This page focuses on economic and financial market information and ideas.
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Dr. G. Kevin Spellman, CFA
April 30, 2020
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At about 2,900, the S&P 500 is only 15% off its all-time high and down just 10% for the year, but the starting points were arguably lofty levels. At its low, the market fell 35% from its intraday peak of 3,394, which is slightly more than the median bear market of 33% during the last seven recessions. The current rally implies all is now fine and well, coronavirus is just a blip, and the economy will be off to the races sometime soon. This may be hopeful thinking.
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- The market’s rally implies all is fine and well, but it is way ahead of profits
- The government came to the rescue, but this could still go on a long time
- The Fed’s liquidity injections are distorting asset prices and misallocating capital
- Fair value could be lower than the prior high even if profits fully recover.
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Dr. G. Kevin Spellman, CFA
March 18, 2020
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So much is happening, and quickly. The S&P 500 is down almost 30%, schools and businesses are closing, people are beginning to panic, and the financial markets are not functioning smoothly (stocks and safe assets are both declining). Monetary and fiscal policy are coming to the rescue, but maybe we just all need to stay home.
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- Human behaviors are following predictable patterns in response to coronavirus
- Markets are not functioning correctly – is Financial Crisis 2.0 brewing?
- Expectations started high, so the sharp correction is not surprising
- A recession could be needed to rid of excesses
- Maybe we should just stay home and watch Netflix
Economy Caught a Nasty Virus..
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Dr. G. Kevin Spellman, CFA
March 4, 2020
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The real and pychological impacts of coronavirus may drive the economy into a recession, and the markets were expecting an earnings recovery.
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Dr. G. Kevin Spellman, CFA
September 23, 2019.
You’ve heard of the old adage, “Don’t fight the Fed.” The Federal Reserve is a powerful force and has great influence over the economy. The Fed influences the economy through the Fed Funds Rate, money supply growth, and announcements of its intentions. The Fed is divided on whether rates will increase or decrease in 2020, but it clearly has a bias toward easing right now. Money supply is growing quicker than GDP. It normally pays to heed the direction of monetary policy..
Does the Trade War Matter? Can the US Win It?.
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Dr. G. Kevin Spellman, CFA
July 30, 2019
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The title of this paper has two questions that may have obvious affirmative answers to many or even most readers, but this paper questions common beliefs. Given media and policy attention on the US-China trade war and how the market seems to react to every bit of news, “yes” may be the answer for many people to the first question, “Does the trade war matter?” The answer to the second question, “Can the US win the trade war?” will also be “yes” if one bases the answer on President Trump’s early explanation that the war will be easily won simply because China exports more to the US than the US exports to China so China has the most to lose by tariffs. However, the US has discovered that this war is not so easily won, and herein I explain why. I also argue that the trade war would not matter to the aggregate economy if it were not for the fact that most people behave based on their belief that it does. Beliefs cause actions, even if they are faulty.
The Time and Place for Active Management.
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Dr. G. Kevin Spellman, CFA
March 7, 2019
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The rise of passive management, index funds and ETFs, has been breathtaking. Is this just a fad, or is it here to last? I suggest it is here to stay, but there are ramifications. Certain market environments, such as those over much of the last decade, favor passive management. However, some of the conditions – low dispersion of stock returns and overall high returns – may be coming to a close.
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This article explores some reasons why active management has performed poorly over the last decade and the possibility for that environment to change. Plus, it provides evidence of what areas of the market provide the most alpha potential and best risk-adjusted returns.
The Wonderful Stock Present Under the Christmas Tree.
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Dr. G. Kevin Spellman, CFA
January 4, 2019
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I have seen several headlines to the tune, “Markets Deliver a Lump of Coal for Christmas.” However, if you have been following Coach Investing articles, you will have expected a sell off given the slowdown, overexcitement about technology stocks, high valuation, and the late cycle nature of the economy. During slowing periods, a rotation to defensive stocks is normal. However, when the correction is so strong and quick, they can create opportunities. Instead of a lump of coal, I am very excited about the stock present under my tree – some perhaps great investment opportunities.
