were to be cut without a balance elsewhere. And in a “lifeboat economy” (my Limits of Debt term) “I” am not prepared to reduce “my” share of the economy only to see “you” get “more”. I fully expect that tax reform will fail to get off the ground.

 

An Elderly Market, With Clear Signs of Aging

And so I come back to my question – how will this market finally reach its end and does it need the kinds of signals and indicators that in the past have been clear precursors of bear markets? I would observe that to a considerable extent, all of the usual precursors are already here. Complacency, mass speculation, and ultra high valuations are already part of the current investment condition. With the Fed trying to pull off Quantitative Tapering, at least one more rug will be removed from under the feet of investors. In medical terms, the patient has a very weak pulse (the VIX), it has no energy to keep going (zero overall intrinsic upside value potential in evidence), and the doctors are actively planning on pulling the life support plug (QT is coming). Personally, I really don’t want to bet too heavily that this sclerotic market is facing a long and healthy life ahead!
But – one last question – how would we “know” when the end finally does come? Does the stock market just lie down and refuse to get up one morning? Like General MacArthur’s ‘old soldiers’, does it just fade away? Or does it suddenly fall by 20% (or whatever)? What about a 10-20 day cascade of prices? I strongly suspect that when the VIX awakens this time, things will not be pretty. Byron Wein can’t see it and the investing public is acting as if there is no end in sight. I would be less than candid if I were to say that I am able to, either. However, the market got here by unusual measures, and its demise should be unusual, too.

What I am doing is what I have done in the past, that is to rely on our valuation measures to tell me when a break is coming. As we did at the break in the market is 1987, 2000, and 2008, I will rely on our technical signals to sound the alarm. Already, the intrinsic potential of the S&P and the NASDAQ are sounding a warning that the market is out of gas. I have not yet seen the technical break that I saw in 2008, but it is close by in percentage terms. A break below the 2400 level (2.5 times adjusted book value, and the ceiling valuation for the S&P for the 2002-8 market period) for the S&P will signal the end of the bull market for me.

For the time being, I have to say that no break has been signalled and that a bull market therefore remains in force, however poorly supported that it may be. I am, however, happy to be defensively positioned with a good cash holding.

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BNN Appearance October 5th, 2017

BNN October 5

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The “Rules” of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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The “Rules of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favour of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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Access to Strategic Analysis Corporation Website

In a way, I must apologize to those who have come to my blog site to read my piece on the Two Dozen Potentially Killer Stocks. There is some SAC nomenclature in there which will not be immediately familiar to the casual reader. However, since most of those who have come to this site have done so because of my exposure on BNN, then you have also heard me use some of the terms that you will have encountered in the TDPKS piece and may wish to learn more about what it is that we at SAC actually do when we analyze a company.

We have a company landing site for those who are interested in our approach to security analysis but do not necessarily wish to approach us directly for more and detailed information. Our site is www.strategicanalysis.ca and has everything that you would want to know about SAC and the background to our services, along with a few short tutorials that will walk you through our techniques in fairly short order.

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Two Dozen Potentially ‘Killer’ Stocks

Severe Valuation Alert (September 2016)

2 Dozen “Quality” Stocks That Could Wreak Havoc in Your Portfolio

One good thing about ­that comes from trying to find value in an expensive market on a regular and ongoing basis is that eventually it dawns on you that among other things, there are an awful lot of stocks which offer very poor value to investors in the sense of any potential increase/decrease to their Fair Market Value (the dotted FMV line on our charts), and yet which the stock market persists in pricing at extremely high valuations (in the SVA price/book sense). When we find a stock that trades at 8 times book value or higher, and whose fair market value is only half of the current price, we have to expect that sooner or later some – or all – of that excess pricing will be taken away. Certainly, based on our experience with our FMV measure, it has had a powerful tendency to attract prices so that when we find that the downside risk of any given stock is 50-70% or more, we can say with confidence that the resulting hole that will be left in ones’ portfolio will be substantial.

