Crying Wolf Barometer - Updated for Coronavirus
By now most of you are familiar with GreenPort's Crying Wolf Barometer (CWB). For those who need a refresher, we introduced the CWB in March of 2018 and update the CWB when the S&P 500 follows a fear-driven sell-off with a new market high. The S&P 500 fell 3.5% in 3 days over fears that the Coronavirus would become an uncontrollable pandemic. While the crisis is far from over, the worst fears of a major global pandemic haven't been realized. Markets recovered their losses and went on to make new all-time highs. The CWB serves as a reminder to focus on the fundamentals (logical thinking) and not let emotional thinking adversely impact our decision making. We decided to call this the “Crying Wolf Barometer” because it reminds us of the Boy who Cried Wolf fable. In the story, the shepherd created so many false alarms that the villagers start ignoring all his warnings, even when the real wolf finally shows up. The moral of the fable, “no one believes a liar, even if they tell the truth,” is an important moral for investors to remember. Eventually, a wolf will show up and end this bull market. We need to recognize that wolf, but also recognize the many false alarms. For visual reasons, we split the graph of the entire 11-year bull market up into 2 graphs.
It's always interesting to look back at what had markets worried during each sell-off. Our guess is most of us barely remember most of the episodes only a short time after they pass. Another expression that investors should remember is, "today is tomorrow which you worried about yesterday". We've argued the reason this bull market is the longest bull market in history, is because it is also the most hated bull market in history. The constant promises of impending recession and disaster have kept this stock market in check. Without a stock market surge, it's difficult to get a stock market collapse. While there has been plenty of volatility, the surge-collapse pattern has been absent. With this latest move to new highs, we are starting to get concerned that markets may finally be getting a little frothy. Let's take deeper a dive. Despite the 25% return on domestic stocks last year, we've been arguing valuation is reasonable. Low interest rates and low inflation make the present value of future earnings more valuable, justifying a slightly higher P/E (18.6X) than the historical average.
Our forecast this year is for stocks to advance in line with earnings growth. The consensus earnings forecast for the S&P 500 this year is up 9.6%. Without any additional multiple expansion, if stocks advance in line with earnings expectations this would imply a 9.6% increase in stock market values for 2020. While simplistic, this seems like a reasonable target for 2020.
So far domestic stocks are up 4.5% this year, outpacing the growth rate of earnings. While this is not overly concerning at the moment, if stocks continue outpacing earnings we will need to reevaluate our equity overweight. There are a lot of other factors to consider in our equity framework, but If stocks continue their surge higher and achieve our year-end target during the first half of 2020, it is likely we will finally remove our stock overweight and move to an equity neutral allocation while we give earnings a chance to catch up. That scenario is still 5% away, so it's an issue we would welcome. GreenPort has been considerably more bullish on domestic stocks during this current bull market than most, and it has treated our investors well. That said, we spend considerable time reading and listening to investment strategists whose opinions are different than ours. An important part of any successful investment process is to consider alternative views. We have written on several occasions about the perma-bears views, and why after examining their investment reasonings we disagree with them. Another group that has been very vocal, and incorrect, during this bull market are the globalists. They have argued throughout this bull market that international stocks should outperform U.S. stocks. This hasn't worked out well at all. The U.S. stock market has clobbered international markets during this 11-year bull run.
The argument that the globalists have made is that international stocks are much cheaper than U.S. stocks, and therefore a better value. We have been much more sympathetic to the globalist's arguments than those of the perma-bears. Valuation is the cornerstone of our investment process, and international stocks are selling at a much lower multiple than U.S. stocks.
The challenge is that cheaper stocks are often cheaper for a reason. Purchasing lower P/E stocks that also have lower and sometimes declining earnings growth expectations usually doesn't work out. This is referred to as a value trap. There are countless examples on an individual stock basis when a low P/E isn't indicative of good value, but rather the expectation of deteriorating earnings. This also appears to be the case with international stocks. Their economies, and therefore their earnings, simply haven't and aren't growing at the pace of U.S. earnings.
So despite our increasing concern that domestic stocks are getting a little ahead of themselves, for now, we are uncomfortably maintaining both our domestic overweight and equity overweight. Q4 domestic earnings are once again beating expectations while low interest rates and tight credit spreads leave investors with limited other investment options. Movie Review – Ford vs. Ferrari – While you may not love this movie, you’ll be hard-pressed not to like it a lot. Matt Damon does a solid job playing the role of Texan Carroll Shelby, the vision behind the Shelby Mustang that shocked Ferrari at LeMans. Christian Bale once again proves he’s the most talented actor of his generation. If you are an automotive buff you will certainly love this movie, but there is still plenty to like about this movie even if cars aren’t your thing.
Have a Wonderful Week, The GreenPort Team