Playing The Bull Market s Final Inning(s)

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1 Playing The Bull Market s Final Inning(s) Douglas Ramsey, CFA, CMT Mid-September 2013 FOR PROFESSIONAL USE ONLY. FURTHER DISTRIBUTION OF THE INFORMATION CONTAINED HEREIN IS PROHIBITED WITHOUT PRIOR PERMISSION.

2 Disclosures This report is not a solicitation or offer to buy or sell securities. The Leuthold Group, LLC provides research to institutional investors. It is also a registered investment advisor that uses its own research, along with other data, in making investment decisions for its managed accounts. As a result, The Leuthold Group, LLC may have executed transactions for its managed accounts in securities mentioned prior to this publication. The information contained in The Leuthold Group, LLC research is not, without additional data and analysis, sufficient to form the basis of an investment decision regarding any one security. The research reflects The Leuthold Group, LLC s views as of the date of publication, which are subject to change without notice. The Leuthold Group, LLC does not undertake to give notice of any change in its views regarding a particular industry prior to publication of their next research report covering that industry in the normal course of business. The Leuthold Group, LLC may make investment decisions for its managed accounts that are inconsistent with, or contrary to, the views expressed in current Leuthold Group, LLC reports. Weeden Investors, L.P., Weeden & Co., L.P.'s parent company, owns 22% of Leuthold Group s securities. A Managing Director of Weeden & Co., L.P. is a member of The Leuthold Group, LLC board of directors. Weeden & Co., L.P. member FINRA, NASDAQ, and SIPC. 2

3 MTI is mildly bullish Major Trend Index Net Reading Intrinsic Value -215 Economic/Interest Rates/Inflation -7 Attitudinal -146 Supply/Demand 75 Momentum/Breadth/Divergence +435 Ratio of Positive to Negative Points: 1.12 Above 1.05 = Bullish Between 0.95 and 1.05 = Neutral Below 0.95 = Bearish 3

4 It s not exactly been a global bull market United States (S&P 500) Foreign Developed Markets (MSCI World Ex USA) Emerging Markets (MSCI)

5 The tape is mostly in gear S&P 500 Dow Jones 65 Composite Dow Jones Transports Dow Jones Utilities Russell 2000 S&P 500 Financials Morgan Stanley Cyclical Index NYSE Advance/Decline Line x10 5 July 22, 2013 S&P 500 bull market high

6 Tape is in gear (cont.) Market Early Warning Signals: Prior S&P 500 Tops Vs. Today Subse- Dow 65 Dow Dow Russell S&P 500 MS NYSE Total Date of quent Composite Transports Utilities 2000 Financials Cyclical A/D Line Number of Bull Market High Decline Warning? Warning? Warning? Warning? Warning? Warning? Warning? Warnings* July 16, % July 17, March 24, October 9, Average: 6.3 Important Highs, March 2009 To Date April 23, April 29, August 2, *A warning is issued when an index fails to "confirm" a new S&P 500 bull market price high during the preceding 21 trading days (one month). Usually most of these internal market measures will deteriorate before the final bull market peak is achieved. But at the August 2nd high, just one of these seven leading measures (DJ Utilities) had raised a warning flag. 6

7 Two longer-term warning signs S&P 500 NYSE Weekly Advance/Decline Line The NYSE Weekly Advance/Decline Line generally acts stronger than its daily counterpart throughout a bull market. But the weekly version now looks weaker, and hasn't made a new high since mid-may S&P 500 NYSE High/Low Logic Index* (10-Wk. Avg.) Above 5% - Tape is "divergent"- BEARISH NYSE new 52- week highs and lows are both at elevated levels, a sign that market strength is not as uniform as indicated by most other measures. Below 1% - Tape is "in gear"- BULLISH Index calculated as the lesser of NYSE Weekly New Highs and New Lows as a percentage of issues traded. 7

8 A possible sign of distribution? SPDR S&P 500 ETF Trust (SPY) SPDR Cumulative Opening Price Change (The "Emotional Money") SPDR Cumulative Intraday Price Change (The "Smart Money") Morning hype has lately been giving way to afternoon weakness a sign the smart money may be "distributing" stock

