Year End Report 2014
This year has been another good one for your account. 100% investment in stocks was a very profitable strategy since the crash, and we have profited from it.
The S&P 500 will be up around 12% this year, but small stocks will rise much less. The return on our managed accounts will far exceed the market averages. The market is becoming very narrow in what it wants to own, and it concerns us. What we plan to do next is outlined below.
S&P 500 bottomed at 666 in March 2009. For those with a spiritual focus, that number resonates. It sure felt like a market from hell. Since then, the market has rallied to new highs this year, at around 2100.
What was once a ridiculously cheap market is now slightly overvalued. If you compare stocks to bonds, we still feel stocks are the better buy. Compare stocks to commodities and things become more complicated.
For the last few years, CNBC has said the stock market is overvalued and in a bubble. When we hear something like this, it’s our job to try to logically prove it or disprove it. We compared stock prices to other asset classes like bonds, oil, gold, and commodities in general. Doing the math at the beginning of 2013, we ranked bonds as the most overvalued asset. Oil was a close second. The cheapest asset class was commodities in general.
During this time, we owned two oil stocks: Exxon and Royal Dutch. We were willing to own them, though our view on oil was negative. Those stocks were cheap, and if oil prices declined, we thought their refinery divisions would protect their earnings better than a pure oil exploration company.
As we write this, ranking asset classes has changed dramatically. Oil has plummeted more than we anticipated: from $108 to $49 in six months. It is now tied with commodities in general for the cheapest asset class out there. The huge drop shocked us, even though we thought oil was overvalued.
In our previous letter, we planned to own more commodity-related investments. Our prior projection is accelerating.
There are myriad ways to play the decline in oil, and how cheap commodities are in general. An obvious strategy is buying the stock or bonds of anybody who produces commodities or involved in drilling for them. Another option is investing in foreign currencies affected by the decline in hard assets, or by owning foreign stocks, as well. Or just buy an exchange traded fund that owns oil or commodities.
We have debated this subject for a while. (When trades come through your account this year, you can see how it plays out.) We view this as a two-step process. First, selling some stocks you currently own to raise cash. Step two is investing the money in commodity-related stuff.
We are monitoring certain economic metrics to help us time buying those commodity-related assets. There will be a waiting period where some cash will sit in your account, earning virtually nothing. The reason? Because what we want to buy is still going down in value, and we are waiting for them to bottom out.
As we type this, the S&P 500 is slightly overvalued. We use S&P earnings divided by the S&P price (this is called the earnings yield) to ascertain the index’s value. We then compare the earnings yield to past history to deduce a fair value for where the market should reasonably trade.
A market valuing system Warren Buffett has used in the past identifies value in the market as it compares to our economy. Buffett divides the entire U.S. stock market capitalization by the U.S. Gross Domestic Product.
As you can see from this chart, the market reflects historically high ground. The problem with Buffett’s system is it doesn’t take into account the companies’ earnings, (see above) or from where those earnings derive. We think it’s a mistake to compare the market cap of companies who do business overseas exclusively to the U.S. GDP. More and more American companies’ earnings are coming from overseas, but aren’t reflected on this system.
Buffett’s calculations also assume U.S. companies’ operating margins will not change much over time. We like his thinking, but it does have flaws.
All systems have problems, and ours is no different. By our method, the earnings yield used to value the market are achieved with the highest S&P operating margins in the last fifteen years.
The average operating margin is usually 7.90%, with the median at 8.53%. Today’s number is 10.17%. This means every dollar of sales is being valued at 19.22% more than the median, and 28.73% more than the average.
Said another way, if a company’s sales stay the same and operating margins go down to the historical average, earnings for all the S&P will drop by over 20%. This potential problem has bothered us for a while now. What could cause those margins to reflect their historical norm?
A partial list would include U.S. wages rising as the economy reaches full employment. Although there is slack in employment statistics because many people have given up looking for work, two-hundred-thousand people per month are being hired. At some point, reducing unemployment will affect wages.
California dock workers’ labor issues are influencing how fast overseas goods are shipped to the U.S. Organized labor continuing its work slowdown increases the cost of goods sold to business. The dollar’s rise will make U.S. goods less competitive against foreign manufacturers, hence business might cut gross margins.
More employer-sponsored healthcare costs are being passed on to employees, who are struggling to pay them. This can’t go on forever. Workers can’t continue to absorb higher deductibles, if their wages don’t increase.
These reasons and others explain what we think could derail record margins, and why a little caution might be warranted.
Twenty years ago, the index was dominated by heavy industry. Today it is more service- and tech-related, which have higher margins. Rest assured, no matter what system is used, it won’t be perfect. Being generally correct is the best we can do on market valuation.
One last thing we want to discuss relates again to declining oil prices. Around 315-million people live in the United States. Of the 315-million, 141 million are employed. Of those 141-million workers, about one million are employed by the mining and drilling industries.
By comparison, when housing tanked in 2007, studies have shown the decline in construction directly and negatively affected 30% of the U.S. economy. Based on the stats above, the current decline in commodities, and by extension, the mining and drilling industries, should affect less than 1% of the total 141- million employed. For the other 99%, oil price declines should boost economic growth here and across the world--except for OPEC.
As you can tell from this letter, we think the markets are entering a transitional phase, where money will shift from one sector (non-asset related) to asset-related investments. We believe markets are opening a door for us to enter and profit from.
Feel free to give us a call about this letter, and any changes to your financial affairs.
Sincerely
Trend Management