When we ran the data for the S&P 500, we discovered, for instance, that 241 stocks in the S&P Index are currently trading with zero to negative Fair Market Value. Now, this is not the bottom of the stock market in a nasty recession that we are referring to, where earnings may have disappeared for the time being and which are likely to bounce back when the economy turns stronger, but eight years into a bull market expansion during which time investor confidence in a number of stocks has vastly outrun the ability of the underlying companies to generate supporting value. Worse, the overall earnings for the S&P 500 have been weakening for 5 quarters running. Of course, the analysts are claiming that 2017 will be a strong rebound year. It will have to be – and in some cases, several more – in order to justify paying some of the prices/valuations that we are seeing. But there is scant evidence that anything like that is remotely possible, save in the imaginations of those forecasting what may well turn out to be impossible earnings.

We have been here before. Only the names of the stocks have been changed to protect the innocently naïve. In 2000, it was high technology with their “for sure” big earnings gains needed to justify their outrageous market price/book valuations. Today, it is Tesla and Netflix among others where big sales and earnings growth are coming – for sure – to justify their massive valuations. Maybe yes, and maybe no – but when the stock market begins to pay for results too many years in advance of their appearance, then it is time for a little prudence to prevail.

When we ran the data for the TSX, of the 230 stocks that we have data for, 130 have zero to negative FMV Potential, with 96 showing actual downside FMV risk potential. We have to underline the reality that nothing is for certain, and just because there is negative FMV potential, it does not mean that a given stock will crater, or even go down. However, in our experience with this measure, when markets do fall, the stocks with very poor FMV potential often do very badly by outperforming other stocks on the downside. The issue is that the same psychology that drove the stocks up way in excess of any semblance of reasonable value, gets turned around against those same winners. We have only to consider the recent experience of Valeant Pharmaceuticals (VRX). When things were going well, management were geniuses, and industry consolidation was the miracle answer to creating value. In the crash, the leverage generated and the questionable goodwill that resulted from high-priced acquisitions saw investors panic when they realized that perhaps there was no, or very little, value at all. Back in 2000, Nortel Networks management created what investors thought was a powerhouse of a company – until investors suddenly realized that they were paying 100 times earnings for a company that was only growing at 15-20% per annum at best (and with a balance sheet equity had virtually all been replaced by goodwill). For the companies that we highlight below, we suggest that you take their bullish “story” and twist it back around and see what you think then. Think about Netflix (NFLX) one of our choices below. Netflix is going to entertain the entire world and is expanding everywhere. Now consider that every telco they are up against is trying to generate content for their own service. Positive earnings are hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, and an FMV potential of -85%, we for one do not intend to find out by personal experience.

In alphabetical order by company name but not by stock symbol, here are the stocks of two dozen major North American companies whose businesses look unassailable and therefore whose stock prices equally ‘safe and secure’ but who history tells us all too clearly, are vulnerable to massive price declines even if not a lot happens to their future earnings.

 

3M Company (MMM- $179.60)

3M has climbed back to its usual extreme valuation high, its SVA Bubble Price (7.4 times adjusted book). Earnings growth has slowed to a crawl over the past 2 years, and although share buybacks have reduced that Bubble Price by about 22%, they appear to have done nothing for the average earnings per share numbers. The Fair market Value (“FMV”) measure is currently 21.3% lower than the market price. Historically, the market has moved the stock above its FMV measure, but also historically, the FMV has always pulled the price back down to and below that critical measure. Without visible growth and an extended valuation, we can see no investment potential for the stock at this time.

Current MV Ratio (Price/book)      7.9x                 Current FMV (+/-)    -22%

 

Amazon.com Inc. (AMZN – $760)

Amazon may be the most problematic of our 24 over-valued stocks because it is not only fast-growing, but also its Fair Market Value based on current earnings forecasts have been rising at a very high rate over the past 2 years – which is due to the massive investment in e-commerce and which is beginning to pay off in terms of earnings and balance sheet growth. Having noted that, the stock is trading at 36.4 times its book value, the PE Ratio stands at 87, and the Fair Market Value of the stock stands at -79%. In the past, the stock has exhibited huge volatility in weak markets and therefore we would have to conclude that the supporting values – however rapidly they are ‘catching up’ with the current price – still represent massive investment risks to investors.

