X-factor 102211 - Market is Not Cheap

8/3/2019 X-factor 102211 - Market is Not Cheap

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DISCLAIMER: The opinions expressed hereinarethose of thewriter and may not reflect those of Streettalk Advisors, LLC, Charles Schwab & Co., Inc.,

FidelityInvestments, FolioFN or any of its affiliates. The information hereinhas beenobtainedfromsources believed to bereliable, but wecannot assure

its accuracyor completeness. Neither the information nor anyopinion expressed constitutes a solicitation for the purchaseor sale of any security.Any

referenceto past performanceis notto beimplied orconstruedas a guarantee of future results. See additional disclaimersat theend.

The Market Is NOT Cheap

On October 3rd we wrote a blog that said: This is why the next rally that we

likely see will be into the end of the year. This will most likely be a suckers

rally as it will suck investors in as the media bleats about the end of the bear

market.

Here are some headlines from last week:

S&P sees longest weekly rise since February

Bulls insist common stocks are cheap as hell.

US Stocks are cheap rally will last

There were many more but you get the idea. This week I wanted to spend alittle time discussing this idea of whether stocks are currently cheapafter the

decline over the previous five months and whether or not this is the time to

buying.

However, before we can start any discussion about valuations on the market

we have to establish that we will only be looking at 12-month trailing reported

earnings.

Trailing "as reported" earnings numbers which is the only method by which

P/E ratios are ever viewed. When analysts began to use operating earnings,

forward estimates or any variation thereof, they are not comparing apples toapples and they are being disingenuous to the valuation process.

There are a number of major problems with not using trailing earnings

besides just being deceitful. Over the last 110 years the S&P 500 has been

priced at an average of 15 times earnings. However, and very importantly,

the earnings used in the calculation were reported (GAAP) earnings, not

operating earnings or estimates.

October 22, 2011

Inside This Issue:

The Market Is NOT Cheap

Oversold and Cheap AreDifferent

Earnings Can't Outgrow

Economy

Fed Model Is Broken

Technically Speaking

Market Breaks Out

Bear Market Still In Tact

401k Plan Manager

May Be Getting Close To A

Change Sell The Rally.

Click Here For Current

Model Allocation.

Disclaimer & Contact Info.
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The problem with operating earnings, which were not used until the mid-to-

late 1980s, is that they exclude write-offs of various kinds as determined

arbitrarily by corporate management. Generally operating earnings are far

higher than reported (GAAP) earnings. GAAP stands for "Generally

Accepted Accounting Principles", and operating earnings do not conform to

those standards. If the historical average P/E was calculated on the basis of

operating earnings the P/E would be much lower.

The use of estimated 12-month forward earnings is also completely ludicrous.The estimates are almost always wrong and most often on the high side. For

instance the estimate for 2001 was $54.20 and came in at $36.85. Reported

earnings that year were $24.89. Similarly, the estimate for 2008 was $99.15,

but came in at only $49.54 while reported earnings were a paltry $14.88.

Another big problem is the volatility

of year-to-year earnings which

constantly fluctuate from high to

low and back again. Historically

the market has valued peak

earnings at an average P/E of 12while valuing trough earnings at a

P/E of 18.

The markets move in very broad

long term cycles as shown in the

chart. These "secular" cycles on

average last about 15-18 years in

total from beginning to end. The

driving factor behind these long

term secular cycles is valuations.

When valuations are low at the

beginning of a period as they were

in 1898, 1922, 1950 and 1982 the

market experienced a bull market of

significant proportions as valuations

rose over time - this is called

"multiple expansions".

During the opposite periods, as

markets experienced "multiple

contractions", returns for investorswere extremely low on a "buy and

hold"basis.

It is important to have a grasp, as

well as a respect, for these secular

cycles as it predicates how invested

dollars should be allocated.


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Oversold And Cheap Are Two Different Things

The talking heads and promoters are mostly saying that either there will be no

new recession any time soon and/or the stock market has already priced one

in.

First of all, just because the market bounces from a very oversold condition

after being down five months in a row, which we said was very likely to

happen in our September 30th

blog post, does not mean that a recession hasbeen forestalled. Time will tell on this point.

However, the second point is much more important as the argument that has

been used repeatedly is that the average price-earnings ratio of the U. S.

stock market in recessions is 13.7, but stocks are selling at 10-11 times 2012

estimated earnings.

Bah!

The problem with it is that those 2012 earnings estimates are based on

upbeat, non-recessionary earnings estimates and, more importantly, areconsistently higher than the actual numbers when they are reported.