9 Rates and stocks prices can rise together Stocks & Interest Rates Can Sometimes Go Up Together S&P U.S. 10-Yr. Treasury Bond Yield (weekly close)

10 Rising rates/ rising stock prices (cont.) S&P Yr. P/E on 5-Yr. Bond Stock Market/ Normalized Dates Yield S&P 500 Bond Yield Action EPS 1 May 2, Stock Market Up: 38.5 % 15.1 July 31, Bond Yields Up: 152 Basis Points 2 January 11, Stock Market Up: 44.7 % 21.0 February 11, Bond Yields Up: 106 Basis Points 3 January 27, Stock Market Up: 25.8 % 21.2 November 29, Bond Yields Up: 131 Basis Points 4 November 5, Stock Market Up: 26.8 % 15.2 January 5, Bond Yields Up: 70 Basis Points 5 March 3, Stock Market Up: 60.1 % 11.3 November 28, Bond Yields Up: 468 Basis Points 6 November 5, Stock Market Up: 19.1 % 8.8 July 22, Bond Yields Up: 95 Basis Points 7 April 18, Stock Market Up: 38.9 % 16.5 August 21, Bond Yields Up: 168 Basis Points 8 January 19, Stock Market Up: 8.0 % 24.6 June 7, Bond Yields Up: 139 Basis Points 9 October 2, Stock Market Up: 46.1 % 27.8 January 14, Bond Yields Up: 238 Basis Points 10 June 13, Stock Market Up: 34.1 % 23.0 May 5, Bond Yields Up: 199 Basis Points 11 March 20, Stock Market Up: 53.3 % 11.3 April 2, Bond Yields Up: 131 Basis Points 12 June 1, Stock Market Up: 29.5 % 18.6 September 6, 2013 (To Bond Yields Up: 147 Basis Points Average Stock Market Gain (Excl ): 35.4 % 17.9 Median Stock Market Gain (Excl ): 36.3 % 17.6 Average Bond Yield Increase (Excl ): Median Bond Yield Increase (Excl ): 170 Basis Points 143 Basis Points 10

11 Bull markets have frequently topped near current valuations S&P 500 Normalized P/E At Bull Market Peaks, 1957 To Date S&P 500 Normalized Date Of S&P 500 P/E At Bull Bull Market Peak Market Peak December 31, x February 28, November 29, January 31, September 29, November 29, August 31, "Normal" July 31, S&P 500 July 31, Bull Market March 31, High October 31, Median At Modern Era Bull Market Peaks (1957 To Date) 20.9 x 1695.ec S&P 500 P/E On 5-Yr. Normalized EPS (1926 To Date - Monthly) 1957-to-Date Median = 18.6x August 30, 2013 = 20.1x (76th percentile since 1926) to-Date Median = 16.6x Great Depression earnings wipeout

12 Profit margins have probably peaked for this business cycle U.S. Corporate Profits As A Percent Of GDP [from National Income and Product Accounts (NIPA); Profits are after tax and Include inventory valuation allowance and capital consumption adjustment] 65-Yr. Median = 6.0% % 8.6% 5.5% 10.3% 10.1% (2Q)

13 Implications of high margins Yr. Annualized Growth In NIPA Corporate Profits (scale at left) Margins Are An Excellent (But Unfortunately Inverse) Predictor Of Future Profit Growth Concept courtesy of Hussman Research & Insight. NIPA Corporate Profits As A Pct.Of GDP - advanced five years and shown on inverted scale (right) Today's profit margins are so inflated that substantially slower profit growth over the next three to five years is almost baked in the cake. 13

14 The bond bull has been a big driver of margin gains How The Bond Bull Boosted Earnings... Net Interest Expense As A Pct Of Earnings Before Interest And Taxes (EBIT) (right scale) likely path Moody's BAA Corporate Bond Yield (quarterly average - left scale) best case

15 Bookkeepers have also helped boost margins How Bookkeepers Have Boosted Earnings... Top Marginal Corporate Tax Rate Corporate Income Taxes As A Percent Of Pretax Corporate Profits (Effective Tax Rate) 19.9% (2Q) Effective Corporate Tax Rate As A Percentage Of Statutory Rate Yr. Median = 80% % (2Q)