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Alibaba is one of the strongest competitors in its diverse set of businesses. Thus, it is moat-like. It also has substantial opportunity for internal growth and for acquisitions as it builds its ecosystem. It generates substantial cash flow to pay for this growth, and it has low amounts of debt. This growth appears to fully justify the premium P/E. Plus, Alibaba’s FCF yield is about the same as the S&P 500’s in fiscal 2022 despite its above average growth opportunities beyond that year, which implies it is more than fairly priced. The correction over the last six months may be a nice gift to investors who do not yet own the stock.
Attractive Cheap, Profitable, Small Companies.
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Dr. G. Kevin Spellman, CFA
November 2, 2018
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After rallying earlier this year, small caps have gotten crushed over the last few weeks (figure 1). This is normal during the slowing phase of the economic cycle since small caps have more domestic and cyclical exposure and perhaps less certain financial stability (see Tactical Allocation Over the Cycle). It may also be deserved.
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There has been a growing number of unprofitable small companies (figure 2) that have received, but more than likely should not have, a life line. This is typical during the latter stages of an economic cycle, but it is not necessarily prudent for the long-term. Plus, the median small cap company ($100 million to $5 billion market capitalization) is more expensive than the median large cap company (figure 3) (> $5 billion in market capitalization) despite its widening net margin deficit differential (figure 4). People have been excited to take risk.
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Maybe the correction will shake out the weak small companies from the strong and lead to a more rational market? The median unprofitable small cap stock is down 10.5% from the market peak on 9/20/18, while the median profitable company is down 7.9%.
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The cheap profitable small cap company tends to outperform over time, but investors have preferred the high flyers over the last several years.
Rising Rates Catalyst for, Not Cause of Correction?
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Dr. G. Kevin Spellman, CFA
October 17, 2018
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Headlines are blaming the recent market correction on rising rates. While this may have been a catalyst for the correction, or a tipping point, it was probably not what really spooked the market.
Over my career, I have observed that the best stocks have solid earnings growth, improving growth, are surprising positively, and price in low expectations. While economic growth is positive, the trend is toward slowing. Surprises have turned much less positive, if not outright negative. Plus, expectations, as implied in valuation, are high.
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The real skeleton that caused the correction is probably because growth is slowing while rates are rising, and since expectations are still high, surprises are turning less positive to negative.
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Happy early Halloween!
EPS Growth Coming in for Landing When P/E is High
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Dr. G. Kevin Spellman, CFA
July 31, 2018
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After three years of positive and accelerating growth, earnings growth is expected to slow starting after the current quarter (figures 1-2). 2015-16 growth was held back by the “recession” in the commodity and industrial markets. 2017 charged back as oil prices and the economy recovered, and 2018 is benefiting from lower taxes. However, these good times are expected to fade as comps become much more difficult in 2019, and 2019 growth is expected to slow.
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Even though a large majority (78.9% through 7/30/18) of companies are beating 2Q estimates, overall surprises are much subdued from recent quarters and are only ahead by 2.5% (figure 3), with the past year market leader (information technology) getting clobbered.
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2019 growth is broad-based (figure 5). Still, it is led by energy and other cyclical sectors including consumer discretionary, industrials, technology, and financials. As note in Tactical Asset Allocation Over the Cycle, cyclicals have been leading the markets; however, since June, defensives (consumer staples, health care, telecommunications, and utilities) have outperformed. Perhaps the market has already priced in current and expected solid growth, or it is questioning 2019 numbers?
Tactical Asset Allocation Over the Cycle
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Dr. G. Kevin Spellman, CFA
July 15, 2018
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Tactically varying allocations to different assets can significantly improve returns; however, it is notoriously difficult to do well for most people. Asset rotations are tied to economic and market cycles; thus, the key to timing asset rotations is an understanding of where one is in the cycle and where it is going. This is easier said than done, since unfortunately, the cycle is driven by a myriad of variables. There is so much information hitting investors each day that it is easy to get lost in the noise. Therefore, to map the economy, I previously introduced, in Positioning the Cycle, a cycle model (figure 3). Assets behave somewhat predictably based on phases of this model.