Whoops!

If there is to be (or, if there already is) a recession any time soon, investors

need to remember that a great many companies are highly leveraged in

various ways. This of course includes many financial companies, but it also

includes a good many others. This in turn means that earnings can turn on a

dime. They do and they will.

Andrew Smithers asserts that the only two proven valuation measures areearnings adjusted for their average over many years, a concept known as
http://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.htmlhttp://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.htmlhttp://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.htmlhttp://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.htmlhttp://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.htmlhttp://www.streettalklive.com/daily-x-change/379-5-down-months-time-for-a-bounce.html


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cyclically-adjusted price-earnings ratio (CAPE), and a totally different

measure known as q. Q is a measure of what it would cost to replace the

assets of companies.

The importance of these two measures is critical to understand. While the

analysts and the mainstream media continually tout that based on one factor

or another stocks are a great buy the reality is that they are quite expensive.

Shillers price to earnings ratio smoothed with a 10-year average strips outthe annual volatility in earning to reveal the longer term trend. As we stated

above; when the multiples of earnings are contracting, as they are now,

market returns tend to be low over a long period of time. As they have been

for the last decade.

Secondly, bear markets have NEVER, and I repeat NEVER, been resolved

when earning were above, equal to or slightly below their long term average.

Bear markets are completed when valuations are near single digits (between

7 and 10x trailing earnings) historically.

The problem is that today the accounting gimmickry and game playing hasgone beyond rationality. Therefore, the measure of Tobin Q-Ratio strips most

of this non-sense out. The Q-Ratio is a measure of what it would cost to

replace the assets of the companies. Liabilities and assets are much harder

to fudge than earnings. Furthermore, no one uses any measure of forward

liabilities and assets when trying to make a case as to why you should be

buying stocks.

Therefore, the elegance of combining these two different measures, as we

have done in the chart above is that it gives you a much clearer picture as to

the relative overvaluation of the market.

Earnings Cant Outgrow The Economy

So, back to the stream of talking heads in the media proclaiming that based

on 2012 expected earnings stocks are undervalued, and, of course, no one

ever challenges them.

Never mind the impending issues with Europe and their economy, the

slowdown in China or the drag of the U.S. consumer on the domestic

economy. Dont pay any attention to the fact that 22% of wages and salaries

are being eaten up by food and energy or the fact that 1 in 5 Americans are

unemployed or working part time for economic reason. Dont discuss the 1in 6 Americans on food stamps, unemployment benefits or welfare. The view

that stocks are cheap based on expectations of continued earnings growth in

this environment is a result of flawed reasoning.

The analysts state that the S&P 500 at about 1200 is selling at about 11 times

estimated 2012 operating earnings of about $108, well below the historical

average of 15 times. In addition when the $108 of earnings is multiplied by

15 the result is a target of 1620 on the S&P 500 by the end of 2012. In other

words they are multiplying 12-month forward estimated operating earnings by

15.

STREETTALK ADVISORS

What makes us diff erent?

Its really pretty simple. We believe thatmanaging risk is the key to long term

success. Conserve the principal and

the rest will takecareof itself.

Risk = Loss

Seems likea simpleconcept yet most

people take way too much risk in their

portfolio which is fine as long as the

market goes up. The problem comes

when it doesnt.

Managed Risk = Returns

By applying varying levels of riskmanagement to a portfolio of assets the

potential for large drawdowns of capital

is reducedthereby allowingtheportfolio

to accumulate returnsover time.

Total Return Investing

We believe that portfolio should be

designed for more than just capitalappreciation. There are times when

markets do not rise. During those

periods we want income fromdividendsand interest to be supporting the

portfolio.

If you are ready for something different

then you are ready for common sense

approach to investing.

Get Started Today!
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5/11

page

That is all fine and dandy until you realize that the economy is growing

around 2% currently and well below the long term trend of nearly 6%. Why

is this important?

The companies that make of the S&P 500 are a reflection of the economy

and not vice-versa. Consumers, which make up roughly 70% of GDP today

are the drivers behind the revenue and, ultimately, the net earnings of

corporations. Therefore, in a slower growth economy earnings are going togrow more slowly.

The massive surge in earnings

that was witnessed post the

financial crisis of 2008 came

courtesy of a massive draw down

in inventories which had to be

replaced and a relaxation of

accounting rules that allowed for a

whole cycle of fictitious accounting

numbers and gimmicks. Also, ahuge part of the rise in profitability

was due to the massive layoffs

and cost cutting by corporations

which has now, for the most part,

run its course.

