Stock Valuation and Occam’s Razor

Among competing hypotheses, the one with the fewest assumptions should be selected.

William of Occam

 

The use of this principle is valuable, but not completely determinative in science.  It often has an important application in investing.

Let us consider two hypotheses.

  1. A method of valuing markets that relies upon backward-looking data, looks at replacement value, or depends upon some other fixed ratio. Put another way, all the most popular valuation metrics.
  2. A method that considers prospective earnings, expected inflation, and interest rates.

Method one has been wrong for many years.  In fact, it has been mostly incorrect for decades.  Method two has been on the right side of market moves, but still shows significant deviations.  What can we learn from Occam’s Razor?

Method One

Since this method has been mostly wrong, many explanations have been offered.  I think I left a few out, but you get the drift.

  1. Speculation
  2. Not recognizing “fundamental” risks – Euro collapse, China collapse, recession, Brexit, etc.
  3. Depending upon dubious earnings estimates
  4. Market is about to crash
  5. Method not good for market timing, but returns will be poor for the next 5, 7, 10, 12, ? years
  6. Fed intervention – money printing and pumping up the market via QE
  7. Plunge protection team
  8. European Central Banks
  9. Suckers’ Rally
  10. Myopia of the investment world – no efficient markets
  11. High Frequency Traders and Algorithms

Method Two

Since this method has been mostly right, little explanation is needed.  The expected increase in market prices and multiples is consistent with the theory.  It should continue for another 8-10% and further if forward earnings increase.

 

Question

 

Should investors accept the complex and ever-changing explanations for method one?  Or perhaps should they consider that the method itself is flawed?

 

Weighing the Week Ahead: Will an Earnings Surge Revive the Stock Rally?

Are you ready for some real news? How about corporate earnings? While there is some economic data on tap, the Q1 earnings season starts in earnest this week. With questions about economic strength, the dollar and the Fed in mind, pundits will be looking for fresh data. They will be asking:

Can resurgent corporate earnings revive the stock rally?

Last Week

Last week the news was heavy but generally neutral. Strong economic data caused celebration. The Fed minutes and concerns about tax reform were the biggest negatives.

Theme Recap

In my last WTWA I predicted special attention to the Trump-Xi meeting. That was a good call, with plenty of discussion all week. The talks did not yield much news, but there might be a lesson from that as well.

The Story in One Chart

I always start my personal review by looking at a weekly chart. While there was not much of an overall change this week, Wednesday was the exception. Stocks moved sharply higher after the ADP number and sold off sharply in the afternoon, perhaps because of reaction to the Fed minutes, perhaps because of tax reform prospects.

 

The News

Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something very positive. My working definition of “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

This week’s news was neutral.

The Good

  • Construction spending rose 0.8%. Steven Hansen (GEI) is not convinced.
  • Rail traffic in March increased 7.3% (AAR).
  • ISM manufacturing maintained recent strength at 57.2. Scott Grannis offers this chart.

  • ADP private employment registered a change of 263K, handily beating expectations.

  • Weekly jobless claims dropped to 234K

 

The Bad

  • Tax reform prospects seemed to get worse at least that was the market take on Speaker Ryan’s press conference.
  • The Fed may be reducing its balance sheet. (Reuters). Fed expert Tim Duy thinks that balance sheet reduction will be gradual.
  • Auto sales were surprisingly weak. Calculated Risk concludes:

    This isn’t a huge concern – most likely vehicle sales will move sideways at near record levels. But the economic boost from increasing auto sales is probably over.

  • ISM services dropped to 55.2. This is still a strong level, of course, but any dip from a peak is drawing attention.
  • Non-farm payrolls registered a net increase of 98K, well below expectations. Doug Short has a nice chart pack, including this rolling average interpretation of non-farm payrolls.

 

The Ugly

Rising global threats including Syrian gas attacks, North Korean challenges, and more terrorist attacks.

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. No award this week, but nominations are always welcome. There are many bogus claims and charts out there!

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

The Calendar

We have a normal week for economic data, including releases on Friday when financial markets are closed.

The “A” List

  • Michigan Sentiment (T). Continued high readings and debate over “soft” data.
  • Retail sales (F). Will negative consumer news be confirmed?
  • Initial jobless claims (Th). Is the series edging up from record low levels?

