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Greenshoots (Park Deux)

| April 03, 2023

There’s an old saying in the market, that “the market can be wrong longer than you can be solvent.” It’s a clever way of saying that the market may know more than you and you may run out of money trying to tell the “market” that it’s wrong. It doesn’t mean you can’t have an opinion or express that opinion in the market (that’s the very definition of a market). But it does mean you should be aware that you could be wrong, or at least early.

Internally we have spirited debates and conversations about how the market looks and what is a fair representation of both risk going forward and return possibilities. We come to the table with differing points of view and biases, but try to look at things objectively and hear everyone’s arguments. The outcome is based on 3 legs of a stool.

  • Fundamentals – Valuations
  • Technicals – What the charts look like
  • Psychology – How are investors “feeling”

Let’s start with that third leg – psychology. We talked last week about how investors are “feeling,” and how that doesn’t always match up to how they are acting. According to some sentiment indicators, investors are quite bearish in their feelings but more middle of the road as far as their actual actions (equity weightings). If you look at the so-called smart money/dumb money index, you can see that the “smart” money (represented by professional investors) was adding to their equity holdings when the market was going down, at the same time the “dumb” money (a somewhat pejorative term representing retail investors) was selling. This is reversing now, as you can see in the chart below.

You can see that dumb money buying usually peaks at the top of the market. We’ve always said we want to make sure we are the smart money, in as much as it’s possible.

I would say Psychology in the market is neutral to maybe slightly bearish (slightly positive).

Valuations (fundamentals) continue to be a big question. As we know, the markets are valued on some form of price valuation. Price to Book, Price to Earnings, Price to Free Cashflow, etc. Different metrics are used by different investors and different metrics are better suited to different sectors. There’s no one size fits all way to value the market.

Let’s take a look at a couple valuation metrics and then we can talk about our opinions of these. The first on is the Shiller CAPE ratio (Cyclically Adjusted Price-to-Earnings).

It is saying that valuations have now come down to the level that the market peaked at in 1929 before the Great Depression. But it is off its highs from last year and much lower than the 2000 Tech Bubble.  The next one is a composite of several different valuations.

And just for good measure, let’s throw in Warren Buffett’s favorite valuation gauge (ratio of total US stock market value divided by GDP).

All these charts say the same thing. The market (at least in regards to the S&P 500) is not cheap. In fact, it’s one to two standard deviations above historical norms.

Now, I said we would discuss our thoughts about these.  The market is rarely black and white, but usually some shade of gray. If we pull out the top 10 companies in the S&P 500, the P/E ratio comes down from almost 18 times to closer to 14.5 times. Much closer to long-term norms. If we look at the S&P 600 (Small Cap stocks), we see that the P/E ratio is almost 12 (11.96). Even better. If we look at Europe, they have a P/E ratio around 14. Finally, if we look at developing economies (“emerging markets”), we see their P/E ratio at 10.81. So the only part of the market that appears to be wildly overvalued is Large Cap US companies, even after a big pullback for many of them in 2022. See the top 10 below.

Many of those top 10 are quite expensive. But it does bring me to a quote that I want to share. Many attribute it to Mark Twain, but he actually attributes it to Benjamin Disraeli.

When we see people dissecting statistics to prove their point of view, we must look at how that data is relevant in the big picture.

Valuations I would say are on the expensive side. Not exactly what I would call a great buying opportunity (slight negative).

Finally, let’s take a look at the technicals. We look at technicals a lot in our weekly piece, mainly because they tend to move around a lot at inflection points. Trying to pinpoint an inflection point is a fool’s game, but as you know, our model looks for inflection areas, not points.

We did get a rare “Zweig” Breadth Thrust on Friday. These don’t happen often, and most times lead to very good future returns. So much so, that technical analysts interested in market breadth say this is the closest signal they have to a “holy grail,” according to the well-regarded SentimenTrader research service.

You can see that the last one was January 7, 2019. Will this one provide the same results? Only time will tell. Here’s what history has shown.

It gives a very high likelihood of positive outcomes. Guaranteed? Of course not, but it’s part of the puzzle. Finally, let’s look at the standard S&P 500 chart.

Looks like a clear break above the previous high in March, above the moving averages, and the MACD is positive. 

We don’t expect you to know all of these terms used in technical analysis and will instead sum it up by saying that the technicals are positive.

Recapping the 3 legs of the stool.

  • Fundamentals are neutral to slightly negative
  • Psychology is neutral to slightly positive
  • Technicals are very positive

It’s not an all clear but certainly allows for more equity exposure. We added some at the end of last week. For now we still have some dry powder until the other two legs of the stool help provide more direction.

Have a good week and as usual, if something doesn’t make sense or you want clarification, let’s talk.