CWS Market Review – November 15, 2013

“There are only two kinds of forecasters—those who don’t know, and
those who don’t know they don’t know.” – John Kenneth Galbraith

This has truly been a charmed stock market this year. On Thursday, the S&P 500 closed at 1,790.62, which is yet another record high. The index is now up 25.53% for the year, and it’s on track to yield its best yearly gain in a decade. The Nasdaq Composite is 25 points away from touching 4,000 for the first time in 13 years.

Last year, I thought I was being bold when I said the market could break 1,500 sometime in 2013. Sheesh, that happened before the Super Bowl, and now the S&P 500 is closing in on 1,800.

What’s remarkable about this year’s market is not only the stunning gain but also the absence of volatility. The market has gone up in a relatively steady manner. Consider that we haven’t had a daily drop of more than 1.6% in nearly five months. Compare that with the second half of 2011, when it happened 24 times. This Saturday will mark the one-year anniversary of the last time the S&P 500 closed below its 200-day moving average. As I said, it’s been a charmed market.

The market’s good fortune has led to a lot of talk, much of it careless, about the stock market being in a bubble. Even Janet Yellen was asked the great bubble question in her Congressional testimony (she said no). In this week’s CWS Market Review, I’ll take a closer look at where the market stands and investigate the issue of a possible bubble. Now that earnings season is past, this is a good time to take a step back and look at the larger picture.

I would be remiss if I didn’t point out that our Buy List continues to outpace the overall market. Through Wednesday, our Buy List beat the S&P 500 for eight straight days. This has been a very good earnings season for us. Since October 9, the Buy List has rallied 9.50%. We’re now up 33.64% on the year (not including dividends), which is 8% more than the S&P 500. This looks to be our seventh market-beating year in a row.

Now let’s turn to the broader market environment.

Is the Stock Market a Bubble?

The latest rage on Wall Street is to proclaim everything, particularly the stock market, a bubble. This is rather understandable when you consider it’s coming after two of the biggest blow-ups in Wall Street history: the Tech Bubble and the Financial Crisis. Naturally, the first sustained rally after these disasters would make anyone feel a bit nervous.

So do I think the market is in a bubble?

The answer is a bit complicated, but I’ll give you the simple version: I don’t know and I don’t care.

For one, it’s rather strange to discuss the stock market as if it were one entity. The stock market is composed of thousands of stocks. Even our Buy List, which is very diversified, contains just 20 stocks. In such a broad market, there will always be gems that the crowd overlooks. For stock pickers, that’s a good thing. I bet a monster-cap like ExxonMobil ($XOM) spends more on erasers than what little Harris ($HRS) earns in a full year. At Crossing Wall Street, we strive to be disciplined stock pickers, so the movement of the S&P 500 is of general importance to us, but it doesn’t alter our strategy of focusing on high-quality stocks going for good prices.

We should also remember that even if the stock market is overpriced, it’s still very hard to get the timing right. Lots of people were short the market going into the Financial Crisis, but it kept going higher and higher. If you’re disposed to see bubbles everywhere, then guess what: you’ll start seeing them everywhere. Remember, the trend is your frenemy. Momentum can always last longer than you expect. For example, I thought Ford Motor ($F) was a bargain at $15. I had no idea it was going to fall below $9 per share, as it did last year. As Lord Keynes famously said, “Markets can remain irrational a lot longer than you and I can remain solvent.” That’s painfully true.

Obviously, it would be great if we could always time the market perfectly, but we can’t. And no one can. I’ll go a step further. Even when disaster strikes, a buy-and-hold strategy can still serve you well. The S&P 500, including dividends, has performed reasonably well since mid-2008. That is, starting before the worst of the Financial Crisis. Time may not heal all investing wounds, but it sure can help a lot.

True market bubbles are very rare. By this, I mean to differentiate a bubble from a typical lousy market. The stock market drops every few years. That’s what markets do, and if you’re not prepared for it, you shouldn’t be in the stock market. Period. Stocks go up, and stocks go down. As Hyman Roth said, “this is the business we’ve chosen.”

The Two Kinds of Bear Markets

I think a good way of looking at bear markets is to divide them into two categories. One is where market prices shoot up far beyond values, and then reality reasserts itself. Those are your classic bubbles like 1987 or 2000. The other kind is where the value falls apart and then prices catch up. That’s what we had in 1990 and 2008. You might be surprised to hear me say that 2008 wasn’t a stock bubble. That’s true. There was a bubble in housing, but stock valuations were rather normal.