Current MV Ratio (Price/book)      36.4x               Current FMV (+/-)    -79%

 

Altria Group Inc. (MO) – $66.35

This venerable tobacco and now wine company has enjoyed a terrific gain of over 400% from the lows of 2008-9 to the current day. In the process, the share price has moved well above our Fair Market Value (“FMV”) calculation ($42.25) to a level which is 40% above that measure at the present time. The reason that we are concerned here is that in a bear market, that FMV will not only exert strong downwards pull on the price, but also, if the company’s own valuation history has any influence, the market price of the shares will fall well below that measure before it finds a low. It is probably safe to project a good discount to the FMV of about the same degree as the current price exceeds it today. While the company’s earnings have enjoyed a steady increase over that period, the market valuation (in price to book terms) has grown much more rapidly – and therefore can fall just as easily.

Current MV Ratio (Price/book)      24.3x               Current FMV (+/-)    -36%

 

The Coca-Cola Company (KO) – $43.75

In recent years, the earnings growth of KO has slowed not only to a crawl but have actually fallen on a per share basis since 2013. The company has been buying back stock to boot, so the decline is even more startling. The Fair Market Value of KO is well below the current market price such that it is impossible for us to identify any reason for holding this stock, save for a modestly decent 3.2% dividend yield. In the 2008 bear market, KO fell from a premium to its FMV to a good discount and we have less reason to suppose that this time around should be any different because the fundamentals – including a negative balance sheet trend – all seem to be aligned against the investor. The stock reached the same maximum valuation, the Bubble Price or about 8 times book value, that it did at the peak in early 2008, and is now trending lower, as far as we are able to ascertain.

Current MV Ratio (Price/book)      6.4x                 Current FMV (+/-)    -23%

 

Colgate-Palmolive Co (CL) – $74.50

Sometimes, you have to stare in stunned admiration at what the market will pay of a given company, and CL is one such example. Although the balance sheet has been declining for years now, and if stock buybacks were supposed to enhance the earnings outlook in this case, they have not, as the earnings per share have been flat or in decline over the same period, the price/book of CL has reached a 120 times (and a paltry 2% yield). The current FMV potential for the stock is now 58% lower than the market price and so we can only imagine what might happen if market conditions became hostile to growth stocks in general and massively over-priced ones in particular. We cannot say that there is any evidence that the shares are about to do anything except head higher but we do not want to be there if the music ever stops.

Current MV Ratio (Price/book)      129.3x             Current FMV (+/-)    -58%

 

Constellation Software (CSU) – $545 (TSX)

Constellation Software Inc. is probably one of the largest companies ($11+ billion market cap) that you have never heard of. It is a Canada-based company, engaged in acquiring, managing and building vertical market software (VMS) businesses. The Company operates through two segments: public sector and private sector. It is also engaged in the provision of professional services and support. The shares have enjoyed an almost straight up run since 2006 from roughly $22 to $580 with only a modest blip in that trend in 2008-9. For a lot of that time, however, the stock price was lower than its Fair Market Value, which we cannot no longer say today, as the share price now exceeds the FMV by some 45%. Since the FMV does exert a powerful pull on price, any significant market weakness is highly likely to draw CSU towards (and usually below) that value, particularly because the price to book now stands at 18.8, a heady valuation by almost any measure.

Current MV Ratio (Price/book)      19.2x               Current FMV (+/-)    -46%

 

Costco (COST) – $168

Costco has attained a valuation of 5.5 times book last experienced in early 2000, and is trading well above its FMV measure of $110. What is peculiar about this is that the growth in book value has slowed to a crawl (although the earnings per share have managed to maintain a decent rate of annual gain). The shares are now 35% above their FMV measure. The decline from the last valuation peak was severe and we would not expect anything different this time around. The usual low following every bear market has been the Growth Price (‘G’ Price) of the stock which currently stands at $61. Pardon us if we stand aside from this one.