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Figure 1 shows returns of several types of risk-on/risk-off asset pairs: stocks versus bonds, small versus large stocks, cyclical versus defensive sectors, high yield versus government bonds, commodities versus gold, etc. Figure 2 shows returns over the prior 15 years. Consistent with how assets normally behave during phases of the model (figure 3), risk-on assets outperformed over the last year. Stocks outperformed bonds, high yield bonds bettered government bonds, cyclical, growth, and small stocks have led the way, gold lagged other commodities, and emerging markets have outperformed. However, over the last month, defensive assets have started to outperform, which is in line with the cycle regime shifting to slowing (discussed later).
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The cycle has been running pretty hot (figure 3) and appears poised for a turn. Due to incomplete economic data at the end of 2Q18, it is still too early to be certain of whether it is moving from improving– the green line which shows the economy is above average and getting better – to slowing – the blue line where the economy is above average but worsening; however, the likelihood of the turn down is rising. The improving phase is associated with a risk-on market environment where stocks outperform bonds, etc; however, “slowing” may take on different defensive asset return characteristics (discussed later).
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Dr. G. Kevin Spellman, CFA
May 14, 2018
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Technology stocks have been on fire and the FAANGs stocks are constantly in the news. Thus, in this piece of Coach Investing, I thought readers may enjoy a macro review of the technology sector and trends in overall investment spending.
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Given the hoopla over the FAANG stocks, some may believe that a winning investing strategy in technology may be different today than in the past, but after analyzing a myriad of variables from profitability to uses of capital to valuation to market cap, it appears that a successful investing strategy has not changed much since at least the early 1990s. Namely, moderation is best. The moderately valued and profitable companies that do not over- or under-invest tend to outperform. Large companies also perform best.
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This got me thinking… Is the talk of increased regulation in the technology sector reasonable? It could be if large technology firms, as they become bigger, have a disincentive to invest and limit R&D and capital spending to the detriment of consumers.
The Stock Market: Where Do We Go From Here?
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Dr. G. Kevin Spellman, CFA
August 1, 2017
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Worries are mounting, but the market keeps rising and it is not just stocks, as other asset classes have charged ahead as well. We are entering the later stages of a cycle when risk rises; however, if earnings growth remains robust, the market normally ignores red flags and rises. We may be safe for the next six months as double-digit earnings growth is realized; although, a 5% to 10% correction is about due. The market normally discounts growth about six months ahead, and in 2H 2018, EPS comparisons become much more difficult.
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The steps to the end of a cycle share some commonalities. The cycle begins with fundamental improvements. Then, people borrow to invest. Third, financial markets get carried away and this propels fundamentals further as people become excited, spend, and invest even more. Doubt eventually arises, but markets continue their run. Finally, markets burst and cycles end. The current cycle is at least in the third step and perhaps moving to the fourth. We are several years into the current recovery and earnings are rising (step 1). Leverage is up (step 2). Markets are excited (based on returns/valuation) and sentiment is high (step 3), and we are overdue for a correction and volatility is low (step 4).
The Expectations Clock: A Model for Cycles and Sentiment
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Dr. G. Kevin Spellman, CFA
May 2, 2017
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The Expectations Clock provides a framework for modeling performance, expectations of future performance, and human behaviors during phases of the performance cycle. It is a model of human over- and under-reactions to the environment.
Success in investments (and business in general) is highly dependent on effectively forecasting future fundamentals (e.g., sales, earnings, etc.); however, these projections are influenced by human interpretation of events which are impacted by behavioral biases. Further complicating forecasts, human reactions (such as investments) to current and recent fundamentals also influence the fundamentals being forecasted. Thus, to predict performance, one must project the underlying cycle and how people interpret and respond to it.
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Dr. G. Kevin Spellman, CFA
February 22, 2017
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The implied long-term earnings growth of the S&P 500 is 5.74%. The return of the market is a function of dividends, earnings, and expectations (quantified by the P/E multiple). The P/E ratio looks extended and is a concern, and while cyclically adjusted market implied growth rate (CAIGR) is low versus its history, long-term earnings growth has also slowed.