16 Virtually all margin improvement has been below the line From The Late 1990s Profitability Peak To Today NIPA Income Statement 1997:Q3 2013:Q2 Earnings Before Interest & Taxes As Pct. Of "Sales" (i.e., GDP) 15.1% 15.3% Net Interest Payments Pct Sales 4.8% 2.7% Corporate Income Taxes Pct Sales 2.9% 2.5% Net Corporate Profit Margin 7.3% 10.1% Margin Expansion: 16

17 On the positive side, EBIT margins have room to move higher Earnings Before Interest And Taxes (EBIT) As A Percent Of GDP 16.7% 15.1% 16.4% 15.3% (2Q) Yr. Median = 13.7% 12.2% 11.9% From National Income and Product Accounts (NIPA); Profits include inventory valuation allowance and capital consumption adjustment. 17

18 Breadth of earnings gains has narrowed dramatically in last year 6 yrs. of strong earnings breadth 4+ yrs. Of strong earnings breadth 2 yrs. of strong earnings breadth % = recession alert 50 Percent Of Companies With Rising Year-Over-Year Earnings* *Based on tabulation of all earnings reports published in Investor's Business Daily

19 Earnings breadth & the leadership inversion Earnings Breadth & Stock Market Leadership February 17, 2011: Peak in earnings breadth Percent Of Companies With Rising Year-Over-Year Earnings Ratio, Morgan Stanley Cyclical Index/ Consumer Index Ratio, S&P 500 High Beta/ Low Volatility Index Ratio, Russell 2000 to S&P

20 Industry groups are enjoying positive feedback Ratio, Strong To Weak Global Industries (Relative price performance of top to bottom quintile of MSCI World Level III industry porfolios formed monthly on trailing 12-mo. price momentum.) 2002 bear market low 2009 bear market low 2011 correction low The stock market is in a "positive feedback" loop in which winning industry themes tend to keep winning over the short- to intermediate-term. This is likely to continue on a relative basis until well into the next bear market

21 Momentum strategies work best near the end of a bull market Performance Of Price Momentum In Last 12 Months Of Bull Markets Stocks With Stocks With Date Of Monthly High Price Low Price Bull Market High Momentum Momentum August February October May July December January November December September November August June June March October Average 34.7 % 16.4 % Number Of Times With Highest Return 12 4 Monthly total returns for large-cap stocks based on Fama-French Momentum Portfolios, Tuck School of Business. Boxes highlight higher return in last year of bull market. 21

22 And momentum even wins during bear markets! Performance Of Price Momentum During Cyclical Bear Markets Stocks With Stocks With Bear Market Dates High Price Low Price (Monthly) Momentum Momentum Sep Jun Mar Mar Nov Apr Jun Jun Aug Oct Jan Jun Feb Sep Dec Jun Jan Sep Oct Feb Dec Jul Sep Nov Jul Oct Jul Aug Apr Sep Nov Feb Average % % Median Number Of Times With Highest Return 14 2 Monthly total returns for large-cap stocks based on Fama-French Momentum Portfolios, Tuck School of Business. Boxes highlight better performer during bear market. 22

23 New bull markets see the Revenge of the Nerds Performance Of Price Momentum In First Year Of New Bull Markets Stocks With Stocks With Date Of High Price Low Price Bear Market Low Momentum Momentum June % % March April June October June October May October March August December October August October February Average 41.6 % 66.6 % Number Of Times With Highest Return 7 9 Monthly total returns for large-cap stocks based on Fama-French Momentum Portfolios, Tuck School of Business. Boxes highlight higher return in first year of bull market. 23

24 Investors remain in love with yield, at a time it scarcely exists Total Yield On A 60/40 Portfolio (60% S&P 500/40% 10-Yr. Treasurys) 1878-To-Date Median = 4.15% August 30, 2013 = 2.43%

25 A sober portfolio forecast Total Yield On A 60/40 Portfolio Vs. 10-Yr. Total Portfolio Return Correlation Coefficient (1878 To Date) = Yr. Trailing Return On 60/40 Portfolio (right scale) Total Yield On 60/40 Portfolio (advanced 10 yrs. - left scale)

