Valuations

We’ve been correctly positioned near our tactical portfolios’ equity minimums, yet we’re oddly compelled to use this month’s “Of Special Interest” section as a very public second-guessing of that move.

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The S&P Industrials’ downside to mean valuation (excludes Utilities and Financials) is 24%, about 3% less than last month’s reading.

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We’ve long argued that this tightening cycle began in January 2014, the month of the first of seven tapering moves which occurred through October of that year. There’s both economic and market evidence to back up this claim.

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The S&P 500 lost 1.8% (price only) in December. Based on the 1957-to-date valuation metrics presented, downside to its historical average decreased by about 2% from last month’s –19% reading.

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The stock market rally has carried far enough to flip some of our trend-following work bullish, lifting the Major Trend Index to a low-neutral reading. The improvement prompted an increase in asset allocation portfolios’ net equity exposure to 42% (up from 36% previously).

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Question: What will you do if the Major Trend Index returns to its bullish zone?

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Foreign valuations experienced nowhere near the expansion enjoyed by U.S. stocks during the latest bull market, but their cheaper valuations rarely seem to inoculate them from outsized losses during corrections and bear markets.

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Corporate profits are notoriously cyclical, and for decades we’ve sought to temper their swings by using a five-year smoothing of S&P 500 EPS in our valuation work.

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The Chinese government’s repeated stock market intervention attempts over the past several weeks have been remarkable, and obviously antithetical to the country’s move toward a more laissez faire corporate environment.

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The recent capitulation of the Chinese domestic equity market (or A-shares) makes headlines almost every day. Different theories, circulating in both China and overseas, pop up frequently to explain the daily movement of A-shares. It seems the investment community gets excited when the Chinese market is on the decline (but not so much when the market is on the upswing); many investors are quite reactive to any negative news coming out of China.

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High Quality stocks had another winning quarter on a relative basis returning +0.1% in Q2, while Low Quality stocks lost 2.8%. Small Cap High Quality stocks also beat their counterparts.

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It now goes almost without saying that whenever the stock market moves to a new cycle extreme, so does the MTI’s Intrinsic Value category. In late May, this reading dropped below –400 for the first time in this bull market, and is now within 150 points of its 2007 extreme.

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It’s generally a bad idea to roll out new valuation readings that one doesn’t fully understand late in a cyclical bull market. But we’re going to do it anyway, recognizing that a similar practice proved to be the undoing of dozens of fund managers and Tech analysts at the turn of the millennium.

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Emerging Market stocks are probably the cheapest equity subgroup in the world today, trading at 13.0x our 5-Year Normalized EPS estimate—much lower than that of foreign Developed Markets (17.6x) and the S&P 500 (21.3x). But, EM stocks have languished near these valuation levels for almost three years.

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At a time when social media stocks are the rage, stodgy “Old Tech” has quietly tacked on a 20% gain in the 13 months since the social media peak, while the NASDAQ Internet Index is still a bit below its March 2014 high. Yet, “Old Tech” P/CF remains below the level of 1995.

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The Street’s most clever invention is “12-month forward operating earnings” because the stock market invariably appears cheap on the basis of such inflated estimates.

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Has the recent collapse in crude oil prices presented us with a good opportunity for an outright commodity investment? No. Energy stocks aren’t on our radar screen either.

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Extreme market viewpoints get the headlines, but it’s baked into our disciplines that we will (occasionally) be noncommittal.

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