The “B” List

  • JOLTS (T). February data. This is about labor market structure, not job growth!
  • PPI (Th). Still tame, with more of the same expected.
  • CPI (F). See PPI. The core increase is starting to approach the Fed’s target level.
  • Business inventories (F). Not much expected from this February data.
  • Crude inventories (W). Recently showing even more impact on oil prices. Rightly or wrongly, that spills over to stocks.

     

The schedule is light on FedSpeak and many markets around the world are closed on Friday.

Next Week’s Theme

In a normal week for economic data the start of the Q1 earnings season will command attention. Geopolitics will grab some headlines, but market participants are eager to see if the recent stock market strength is supported by corporate earnings. The key question?

Will resurgent earnings revive the rally in stocks?

Each earnings season sees a revival of a familiar theme: Companies guide expectations lower. The final report is a “beat” compared to this lowered bar.

More objectively, observers can compare earnings to the prior year. The weak energy sector has been a drag on these comparisons, leading to an “earnings recession.” This name was attached to two consecutive quarters of decline. This quarter seems more promising. Earnings expert Brian Gilmartin does a sector-by-sector analysis, concluding that this quarter might see S&P 500 growth of 12-14%.

John Butters of FactSet notes that current expectations are an increase of 8.9%, but that “double-digit” growth is more likely. He looks at the history of “beat rates.”

 

What does this all mean for investors? As usual, I’ll have a few ideas of my own in today’s “Final Thought”.

Quant Corner

We follow some regular featured sources and the best other quant news from the week.

Risk Analysis

Whether you are a trader or an investor, you need to understand risk. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.

The Indicator Snapshot

 

 

The Featured Sources:

 

Bob Dieli: The “C Score” which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment. (see below).

Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.

RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has several interesting approaches to asset allocation. Try out his new public Twitter Feed.

Georg Vrba: The Business Cycle Indicator and much more.Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli’s enhanced aggregate spread, considering when it might first give a recession signal. His interpretation suggests the probability creeping higher, but still after nine months.

Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies. His most recent post notes that the expected growth rate in S&P earnings is now 8.41% — the highest level since October, 2014.

Doug Short: The World Markets Weekend Update (and much more). His Big Four chart is the single best method to monitor the key indicators used by the National Bureau of Economic Research in recession dating. The latest update now includes the employment data.

 

 

How to Use WTWA (especially important for new readers)

In this series, I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. Most readers can just “listen in.” If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have eight different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:

Are you preserving wealth, or like most of us, do you need to create more wealth?

Most of my readers are not clients. While I write as if I were speaking personally to one of them, my objective is to help everyone. I provide several free resources. Just write to info at newarc dot com for our current report package. We never share your email address with others, and send only what you seek. (Like you, we hate spam!)

 

Best Advice for the Week Ahead

The right move often depends on your time horizon. Are you a trader or an investor?

Insight for Traders

We consider both our models and the top sources we follow.

Felix, Holmes, and Friends

We continue with a strongly bullish market forecast. All our models are now fully invested. The group meets weekly for a discussion they call the “Stock Exchange.” In each post I include a trading theme, ideas from each of our five technical experts, and some rebuttal from a fundamental analyst (usually me, but sometimes a guest expert). We try to have fun, but there are always fresh ideas. Last week the group discussed how to find trading ideas in a quiet market. We were delighted to have expert commentary from Chuck Carnevale, founder of F.A.S.T. Graphs and a frequent source for WTWA. Check out the five stock ideas from our regular group, and especially Chuck’s reactions.

Top Trading Advice

 

Brett Steenbarger continues his stream of great posts. My favorite this week is his explanation of the real reason traders lose money. That should certainly attract universal interest! Here is a key takeaway:

There is only one source of making money in markets, and that is identifying recurring patterns in market behavior and exploiting those in a manner that provides solid reward relative to risk.  We marshal and attenuate various personality traits to identify and exploit those patterns.  Success comes, not from indulging our personalities, but from knowing which traits to draw upon and which to work around.  That is called wisdom.

Peter Coy has great advice for system traders: Beware of excessive back fitting of your data. If this seems too nerdy, you are probably making serious errors in developing your trading system.

Insight for Investors

Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!

Best of the Week

If I had to pick a single most important source for investors to read this week it would be Gary Belsky’s, Why We Think We’re Better Investors Than We Are. Here is a sample, comparing an unhappy lawyer with a disappointed investor:

Both people are highly likely to obsess over their sunk cost — law school tuition and time served for the lawyer, the original investment amount for the stock picker — in a nonconscious desire to justify their earlier decisions. Both are also very likely to fall prey to “loss aversion,” a key tenet of Prospect Theory, which tells us that humans typically respond to the loss of resources — be it time, effort, emotion, material goods or their proxy, i.e., money — more strongly than they react to a similar gain.