Therefore, as earnings are now

back towards their peak, on a

reported basis, the question to be

asking is now much further can

earnings stretch before a reversionto the mean occurs as shown in the

chart.

Could earnings go higher from here?

Absolutely. With recent

announcements of more layoffs, cost

cutting measures in full swing,

investments to increase productivity

and suppress labor costs, combined

with the ongoing massaging of the

books through creative accounting, earnings certainly could rise.

The issue, however, is that since secular bear markets typically bottom at

P/Es of 10 or under, there are only two ways to resolve that valuation issue.

The first is that earnings rise as prices remain fairly stable OR there is a sharp

and rapid drop in price. Either will resolve the overvalued market and we

suspect that the next recessionary bear market will suffice to make that

happen.


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The Fed Model Is Broken

Earnings yield is a different matter altogether and a completely bogus

investment strategy. This has been the cornerstone of the "Fed Model" since

the early 80's. The Fed Model basically states that when the earnings yield

on stocks (earnings divided by price) is higher than the Treasury yield; you

should be invested in stocks and vice-versa.

The problem here is twofold. First, you receive the

income from owning a

Treasury bond whereas

there is no tangible return

from an earnings yield.

Therefore, if I own a

Treasury with a 5% yield

and a stock with a 8%

earnings yield, if the price

of both assets do not move

for one year - my net returnon bond is 5% and on the

stock it is 0%. Which one

had the better return? This

has been especially true

over the last decade where

stock performance has

been significantly trounced

by owning cash and

bonds. Yet, analysts keep

trotting out this broken model to entice investors to chase the single worst

performing asset class over the last decade.

It hasn't been just the last decade either. An analysis of previous history

alone proves this is a very flawed concept and one that should be sent out to

pasture sooner rather than later. During the 50's and 60's the model actually

worked pretty well as economic growth was strengthening. As the economy

strengthened money moved from bonds into other investments causing

interest rates to have a steadily rising trends.

However, as we have discussed in the past in "The Breaking Point" and "The

End Of Keynesian Economics" as the expansion of debt, the shift to a

financial and service economy and the decline in savings began to

deteriorate economic growth the model no longer functioned. During the

biggest bull market in the history of the United States you would have sat idly

by in treasuries and watched stock skyrocket higher. However, not to

despair, the Fed Model did turn in 2003 and signaled a move from bonds

back into stocks. Unfortunately, the model also got you out just after you lost

a large chunk of your principal after the crash of the markets in 2008.
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Currently, you are back in again after missing most of the run up in the current

bull cycle only most likely to be left with the four "B's" after the next recession

ends - Beaten, Battered, Bruised and Broke.

The bottom line here is that earnings yields, P/E ratios, and other valuation

measures are important things to consider when making any investment but

they are horrible timing indicators. As a long term, fundamental value

investor, these are the things I look for when trying to determine "WHAT" to

buy. However, understanding market cycles, risk / reward measurementsand investor psychology is crucial in determining "WHEN" to make an

investment. In other words, I can buy fundamentally cheap stock all day long

but if I am buying at the top of a market cycle I will still lose money.

As with anything in life - half of the key to long term success is timing. Right

now, with virtually all of the economic indicators weakening and pointed

towards recession, a lack of support by the Fed in terms of stimulus and a

vast array of varied risks from credit downgrades, Eurozone issuers on the

brink of default, valuations not extremely cheap and a breakdown of technical

strength in the market - timing right now could not be worse for long term

investors. Of course, this is all assuming that "The Bernank" remains silenton the next stimulus induced market rally...otherwise the game is changed

temporarily.

Have a great weekend and I will talk to on the radio next week.

Lance Roberts


8/11

page

Technically Speaking

Market Breaks Out Time To Buy?

The market broke out of its trading range

this past week and is now challenging

resistance from the break of the head

and shoulders neckline back in August.

Currently, as we have stated many times,

that a rally was likely this month and

such has been achieved. We are now

into the seasonally strong time of the

year as well.

So, with that, we should be allocating

more equities into portfolios to participate

on the back of the next cyclical bull market? Right?

Not so fast. While things have improved on the surface the bulk of this rally

has occurred for three reasons:

1) The markets were massively oversold after five months of declines

leading into October.

2) Short covering has been a major source of the rally.

3) The catalyst for the rally has primarily been the rumor of a bailout for

Europe which may

or may not occur.

