As investors, we often believe, consciously or otherwise, that we need to own some type of asset at any given time in order for our wealth grow. And for the most part, this intuition is correct. Whether it be equity, fixed income, commodities, or any of the other investment vehicles available today, the thought of not having a significant portion of our assets allocated to one or more of these vehicles is nearly unfathomable. Think about it. How often has your personal portfolio consisted primarily of a simple money market fund? Your answer is likely to be never. If this wasn't your answer, odds are that this has been a recent occurrence rather than a longer term investment position. And for those whom this is the case, I would venture to guess that there's been a fair bit of stress or tension related to this positioning. But why all the consternation? With the S&P 500 currently down about 3% this year, those 'stuck' in cash have out performed the market rather significantly. Had we been a mutual manager, showing a 3% out performance of our benchmark index so far this year, we'd be lauded with praise for our adept managerial skill. But it's the stigma of cash as a 'do nothing' investment vehicle that causes so many of us to venture into markets that we may otherwise have avoided. And as we now enter the final months of 2010 and begin to see the effects of a slowing domestic economy in real time, our willingness to simply stay on the sidelines (or on defense) until the skies clear could be among the most logical investment decisions we make for a long time. As the title of this post implies, hiding out in cash (and to a lesser extent Treasury bonds) could be the hippest thing you do. If you don't mind being a bit of a square, of course.
Unfortunately for the equity bulls, today's market action did little continue the positive momentum that was seen at the end of Friday's session. While the S&P 500 was able to hold above the important 1,065 level, the sideways action for the majority day along with the 8 point sell off in the last 30 minutes of trading certainly did little to inspire expectations of an imminent move higher. In fact, looking across nearly all markets, selling was again the en vogue action of the day as commodities and gold fell along with the equity markets. Treasuries remained resilient throughout the day and managed to finished mixed. The ten year Treasury note saw its yield fall about 1.5 basis points to 2.60% while thirty year bonds yields rose marginally to 3.665%. This general aversion to all asset classes is a particularly interesting development to me as it appears that investors may actually be looking to cash as the vehicle of choice in this environment. With Treasury yields at historically low levels, stocks in the midst of a sell off and fully exposed to the concerns about deflation and a double dip recession, and commodities like crude oil failing to hold on to their recent price gains, I suppose it's unsurprising that many would throw up their hands in frustration and seek solace in the one asset that perceived to remain stable in value. However, whether or not this is a long term shift in investor preferences or is simply a product of today's uncertain economic environment is the more critical question. I tend to think that investors, especially those on the retail side of the ledger, have had enough with investments in general. Most have been decimated over the past decade as the dot com boom and recent credit crisis have taken large chunks from their retirement accounts. As a result, the preservation of capital is becoming much more important than the growth of capital. This is an amazing change in perspective over just a couple of years ago and is likely a trend that will continue for the foreseeable future. To be sure, this will keep the equity bulls' case under pressure.
Technically speaking, virtually all markets continue to vacillate in their recent ranges, with prices near the lower ends. However, when considering that these markets are nearing downside breakout levels as the typically dour month of September approaches, I think the market is signaling that additional pressure is coming. I've been saying for some time now that broad participation will be needed to push these markets out of their ranges. And with many charts looking vulnerable, I suspect downside volume is much more likely to materialize next month than outright buying. This (along with my fundamentally bearish outlook) is why I suggest staying defensive and looking to boring old cash for the next coupe of months. For my part, I'm looking to pare my Transports position if/when equities see a pop. While it'll end up being a loser, I'm at least comforted by the knowledge that I did a good job managing my risks by keeping the position small.
For my last point tonight, I'm going to delve into the question of corporate sales and their prospects for growth during the remainder of the year. There are a lot of different ways to project sales, but, ultimately, all the econometric models, statistical sampling, and expert surveys are simply fancy guesses. Some are better than others, to be sure, but they're still guesses. Frankly, I stink at forecasting virtually anything. That's why I don't do it. But what I do think I'm pretty good at doing is taking what the markets are implying and determining whether or not the consensus is too bullish or bearish. So with that in mind, I decided to use the widely used, relatively simple Dividend Discount Model (DDM) as a way of determining the level of sales growth the market is currently expecting. But before I get into the minutia of how I come to my conclusions, a little bit of explanation of the DDM and its limitations is probably in order.