Current MV Ratio (Price/book)      5.5x                 Current FMV (+/-)    -34%

 

Dollarama Inc. (DOL – $99.50)

DOL is untested by the fickle finger of market fate (a bear market) but is already indulging in some stupid capital market moves that will guarantee that downside price pressures – when they come – will be severe, namely the buying back of stock which is diminishing the book value support as well as diminishing the capital available for expansion in the future, and hence its intrinsic growth outlook in the longer term. The company is currently trading at 24.3 times book value, and its current Fair Market Value is 47% below the current price. It may be the only dollar store game in the Canadian market which appears to have given it a cachet that its results and current value to not support. In weak markets, expensive stocks tend to move back to, and then a discount to, their FMV values. The stock could fall to $30, and still trade as what we refer to as a bubble stock (any stock with a valuation above 8 times book). Caution in this Canadian growth favourite.

Current MV Ratio (Price/book)      24.3x               Current FMV (+/-)    -47%

 

Fiserv Inc. (FISV – $102.70)

Fiserv, Inc. (Fiserv) is a major global provider of financial services technology. The shares are currently trading at their highest valuation ever, having recently risen to their Bubble Price (7.4 times book) before setting back very modestly this far. The stock is 21% above its Fair Market Value, having enjoyed a 1000% price gain since 2008. Of all of our choices, changes in payments methodology is enjoying great optimism so this stock may hold up better than most. But is own history tells us that valuation has become extended and the potential markets risks are rising significantly.

Current MV Ratio (Price/book)      7.4x                 Current FMV (+/-)    -21%

 

Home Depot Inc. (HD – $135)

HD is trading at the highest price/book ratio that it is has [ever] enjoyed, at least for the past 25 years. It is also trading at 30% above its Fair Market Value. While the company has “been here before”, it has also had a nasty tendency to fall back to and then below its FMV measure. Worse – from our point of view – the company has been buying back its own stock at very high price/book levels which diminishes its ability to expand in the future while providing very little benefit to ongoing shareholders in the way of increased earnings per share. We admit that we do not know what is going to happen to such companies in the years ahead, but we do suspect that when companies do things that do make economic sense, eventually their shareholders will pay for those mistakes. Just to remain as a Bubble-valued stock (7.4 times book or greater), the shares could currently fall to $57, which offers scant comfort to investors.

Current MV Ratio (Price/book)      17.7x               Current FMV (+/-)    -29%

 

Illumina INC. (ILMN – $169.50)

Illumina, Inc. is engaged in production development of sequencing-and array-based solutions for genetic analysis. The stock has already suffered a fair setback from its peak valuation to its current price/book ratio of 10.8 times, but in the past, the stock has set back to its Fair Market Value measure, which currently stands at -59.5%. The investment risks into what may be late in the market cycle are therefore considerable. Earnings growth has slowed to a crawl over the past year and, should that trend continue, is likely to cause a further decline in the market price of the shares.

Current MV Ratio (Price/book)      10.8x               Current FMV (+/-)    -59%

 

L Brands Inc. (LB – $77.25)

L Brands, Inc. is a specialty retailer of women’s intimate and other apparel, beauty and personal care products and accessories including Victoria’s Secret. The stock has an almost mystical valuation, trading as it does at almost 80 times its book value, although ‘only’ 20 times earnings. If earnings were growing more rapidly, or the business segment more esoteric, we might understand a little better. Furthermore, the book value has not been growing very rapidly either, although that is due to stock buybacks which further inhibits future growth potential. Anything this expensive triggers an ‘Alert’ in our valuation methodology, and this would be a stock that we would cheerfully avoid.