I very much doubt that we’re currently in a classic bubble. Earnings for the S&P 500 are expected to be about $107 per share (that’s an index-adjusted figure), and companies will probably pay out $35 per share in dividends. That works out to about 2%. Interestingly, the market’s dividend yield has hovered around 2% for much of the last decade, except for the most frightening parts of the Financial Crisis. Analysts currently expect the S&P 500 to earn about $121 per share next year. So even after our robust rally, the market is still going for about 14.8 times next year’s earnings estimate. That’s normal. We haven’t gone from normal valuations to sky-high ones. Rather, we’ve gone from duck-and-cover valuations to average ones.

Janet Yellen seems to agree. During her Congressional testimony this week, she was asked if the stock market was in a bubble. Yellen responded, “Stock prices have risen pretty robustly, but I think if you look at traditional valuation measures—the kind of things we monitor akin to price-equity ratios—you would not see prices that suggest bubble-like conditions.” Of course, investors should pay attention to more than a few easy-to-find ratios. But the general view indicates that equity valuations are quite normal.

Now the question that most concerns me is, are analysts too optimistic for the market’s future earnings? That’s a much more difficult question to answer, and if the answer is yes, then we have a different story. As I said, analysts see earnings coming in next year at $121, but I need to add that analysts don’t have an enviable track record with their forecasts (see the Galbraith quote above).

What concerns me most is that profit margins have grown very high and are near multi-decade highs. If (or when) we revert to the mean, then corporate profits will not grow as rapidly as the overall economy. However, the high margins may be a result of slow growth and ultra-low interest rates. We’ve never been in a situation quite like this, so the old rules may not apply.

Expect Small-Caps and Cyclicals to Lag

While I’m not a fan of market-timing, I do think it’s possible to spot areas that are due for outperformance or underperformance. In particularly, I’ve grown leery of the small-cap sector. Historically, small-cap stocks have done very well. The catch is that they’ve gone on long, multi-year runs of beating the market, then long runs of trailing. The current small-cap cycle began in April 1999.

Here’s a stunning fact: If the Dow had kept pace with the small-cap Russell 2000 since April 8, 1999, it would be over 28,000 today. I think investors should steer clear of macro bets on the small-cap sector. There are still many outstanding individual names there, but the sector as a whole needs to rest.

Related to small-caps are cyclical stocks. From a macro perspective, small-caps and cyclicals behave somewhat alike. This makes sense in that smaller companies tend to be more focused on domestic industries while mega-caps are skewed to large-scale multi-national service businesses. Cyclicals also tend to outperform when the market itself does well (hence the name “cyclicals”). Again, there are many individual cyclical names I like, such as Ford Motor ($F), but I expect the sector to lag the market for the next few years.

Updates on Some of Our Buy List Stocks

I want to caution investors not to expect more years like 2013. While I refuse to play the bubble guessing game, it’s certainly prudent for investors to grow more conservative as the rally goes on. Let’s take a look at a few of our Buy List stocks.

Despite missing earnings by one whole penny, AFLAC ($AFL) made back everything it lost and just rallied to another 52-week high. The duck stock announced that it’s expanding its buyback program by 40 million shares. Don’t chase this one. AFLAC is a good buy up to $70 per share.

FactSet Reseatch Systems ($FDS) just hit a new 52-week high. The stock is having a very good year. We’ll get another earnings report before the end of the year. I’m raising our Buy Below to $119 per share.

Several more of our stocks hit new 52-week highs on Thursday, such as Harris ($HRS), Fiserv ($FISV), Cognizant ($CTSH) and CA Technologies ($CA). So did WEX Inc. ($WEX), which was raised to a buy by Zacks. WEX looks to crack $100 per share any day now. I was impressed to see Oracle ($ORCL) hit $35 this week for the first time since May. Oracle continues to be a very good buy up to $35 per share.

Both Ross Stores ($ROST) and Medtronic ($MDT) made new highs on Thursday, and both stocks are due to report next week. I previewed their earnings reports in last week’s CWS Market Review. This week, I’m raising the Buy Below on Medtronic to $61 per share. Expect to see another solid earnings report this Tuesday.

That’s all for now. This Wednesday, the Commerce Department will report on retail sales. Also on Wednesday, the Labor Department will release the inflation report for October. Expect to see more subdued inflation. However, the most important release will be the minutes from the Fed’s meeting three weeks ago. As expected, the Fed decided to hold off tapering, but it will be interesting to see what issues the FOMC discussed. The Street is now expecting a tapering move in March. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by Eddy Elfenbein on November 15th, 2013 at 7:11 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.