Simply put, the Dividend Discount Model assumes that the value of a share of stock is a function of three factors: 1) the dividend a stock pays, 2) the rate of return investors demand for owning the stock, and 3) the long-term growth rate of the dividend. So, for a stock that pays a $1.00/share dividend that is not expected to grow over time, an investor that demands a 10% return would value the shares at $10 [1 / (0.10 - 0.00)]. Had the dividend been expected to grow 5% per year, the value of the shares would have rise. to $20 [1 / (0.10 - 0.05)]. So as you can see, the faster a company can grow its dividend, the more highly valued their shares would become under this model. Additionally, a reduction in the rate of return required by investors as well as a greater absolute value of the actual dividend will cause the shares to be more highly valued. Of course, if any of these inputs move in the opposite direction the calculated value of the shares will fall.
One of the cool things about a model like this is the fact that you can take current market prices and solve for any one of the inputs directly. So long as you know two of the three components, you can set the equation equal current market prices and solve of the third variable. With this in mind, I have decided to use a special form of the DDM to solve for the sales growth rate the market is currently forecasting. WARNING: The coming section is a bit wonkish, so please do not operate heavy machinery while reading this final section.
In this special form of the DDM, the Price to Sales ratio for a particular share of stock is a function of: 1) profit margins, 2) investor's required rate of return, and 3) the Payout Ratio (this is the percentage of a stock's earnings that are paid out as dividends. For the sake of this analysis, I will use the S&P 500 as the gauge of the market's sales growth expectations. According to data provided by Standard and Poors (a blend of reported Q2 data and Q2 forecasts), the components of this ratio are as follows: Current Price to Sales Ratio - 1.33, Profit Margin - 8.33%, Payout Ratio - 32.8%. As far as the required rate of return, this number cannot be directly observed and, therefore, must be assumed. While there are a host of different theoretical methods for determining this input, I approached this question in the following manner: ten year Treasury rates (a risk free rate) currently sit around 2.60%. Since equity is considerably more risky, I opted to add an additional 6% to this rate as compensation. This, therefore, means that I assume that the average investor would require 8.60% rate of return in order to own the S&P 500. If you want to have a debate about the correct required rate of return, that's a discussion for a different day and one that I am more than willing to engage in. However, for the sake of this example, let's assume that 8.6% is at least somewhat close to the correct level.
So with these inputs now in hand, we can solve for the implied growth rate. (The equation is as follows: [Profit Margin * Payout Ratio * (1 + Growth Rate)] / (Required Rate of Return - Growth Rate) ) Working through the algebra, a growth rate of 6.7% can be determined. This, therefore, means that the market is expecting sales to grow at the rather healthy clip of 6.7% in the coming quarters. But how realistic is this assumption? Given what we've seen in Q2 earnings reports along with the numerous macroeconomic issues that are looming for the domestic economy, I think it's fair to say that this estimate is probably optimistic. As most economists expect domestic GDP growth to languish in the 1.5% to 3.0% range, the ability of firms to grow sales at a rate greater than this is virtually impossible unless they are located within a fast growing industry or are able to take market share consistently from competitors. While this is certainly the case for some firms, it certainly won't be the case for all. Giving S&P 500 companies the benefit of the doubt in their ability to grow sales at a rate greater than GDP and plugging in a more conservative growth rate of 4% into the model, the Price of Sales ratio falls to about 0.61. This would put the S&P 500's value around 500! To be sure, there are limitations to this conclusion, but I think the result is eye opening just the same.
While I'm not claiming that our next stop is S&P 500, I do think this is a good illustration of how growth dependent this market is and how quickly things could change if things slow further. All the more reason to remain defensive. I apologize for the long post tonight, but I hope that this illustration has at least perked your interest and perhaps exposed some risks that you might not have considered. Until tomorrow.....
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