Current MV Ratio (Price/book)      79.7x               Current FMV (+/-)    -46%

 

McDonald’s Corp (MCD – $114.85)

In the 25 years of valuation history that we have for MCD, the shares have exceeded their Fair Market Value measure only once before. What followed was not the sort of experience that any investor on the long side of the market would choose to suffer. So MCD is up there again, and they are cheerfully buying back stock at extreme prices and collapsing the book value support under the stock while their earnings per share growth and hence their Fair Market Value have totally stalled out for the past 5 years. The company could fall to $48 and still remain with what we term a Bubble Valuation of 7.4 times book value or greater – which would be merited (in a sense) by its very high ROE, but that might offer slim solace to the investor.

Current MV Ratio (Price/book)      17.6x               Current FMV (+/-)    -28%

 

Mead Johnson Nutrition Co. (MJN – $83.25)

MJN stock has gone virtually nowhere in the past 5 years, although it has done so with considerable volatility. Even the earnings per share have been quite flat over the same period. At the same time, the price/book per share has been about 100 times, which is to say that there has been no real book value under the share price whatsoever, allowing for a very Fair Market Value (although the share price still exceeds its FMV by some 53%). The company has managed to achieve this feat by dint of having an extremely high ROE on what equity that it does have. To our way of thinking, the shares do not represent investment value in any meaningful way or in any traditional way of analysis. As the shares have only been public since 2009, there are no historical metrics or guidelines to judge the eventual market outcome for the share price in any potential weak market, so any ‘forecast’ of the future price action is purely notional. On the other hand, What parallels that we do have with similar kinds of valuations would not encourage us to be optimistic about the price outcome for MJN over any longer term time horizon.

Current MV Ratio (Price/book)      100x                Current FMV (+/-)    -53%

 

Netflix Inc. (NFLX – $95.20)

Netflix is going to entertain the entire world and is expanding everywhere. But consider that every telco they are up against are also trying to generate content for their own service. Positive earnings have been hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, a PE Ratio of 143 next year’s earnings, and an FMV potential of -85%, we for one do not intend to find out by personal experience.

Current MV Ratio (Price/book)      14.7x               Current FMV (+/-)    -85%

 

Nike Inc. (NKE – $60.25)

NKE has only traded up this high – at its Bubble Price or 7.4 times book value – only twice before in its past 25 years of valuation history, and both times came to an unfortunate conclusion for investors. It has also only traded above its Fair Market Value during the same two extreme events. The PE Ratio is also very high relative to most other stocks and the yield is tiny. We therefore have to conclude that the risks in this stock now considerably outweigh any potential returns that may be available and therefore the shares should be held by anyone else except our readers.

Current MV Ratio (Price/book)      7.1x                 Current FMV (+/-)    -30%

 

NVIDIA Corporation (NVDA – $62)

NVIDIA Corporation (NVIDIA) is engaged in visual computing, enabling individuals to interact with digital ideas, data and entertainment. With a $33 billion market cap, this is also one pf the largest companies that not many investors have really heard about. It has enjoyed a powerful run in the past year, doubling in price from 3.5 times book to 7.4, and in the process, outstripping its Fair market Value by a solid 50%. Based on its past history of trading, the stock could easily lose 50% of its price in a market setback as a sort of ‘routine matter’ and so we would be extremely careful at current valuation levels – while also being aware that such a tumble could open up a superb buying opportunity, again based its past history.

Current MV Ratio (Price/book)     7.2x                 Current FMV (+/-)    -52%

 

Paychex Inc. (PAYX – $60.70)

The growth rate of PAYX – as measured by its balance sheet equity per share – of this company has markedly slowed in the past 8 years but the share valuation has happily plowed ahead back to an above the Bubble Valuation that it enjoyed when it was growing much more rapidly. The company has outrun its Fair Market Value by some 39% at this juncture, although it does have a nice 3% yield (which absorbs nearly all of the earnings that the business produces). Growth in earnings only modestly exceeds the equity value per share growth. A once-impressive growth story is coming to earth – as one would expect with the size that the company has achieved.

Current MV Ratio (Price/book)      10x                  Current FMV (+/-)    -39%

 

Starbucks Corp ((SBUX – $57.10)

Been there before, done that before, got crushed before. SBUX is back up at its usual extreme valuation and has managed to run well ahead of its Fair Market Value to boot. The growth rate of the equity per share has slowed even allowing for the share buybacks and the yield is nothing to write home about.