With that said, our two

major weekly signals are

still in SELL territory as

well which also predicts

more caution at the current

time.

As you can see these

signals have kept you out

of trouble. No, you didntget the exact top or

bottom, but you did

participate in the majority

of the move up and missed

the bulk of the downside.

Currently, the market is

working on a pretty normal retracement of the previous sell off. IF the market

gets above this dashed blue line AND our weekly BUY signal kicks in (lower

chart) then we will recommend adding exposure to portfolios.


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page

It generally doesnt pay to go against these indicators but if you feel you must

be investing in the market now we recommend that you do so cautiously.

Bear Market In Tact

This is further confirmed by our standard deviation chart. As you can see in

the chart below the market got two standard deviations oversold in August

and September and we are now experiencing a normal retracement of that

decline to the moving average.

In normal bear markets the index tends to trade in the lower half of the

standard deviation range. A move into the upper half of the band will be a

much more positive development for longer term investors.

Finally, our McClellan Oscillator is extremely OVER BOUGHT which signals

that the next week most likely will offer some sort of correction. The

magnitude of that correction is critical to whether we upgrade our allocation to

equities in the next week. Caution is still highly advised.


10/11

page1

401K Plan Manager

The rally that has run over the

last three weeks has now

worked off a lot of the oversold

condition that existed at the end

of September.

We may be getting close to

being able to upgrade our

allocation model but the all clear

signal is not yet in as shown in

the Technically Speaking

section above.

At the current time we suggest

that you SELL all positions that

have not performed well overthe past few months (ie worse

than the market) and reduce

exposure to international

markets until something is

resolved in the Eurozone.

This will provide cash to allocate back to the portfolio model should a buy

signal be triggered in the next couple of weeks. Caution is still advised but

things may finally be turning around.

If you need help after reading the alert; dont hesitate to contact me.

Current 401k Allocation Model

35% Cash + Future ContributionsThese options include:

Stable Value, Money Market, Retirement Reserves

35% Fixed IncomeBond funds are a play on the direction of interest rates

Short Duration, Total Return & Real Return Funds

30% EquityThe majority of funds track their respective index.

Therefore, selectONEfundfor each category. Keep it

simple.

30% Equity Income/Balanced/Growth & Income

0% Large Cap Value

0% International VALUE

___________________________________

ALL NEW MONEY (Monthly Contributions)100% Cash

X-Factor (Equity Allocation Adjustment)

50%

Target Allocation

Equity

60%

Bonds

35%

Cash

5%

Tactical Allocation

Equity

30%

Bonds

35%

Cash

35%
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page1

Disclaimer & Contact InformationDisclaimer

The opinions expressed herein are those of the writer and may not reflect those ofStreettalk Advisors, LLC., Charles Schwab & Co, Inc., Fidelity Investments, FolioFN, or anyof its affiliates. The information herein has been obtained from sources believed to bereliable, but we do not guarantee its accuracy or completeness. Neither the information norany opinion expressed constitutes a solicitation for the purchase or sale of any security.Past performance is not a guarantee of future results. Any models, sample portfolios,

historical performance records, or any analysis relating to investments in particular or as awhole, is for illustrative and informational purposes only and should in no way beconstrued, either explicitly or implicitly, that such information is for the purposes ofpresenting a performance track record, solicitation or offer to purchase or sell any security,or that Streettalk Advisors, LLC or any of its members or affiliates have achieved suchresults in the past. ALL INFORMATION PROVIDED HEREIN IS FOR EDCUATIONALPURPOSES ONLY USE ONLY AT YOUR OWN RISK AND PERIL.

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Different types of investment involve varying degrees of risk, and there can be noassurance that any specific investment will either be suitable or profitable for a clientsinvestment portfolio. No client or prospective client should assume that any information

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The information on this site is provided AS IS. Streettalk Advisors, LLC does not warrantthe accuracy of the materials provided herein, either expressly or impliedly, for anyparticular purpose and expressly disclaims any warranties of merchantability or fitness fora particular purpose. Streettalk Advisors, LLC will not be responsible for any loss ordamage that could result from interception by third parties of any information made

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STREETTALK ADVISORS

Lance Roberts

Director of Fundamental &Economic

Analysis

Michael Smith

Director of AlternativeInvestments

Luke Patterson

Chief Investment Officer

Hope Edick

Compliance Officer

Leah Miller

Operations Manager

Lynette Lalanne

General Partner StreettalkInsurance

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X-factor 102211 - Market is Not Cheap

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