This is the January 2015 investment conditions update and market exposure recommendation.
Favorable investment conditions can be thought of as favorable weather. Just as you don’t launch a sail boat when heavy storms are likely, there are favorable investing conditions when the sun is shining and there is a tailwind that raises the likelihood of positive portfolio returns.
Identifying favorable conditions is much easier than predicting specific events. It is the difference between predicting that it will be cold this winter versus whether it will snow on Christmas Day in the Northern Hemisphere. The more specific the prediction, the more likely it is to be wrong.
Investment conditions for stocks are favorable. Market Internals (including sentiment) and Economic/Central Bank Trends are rated Green while valuations are rated YELLOW.
This means the market environment for stocks remains favorable and conducive to the continuation of the secular bull market that has been in place since 2009.
Investors should maintain a weighting in stocks toward the upper end of their target allocation range.
The following report divides investment conditions into three areas:
1. Market Valuations
2. Market Internals (including Investor Sentiment)
3. Economic and Central Bank Trends
Market valuations, market internals and economic and central bank trends can be thought of as traffic stoplights that are each individually flashing red, green or yellow.
When all three are red as they were in September 2008, that warrants extreme caution and a more conservative investment approach. When two out of three are green as they are today, it warrants a higher allocation to stocks.
Here is a review of each segment:
Market Valuations – YELLOW
Almost six years into a bull market that began in March 2009 global stock market valuations are no longer cheap. Nor are they overly expensive.
The earning yields for the MSCI AC World Index, a measure of global stocks, is 5.5%, right at its 20 year average but above its average of 6.5% going back to 1970.
The MSCI AC World Index would be considered expensive if the earnings yield fell to 5%, which would equate to a price-to-earnings ratio of 20.
Recall that an earnings yield is the inverse of a price-to-earnings ratio so the lower the yield, the more expensive the market.
If global earnings remain stable, the global stock market as measured by the MSCI AC World Index could appreciate approximately 14% before it reaches an earnings yield of 5%.
The earnings yield for the U.S. is 5.2%, Europe is 5.8% and the Pacific region is 6.4%.
The most attractive areas from a valuation perspective is Emerging Markets, particularly China. The earnings yield for all emerging markets combined is 7.5% and China is 9.9%. Those earnings yields are above their respective historical averages.
Market Internals – GREEN
Market valuations are helpful to assess the long-term potential for stocks, but they are not particularly useful in determining market direction in the short to intermediate time frames.
Markets can stay overvalued for long periods of time and investors can leave a lot of money on the table if they rely exclusively on asset class valuations to determine their investment strategy.
Market direction in the short-to-intermediate time frame can often be determined by monitoring market internals.
Market internals measure a stock market’s health. Market valuations are just one symptom of the market. Valuations are like taking the market’s temperature. Just as a doctor doesn’t diagnose a patient’s health by relying exclusively on a thermometer, we have to look at other measures to determine what is really going on with the stock market.
(Note: for clarification in this and future reports I will use the term market internals instead of investor sentiment because it is a more comprehensive description.)
Determining Market Internals
Questions we have to answer to assess market internals include:
What is the market’s upside or downside momentum?
How broad or narrow is the market advance?
What is investors’ level of fear and greed?
Answering these questions helps us stay in sync with current trends. In other words, an understanding of market internals allows us to invest on the leading edge of the present rather than base our investment success on trying to predict the future.
I use numerous measures to assess market internals. In order to keep this report brief, however, I won’t highlight each one but instead spotlight a few examples.
Breadth measures whether the global stock market advance is broad or narrow. One way to measure it is the percentage of global markets (i.e. individual countries) trading above their 50 day moving average.
When more than 50% of global markets are above their 50 day moving average, the global stock market as measured by the MSCI AC World Index has risen 10.7% per annum. When less than 50% of markets are below their 50 day moving average, the global stock market has fallen 13% per annum.
Currently, 54% of global markets are above their 50 day moving average.
Another indicator is where are global stock prices as measured by their six month moving average relative to their one year historical range.
When stock prices are above their historical range, markets have advanced over 8% per annum whereas if they are below their historical range they have fallen over 12% per annum.
Global stock prices are above their historical range.
One way to determine the level of investor fear and greed is by comparing the trading volume of stocks that are rising to the trading volume of stocks that are declining. This is a proxy for market demand or the ferocity with which investors are willing to buy or sell. Currently “demand” is greater than “supply” which is bullish for stocks.
One negative mark for stocks is survey data indicates that investors are again quite optimistic after being overly pessimistic when markets sold off in October. It is something I continue to monitor. The risk of a sell-off can increase when optimism hits an extreme and then reverses.
Bottom line is market internals are positive suggesting the current long-term uptrend in stocks will continue.
Economic and Central Bank Trends – GREEN
The most robust data set for understanding global economic growth trends is Purchaser Manager Indices (PMIs), which are monthly surveys of businesses conducted by Markit and other providers.
There are both Manufacturing and Services PMI surveys conducted each month. Generally, a reading above 50 suggests an economy is expanding while a reading below 50 suggests an economy is contracting.
For purposes of this report, I focus on Manufacturing PMIs as they have a longer and more accurate history of predicting global recessions.
The most recent JPM Global PMI data for the month of December slipped to 51.8 versus 52.2 for the prior month. This is the lowest since September 2013 but still suggests the global economy continues to expand.
Despite the lower overall PMI level, two-thirds of countries saw their manufacturing PMI increase month over month, the highest since last January. The share of countries in the world with positive Manufacturing PMIs is 70%, with 40% of countries showing a year-over-year increase in manufacturing PMI. That compares with 30% of countries that showed a year-over-year increase last month.
Global economic expansion appears to be continuing at its modest pace and is supportive of a continued uptrend in stocks.
Central banks remain accommodative throughout the world, although if the U.S. economy continues to accelerate it is likely the U.S. Federal Reserve will start raising interest rates beginning in June 2015.
In the coming weeks, we’ll take a closer look at the ramifications of the Federal Reserve raising interest rates.
With market internals and economic/central bank trends GREEN, and valuations YELLOW investment conditions suggests a continued favorable environment for maintaining an overweight exposure to higher risk, more volatile assets such as stocks.
In addition, seasonality trends in the first part of the year are quite favorable, particularly in the U.S. as typical early year seasonality is combined with the strong third year presidential effect and the fifth year of the decade effect.
My stock exposure remains above average.