The foundation of a sound long-term stock portfolio begins with analyzing market risk and reward. Individual stock and sector selection are important but are most effective in the context of an attractive market. In this post I will show how to measure the key concepts.
Each week I publish a table called the “Indicator Snapshot.” It provides an easy summary of the risk and reward indicators. Here is the current version.
Let’s work through the example.
There are many measures nominated as the best for market valuation. Beyond saying that none of the popular ones are very effective, I am not going to do a critical review of each. But I could!
My fundamental approach was expressed again today by Warren Buffett. He said that if interest rates remained at 3% for the next ten years, stocks would significantly outperform bonds. This is the key comparison. There are other asset classes, but most are aggressively “risk-on” or interest-rate sensitive. The biggest flaw in popular valuation methods is leaving out current and expected interest rates.
Valuation shows the potential gain for the overall stock market. This helps investors avoid an undue focus on the ever-present “headline risks.”
As our risk-free return, I use the ten-year note – current yield 2.65%. The S&P forward earnings for the next twelve months imply an earnings yield of 6.04%, for a difference of 3.39%. This is called the equity risk premium, which varies with conditions. I view the premium as quite high in the context of low anticipated inflation.
The market has a slavish adherence to the use of trailing earnings for the overall market, even though individual stocks are valued based upon expectations and outlook. Go figure. Like Mr. Buffett, I see more risk right now in the Treasury note, which would decline sharply if interest rates move higher.
FactSet regularly updates the chart below:
Some assert that expected earnings are always too high. This is an issue for another day, but feel free to reduce the estimate a bit if you wish. You can determine an upside target by choosing a forward multiple and applying it to the earnings. I think 18.5 is reasonable. This implies 3145 as a reasonable S&P value. Many look at an average multiple without considering interest rates. 18.5 or higher is quite common when rates are below 5%. When multiples are lower, it reflects strong skepticism about earnings and the economy. This goes to the heart of my approach.
The biggest risk to earnings estimates and stock prices comes from a recession. Understanding recession chances is the single most important part of fundamental investing. Most major stock declines are associate with recessions, but you must be careful not to jump the gun in cutting risk. The two years preceding a recession have shown nice gains for decades.
The average rise was 29%.
In 2010 I did a major review of recession indicators, seeking input from everyone. I chose three approaches. Dr. Robert Dieli’s Enhanced Aggregate Spread is simple, yet elegant. Using only four variables, he avoids overfitting the data. His method of combining them captures the key leading indicators. Special strengths of the approach include that it is based on sound theory and has worked in real time. The C-Score is a weekly approximation of this indicator.
The other included indicators were derived through a backtesting process. Dwaine van Vuuren’s Recession Alert and Georg Vrba’s iMarket Signals both include several methods and time frames drawn from sophisticated statistical analysis. The models have worked well in real time.
No one has any proven record of successful forecasting more than a year in advance, although you often hear such assertions. A statement like “There is a 50% chance of recession before the end of 2020” has no sound basis and would provide little value even if it did.
The biggest challenge in analyzing recession risk is finding the best sources and methods. I have done this for you.
The second big risk is a financial crisis, which might not be linked to a recession. The St. Louis Fed did a careful job in creating their Financial Stress Index.
The least reliable indicators are the stock and commodity markets. There are many expensive false positives from using markets to predict the economy.
The rest of the Indicator Snapshot includes important technical indicators for those who choose to seek and follow a message from the markets. Since today’s post is about fundamentals, I’ll take that up another day.
I do not let the emotional Mr. Market guide my economic conclusions. Instead, I use economic analysis to decide if the market worries are justified.
If there is a warning from the recession or financial stress indicators, I reduce position size on a scaled basis.
Most importantly, I always consider upside as well as downside. Without this in mind, it is easy to miss big market rallies. The Indicator Snapshot helps keep this crucial information in front of us. It provides a solid foundation for successful stock-picking.