Round and Round

As of today’s close, the S&P 500 is up 0.81% on a simple price basis.  Except for the late January correction and subsequent rally, this has been the quintessential “dog chasing its tail” type market year to date.  

While there are three trading days left in April, and anything can happen of course, we thought it might be interesting to see what has happened in the past when the S&P 500 has finished the first third of the year near flattish levels.  Why the first third?  Nearly everyone focuses on quarterly data.  Why not look at sometime a little different.  And, April leads into May, the beginning of a historically week seasonal period.  Remember, we should all sell in May and Go Away.  April just might be a good spot on the calendar to evaluate performance dynamics.  

We looked back over the past 83 years of S&P data and learned a few things.  First, it’s somewhat rare for the S&P 500 to finish the first third of the year near the zero line.  There have been only 14 instances over the past 83 years where the S&P 500 finished within a +2% to -2% range over the first four months.  Second, there’ve only been five instances where the market has finished the first third of the year between 0% and +2%, the range that pertains to this year’s market.  

So, what happens the rest of the year when the market starts off flattish?  

Looking at the 14 overall instances where the market has begun the year within + or – 2% of the zero line, there are frankly no solid conclusions to draw from the data.  Average total year returns for those years is -1.15% and median performance is 2.76%.  However, the standard deviation of yearly returns is a whopping 17.6%.  Full-year returns ranged from +25.8% to -47.1%.  

Keep in mind, though, that 9 out of the 14 yearly results during the first third fell between 0% and -2%.  In those nine years, average full year returns were -5% and median full year returns were negative 10.1%, with a standard deviation of 20.9%.

Focusing on the 5 years that ended the first third between 0% and +2%, the picture is more encouraging, though we’ll admit that 5 occurrences is far from meeting the standard of statistical significance.  Average full year returns for the five year: 5.8%.  Full year median returns come in at 7.1%.  The standard deviation is a much tighter 5.8%.  All in all, this presents a much better picture than the volatile, negative stats above.  Four out of the five years that finished the first third of the year between 0% and +2% closed out the full year in positive territory.

Are there any conclusions to draw?  As mentioned, statistical significance is lagging.  And the overall data is all over the place.  But, if we had to choose, we’d err on the side of hoping that the S&P 500 can finish April on the positive side of zero.  Many have struggled to explain the January effect through the years. Maybe, this situation is similar.  There’s no rational reason why the market should behave markedly different the rest of the year based on the fact that the market happens to be slightly on one side or the other of zero.  Yet, looking at the past numbers, if April can close around these levels, just on the right side of zero, it will fit in with our expectations from other statistical research that 2014 should be a modest but OK year.  A negative close to the month may, rationally or irrationally, open markets up to a volatile and frustrating final nine months.  

When Momentum Bites Back

In a broader sense, the “dog chasing its tail” market action continues.  All said, the S&P 500 entered today (Friday) down less than 1% for the year and the broader New York Stock Exchange Index was actually around flattish.  Put in those terms, we see a market that is certainly frustrating for those that became accustomed to last year’s steady and satisfying upward march, yet a round and round yawner at the end of the day.  Why all the hand-wringing, then, with this week’s declines?  The high-flying momentum names have been crushed.  These are the names that have been media darlings and obsessions for months and that have produced some amazing returns over the past two years.  Biotech has been completely beat up, with the biotech ETF falling nearly 20% from its peak on February 25^th (though amazingly it’s still basically flat for the year).  Techie names such as Tesla, Facebook, Amazon, and others have faced heavy distribution.  

What’s the lesson here?  You live by the sword you die by the sword.

We’ve seen a bunch of whining in the popular business press about a “lack of justification” for the momentum selloff or a lack of catalysts or news.  There was a particularly funny article in the Wall St. Journal this morning concerning the biotech sector selloff with one analyst proclaiming, “Horrible day in #biotech.  I’m frankly at a loss for an explanation.  And it’s my job to at least know why.  Humbling day.”  Another gem comes from an analyst that had the gall to express a cautious view about the sector: “At some meetings and dinners with investors’ nerves have become frayed and tempers a little flared,’ he said.  ‘Nothing in an aggressive way, but: ‘Why are you doing this?...Why are you ending this terrific ride?”  Again, let us remind you that the sector was up approximately 100% between 12/31/2012 and the end of February 2014.  Facebook stock was up 175% from 6/30/13 to the end of Februrary.  The list goes on and on.