26 The bipolar modern history of bonds U.S. 10-Yr. Treasury Bond Real Total Return Index (Cumulative Total Return Deflated By CPI) 1926 To Date Annualized Real Total Return, Jan26 - Jan13 = +2.38% Annualized Real Total Return, Oct81 - Jan13 = +6.67% Annualized Real Total Return, Jan26 - Sep81 = +0.01% September 30, the best date in U.S. history to retire

27 A simple way to forecast bond returns Current Bond Yields Have Historically Been An Excellent Estimate Of Bonds' 10-Yr. Future Total Return Potential... Correlation, January 1930 To Date = Yr. U.S. Treasury Bonds 10-Yr. Annualized Total Return U.S. 10-Yr. Treasury Bond Yield, Advanced 10 Years

28 Bond market symmetry! The Bond Bull Market Has Essentially Been The Mirror Image Of The Previous Bear! September 1981 yield peak = 15.32% Correlation Between Actual Yield and "Mirror Image" Forecast, October 1981 To Date = 0.92 Oct81-To-Date Actual U.S. 10-Yr. T-Bond Yield (mo. avg.) Sep41-Sep81: U.S. 10-Yr. Treasury Bond Yield (mo. avg.) Oct81-Sep21: "Mirror Image" of U.S. 10-Yr. T-Bond Yield (mo. avg.) To preserve its near-perfect symmetry with the preceding bear market, the secular bond bull begun in September 1981 would need to last until July

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30 S&P A Simple, Single-Asset Annual Allocation Strategy: Invest Using Last Year's Performance Rank, Second Best Third Best Fourth Best Fifth Best Sixth Best Worst Performing Asset 30 Best Performing Asset T O T A L R E T U R N (%)

31 Buy last year s Bridesmaid asset class! 2012 Total Return REITs (NAREIT Index) 20.1 % MSCI EAFE 17.9 Russell S&P Gold Yr. U.S. Treasury Bonds 2.8 Commodities (GSCI) 0.1 Year Bridesmaid Asset Class Owned During Year % Commodities 75.0 % Gold Commodities Large Caps REITs Gold EAFE Small Caps Large Caps Govt. Bonds REITs REITs REITs Large Caps Govt. Bonds Commodities Commodities Large Caps Govt. Bonds REITs REITs Small Caps Commodities Small Caps Commodities Small Caps EAFE EAFE REITs Govt. Bonds Gold EAFE EAFE Gold EAFE Gold Gold REITs REITs Gold EAFE , Annualized Total Return: 9.8 % 15.6 % 14.2 % Std. Deviation: 18.1 % 19.0 % 20.2 % No. Yrs Matching Or Exceeding S&P 500: 28/40 23/40 Correlation With S&P 500 (Annual Returns): S&P 500 Total Return Bridesmaid Strategy (Own Previous Year's Runner-Up Asset Class) Total Return Bridesmaid Strategy With Monthly Rebalancing (Using 12-Mo. Momentum) 31

32 Bridesmaid has been a winning sector strategy, too 2012 Total S&P 500 Sectors Return Financials 28.8 % Consumer Discretionary 24.1 Telecom Services 18.3 Health Care 17.9 Industrials 15.3 Materials 15.0 Information Technology 14.8 Consumer Staples 10.8 Energy 4.6 Utilities 1.3 S&P % Bridesmaid Sector Strategy With Bridesmaid Monthly S&P 500 Bridesmaid Strategy Rebalancing Total Sector (Last Year's Total (Using 12-Mo. Return Second Best Sector) Return Momentum) % Consumer Staples 41.7 % Financials Consumer Discretionary Industrials Health Care Financials Financials Health Care Telecom Services Materials Health Care Consumer Discretionary Materials Materials Utilities Utilities Energy Materials Health Care Materials Industrials Consumer Staples Consumer Discretionary Annaulized: Total Return 9.1 % 13.3 % 14.6 % Std. Deviation 18.7 % 25.3 % 24.5 % No. Yrs. Outperforming S&P 500: 13/22 15/22 Correlation With S&P 500 (Annual Returns): Results assume annual rebalancing of S&P 500 sectors; numbers include dividends, but exclude transactions costs. 32