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Since 1989, S&P 500 earnings per share have grown at about 5% (figure 1), with operating earnings growing slightly faster than reported earnings (5.3% versus 4.9%). S&P 500 EPS growth is about the same rate of nominal GDP. Operating earnings, which remove the impact of one time charges (mistakes of corporate management), are less volatile than reported earnings (standard deviation of 21% versus 120%), and recently the gap between the two numbers has widened. This is normal during earnings recessions when management writes off assets and tries to hide the real results. Earnings growth is tied to long-term price appreciation (figure 2); thus, a closer look at the market’s expectations for growth is warranted.
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Dr. G. Kevin Spellman, CFA
January 31, 2018
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Understanding the position in the cycle is paramount. That point determines returns and risks. Future risks are highest when returns are strong during the latter stages of the cycle, but investors frequently ignore them to their detriment. And the cycle is getting old. Perhaps we have one to two years to go in this expansion, but if it is longer bubble conditions will likely continue to materialize. While tax cuts may spur short-term economic growth, higher growth could be counteracted by the Fed; therefore, tax cuts may just add debt that will need to be dealt with later. Inflation may not be dead; it may just be in hibernation. If it awakens, rates will probably rise quicker than the market expects and this is more than an outlier risk. 2018 earnings growth is expected to be robust – even higher than 2017. However, my earnings expectation model suggests that 2019 will not repeat 2018’s high rate of growth, and the market anticipates earnings trends by about six months.
When Do Value and Growth Outperform?
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Dr. G. Kevin Spellman, CFA
June 5, 2017
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Over the past 30 years, numerous investing “anomalies” have been identified that cannot be explained if the markets are efficient. These factors, which provide the basis of
value and growth investing, range from price multiples to momentum to financial variables that measure corporate performance. As passive investing and ETFs have grown in popularity, new smart beta products that tilt passive portfolios to these factors have taken off. However, while these factors may lead to outperformance over long periods of time, they do not work all of the time and in all areas of the market. There is still a dearth of knowledge of when, and where, these factors work, and this paper provides an answer. Like sectors that have cyclical and defensive qualities and vary in sensitivity to the economy and financial markets, factors have similar characteristics and also rotate predictably through economic and market cycles. For instance, value performs well during early and mid-expansion phases of the economy. At these times, growth is abundant, so there is no need to pay up (higher multiples) for growth; however, when growth is scarce during late economic expansions or early to mid-slowdowns, quality and growth factors outperform. Over about the last 18 months, there were four rotations between value and growth; in general, they were “on schedule” according to the model presented here. [i] Currently, the model points to growth.
Sentiment Rises: Modestly Cautious Readings
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Dr. G. Kevin Spellman, CFA
March 26, 2017
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Sentiment has risen strongly over the last six months to a high level while earnings growth has accelerated, a perfect environment for the stock market which posted strong gains (up 8.9% over the last six months). Consensus estimates call for earnings growth to continue to accelerate, but sentiment already implies this so the odds of negative surprises and declining expectations has risen. Over the last month, the market has rotated to growth and defensive sectors, which implies that investors are beginning to realize that financial markets may be ahead of fundamentals.
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Level of sentiment is positively correlated (R2 = 0.63) with historical 1-year returns (figures 2-3, top charts below). Furthermore, even short-term changes in sentiment are correlated with short-term returns (figures 4-5, bottom charts). The stock market is a gauge for expectations of earnings and risk, so predicting sentiment is useful for predicting returns. Sentiment is likely to decline from these levels (sentiment declined in 53 of 72 months since February 2000 when sentiment was over 60%), and falling sentiment from these levels is associated with muted (slightly positive) returns.
Financial Sector Valuation Up So Fundamentals Must Deliver
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Dr. G. Kevin Spellman, CFA
March 9. 2017
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Over the last six months, the S&P 500 Financials sector has rallied 24.2% (banks are up 34.3%) versus 8.3% for the S&P 500. This return has outpaced every other sector, and financials have also had the best return for the last 52 weeks and one month. Most of the drivers for the sector are hooking up, but valuation has also risen so earnings must now deliver to justify the outperformance.
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Earnings have been improving since the financial crisis (figure 2), and as expected, earnings growth relative to the S&P 500 is somewhat correlated with the sector’s relative returns to the S&P 500 (figure 3). The sector’s latest twelve months (LTM) earnings growth on a monthly basis has been greater than the S&P 500 since June 2015, and in February 2017 financials earnings grew nearly 8% more than the market.