Current MV Ratio (Price/book)      13.4x               Current FMV (+/-)    -32%

 

Tesla Motors Inc. (TSLA – $222.60)

This should be an interesting stock to watch in any market weakness, or worse, a meltdown. The company is running on hot air and hope, having managed to miss virtually every business target set for it. Worse, the balance sheet is very weak as we measure it so there is nothing in the tank if the market price fails to hold up. Lots of promise but poor delivery. This is a raging bull market stock but not one for the faint of heart if ever markets weaken.

Current MV Ratio (Price/book)      15.2x               Current FMV (+/-)    -88%

 

Under Armour Inc. (UA – $43.15)

Under Armour, Inc. is engaged in the development, marketing and distribution of branded performance apparel, footwear and accessories for men, women and youth. The company started out 2016 with an impressive 22% jump in price as it beat estimates by $.02 on a 95% surge in show sales – and that was about it for the year to date! What this proves, we are not sure, but we do wonder whether all of those nice price jumps following under-estimates for earnings that come in 2 or 3% above those estimates wind up the same way – buyer’s remorse. The shares are significantly over-valued based on their FMV measure and we would be concerned that the shares will not hold their price in weak markets.

Current MV Ratio (Price/book)      9.9x                 Current FMV (+/-)    -68%

 

Verisign Inc. (VRSN – $74.45)

If you have ever wondered who manages all of those web domain names, and hopefully stops people from copying yours, here’s your answer. VeriSign, Inc. is a global provider of domain name registry services and Internet security, enabling Internet navigation for domain names and providing protection for Websites and enterprises around the world (Registry Services).  Make no mistake, VRSN has not only had a great run in the stock market, but with a 350% ROE may be able to hold its’ valuation as well. The problem is now what? The stock has a massive valuation, is trading with an FMV measure of -46%, no dividend at all despite its huge profitability. It makes one wonder what they do with all the money that they make. The Stability Ratio is not all that strong, so clearly they are not sitting on bags of cash. Hmmm. Perhaps this will continue to do well regardless of the intrinsic value, but we would not touch anything that looked like this under any circumstances.

Current MV Ratio (Price/book)      72x                  Current FMV (+/-)    -46%

 

Vertex Pharmaceuticals Inc. (VRTX – $97.71

Vertex Pharmaceuticals Incorporated (Vertex) is a global biotechnology company. The Company is engaged in the business of discovering, developing, manufacturing and commercializing small molecule drugs. The shares have had a wild ride over the past 15 years, and to judge by what the company is doing and its current metrics, we can probably expect more of the same ahead. Right now, the shares have been on a roll, are very expensive on a price/book basis, a PE basis, and a Fair Market Value basis. On top of all that, if anyone by the name of ‘Clinton’ gets into the White House in November, we suspect that the pharma companies are going to have a much rougher ride in the future than they have had since the last Clinton left that office. Talk about hopes, dreams and waking up screaming. VRTX has had it all with more to come, as far as we can see.

Current MV Ratio (Price/book)      21.2x               Current FMV (+/-)    -62%

 

Yum! Brands Inc. (YUM – $89.75)

Yum! has reached what may or may not prove to be a double top at the $90 level, but from a valuation point of view, deserves to be a maximum. As we observed last year about this time, “No matter how poor your basic stock values, buy back some stock and the market will drive your shares higher – but not forever. Sooner of later, you have to produce sales and earnings. Or, as YUM found out, your stock price drops. Poor value, risky. We would avoid the stock.” Well, as it turned out, the shares did suffer a hefty decline, but then recovered right back to their previous price high, but well above their previous valuation high in price/book terms. In the meantime, earnings forecasts have been steadily slipping, and the over-valuation as measured by our FMV measure

Current MV Ratio (Price/book)      51.2x               Current FMV (+/-)    -47%

 


 

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