Growth and momentum strategies are perfectly valid ways to approach the investment universe.  We happen to prefer the value side over the long run; there are plenty of professional and individual investors, however, that know the growth markets inside and out and have generated very successful long-term track records navigating the space.  In value, the big risk oftentimes is getting into names too early and having them move against you, or buying the dreaded “value trap.”  The key is making sure that risk management techniques are such that the “value traps” don’t drown bog down performance.  In growth, the key seems to be capturing gains in names that trade at very high multiples before the dreaded “missed expectations” bug hits and brings performance down to earth, or before profit-taking morphs into broader, more violent declines, which is probably the case here.  

In any case, we know that over the long-run, regression to the mean exists, companies’ growth prospects ultimately return to a normal trajectory, and that valuation multiples tend to compress back to more pedestrian levels.  Looking at some of the multiples for the names and sectors that have been hit, it shouldn’t be a surprise that they’re facing this type of volatility.  The biotech sector, for instance, is trading with a price to book of 7.51x, approximately 3x the level for the broader S&P 500.  On a price to sales basis, the level is 7.9x versus 1.7x for the S&P 500.  Price to cash flow?  The average for the underlying names is 50.75x, upwards of 5x the level for the S&P 500.  Amazon?  The EV/EBITDA is 34x and price to book is 14.8x.  Facebook?  EV/EBITDA comes in at 37.7x and price to book 9.8x.  Priceline?  22x and 8.8x respectively.  Yes, some of these companies are growing rapidly though even at very generous growth rates it’s hard to back into and justify these valuations.  Sky high multiples form the basis for the performance air pockets seen from time to time in these names.  

In the end, trade away in the super-momentum stocks all you want and enjoy the good times when they happen.  Don’t complain, though, when emotion and sentiment reverse and investors begin refocusing on valuation metrics and other factors creating big-time downward thrusts.  Ultimately, valuation does matter.  While nothing we’ve observed in recent weeks comes close to the tech frenzy of 1999, there are companies whose stock prices were running on fumes that have seen price declines of 40% to 50% plus in a matter of weeks.  Getting caught up in media and market sentiment driven frenzies while taking the eye off the valuation ball can lead to some significant pain and volatility in portfolios.  Unfortunately, those with the least experience in markets end up piling into these names at the end of the run.  The more things change the more they stay the same.

Sentiment Picture: Q1 End

After a full quarter of “dog chasing its tail” type action in global markets, various global indices ended Q1 at or near highs.  All of this happened in spite of a backdrop of China fears, Ukraine fears, polar vortex fears, US growth fears, valuation fears, European deflation fears, fear of flying, fear of Ebola, and fear of earthquakes.  After everything US and global markets have “endured” these first three months, we’ve been rather impressed with market resiliency.

Following whirlwind quarters like the one just experienced, we like to check in on how various sentiment indicators in the marketplace are lining up.  When the market is breaking to new highs, we’re always a little more encouraged when sentiment leans to the dour side.  Interestingly, that’s exactly what’s happened.  The sentiment indicators we follow indicate mild caution, which we’ve found generally supportive of market performance.  

Let’s begin with the US CBOE equity Put/Call ratio.  Again, we use the 10-day moving average to smooth out some of the noise.  Last time we checked in ahead of the Q1 market correction, this indicator had hit some of the lowest (more bullish) levels observed over the past several years.  The correction and general negative noise in the marketplace have brought this indictor back above the long-term median and back to the middle of the range observed over the past several years despite the fact that the S&P 500 has moved into new all-time (nominal) high territory.  

Next, the ISES All Equities Sentiment Index, which also captures sentiment in the options market, shows a similar picture.  At the beginning of 2014, the 10-day average had reached the highest levels (more optimism) in two years.  Since then, at 152.50, the indicator has dropped back into the more cautious “wall of worry” range it’s occupied since early to mid 2012.  

The Farrell Individual Investment Sentiment Indicator uses the bull/bear/neutral readings each week to provide a picture on overall sentiment.  Sounding like a broken record, this indicator had moved above historical median early this year towards the highest levels observed since early 2011.  Since then, even with market grinding higher, the 10-week average has now moved back below median levels.

Finally, the 4-week moving average for the BNP Paribas Love-Panic Market Timing Indicator gives a picture of sentiment over in Europe.  Europe has been acting swimmingly of late, yet sentiment remains in neutral territory.

Taking all into consideration, market participants aren’t demonstrating outrageous pessimism.  Nonetheless, it’s interesting and mildly encouraging that investors maintain a healthy dose of skepticism while global and US markets have found a way to move towards new highs.  Likewise, though there’s been some noise associated with weather in the US and abroad, there’s no indication at this point that developed market economies face immediate recession dangers.  The overall backdrop isn’t completely hunky-dory for markets.  For instance, we remain concerned intermediate-term about valuation levels in the US markets.  Until we see a combination of overly optimistic sentiment, negative market momentum, and cracks in the growth trajectories for the leading developed markets, we’ll have to give equity markets the benefit of the doubt right now.