What differentiates the typical lawyer and average investor, however, is their justification for engaging in their activity. Lawyers are trained to do what they do, while the majority of investors are not. Ask a random player in a law firm’s basketball league whether he or she could compete with LeBron James, and the most common response will be laughter. Yet many of those lawyers would willingly compete with the billionaire investor Warren E. Buffett.

 

Stock Ideas

 

Barron’s has some undervalued energy stocks for consideration.

Our Stock Exchange always has some fresh ideas. There are ideas from five different approaches. Felix, who is most aligned with long-term traders, likes Sprint (S). You will enjoy the careful response of our guest expert, Chuck Carnevale, to that idea! The entire post has a good discussion.

Blue Harbinger has ten attractive ideas with 10% yields. It is a thorough analysis, and read the cautions carefully.

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. If you are a serious investor managing your own account, this is a must-read. Even the more casual long-term investor should make time for a weekly trip on Wednesday. Tadas always has first-rate links for investors in his weekly special edition. As usual, investors will find value in several of them, but my favorite is Jane Hwangbo’s 6 Things You Don’t Know About Money. The six points are interesting, as is this conclusion:

The point of money is to magnify you.

If you care about something, you get the opportunity to make more impact. If you love someone, you can give them more of what they need. You can share more. You can contribute more. You can invest in your future more.

You get more options.

In his regular column, Seeking Alpha Editor Gil Weinreich takes up an intriguing question – whether boomer retirements will cause a market crash. There is also a good discussion as well as links to other sources.

Value versus Growth

It is always interesting to see whether market sentiment is favoring value or growth. Blue Harbinger provides this interesting table.

Watch out for…

 

Kinder Morgan (KMI) and other pipelines. The operations are amazingly extensive.

The “toll road” analogy is also seductive for the pipeline companies. But that is only part of the story. Simply Safe Dividends has an excellent and thorough examination of the underlying finances, cost of capital, safety of the dividend, and the effect of changing energy prices.

 

Final Thoughts

 

There are several developing themes that require more elaboration than I can provide in WTWA. In such cases I often state my conclusions in advance – with more to come. Here are a few such ideas.

  • There are some lessons from the Trump-Xi meeting. Nothing bad happened. That may not seem newsworthy, but it is useful intelligence.
  • President Trump had his first test as Commander-in-Chief. He consulted experts and took their advice. Whether or not you agree with the decision, the process is better than we might have expected a few weeks ago.
  • The hard data, soft data meme is the latest way to find a source of market worry. The definition of the categories is not objective, nor is the analysis of the sources carefully done. This is definitely an agenda item.
  • The employment report is a single important example. The headline payroll report change was only about 100K. Despite repeated warnings that sampling error alone is +/- over 100K jobs, discussing smaller changes is great sport. The ADP report is a good independent source. Jobless claims are excellent. Wages are rising. The unemployment rate is declining. There is no reason to look for excuses (like the weather) for a weak number. But pundits must earn their pay!

Each earnings season I offer a challenge. I am still waiting for an answer. Those who do not trust earnings say that the estimates are too optimistic. They also say that (at the time of the report) they are too low. If both are true, there must be some point in time when the estimates are pretty accurate. John Butters provides this interesting table, looking only at the last-quarter effect.

 

If earnings growth continues this pattern it can do the following:

  1. Increase confidence in earnings estimates;
  2. Increase confidence in an improving economy;
  3. Provide the basis higher forward earnings;
  4. Support the idea of a higher PE multiple.

Eventually, whatever the other worries, it is all about earnings.

Stock Exchange: Finding Trading Ideas in a Low Volatility Market

Ted Williams was a terrific ball player, but he had one tactic that many found…questionable. He almost never swung at the first pitch.

Many short term traders and individual investors could take a lesson. The market has been dragging sideways for weeks. Volatility is low. There’s a great temptation to force in a few trades. It can be difficult to resist.

As we often discuss, successful investors have a system – and they stick to it. That is as true for periods of low volatility as it is for any other market phenomena. Ben Carlson covered this topic recently, calling it “the hardest question in portfolio management.” He opens with a quote by Jim O’Shaughnessy:

“If you don’t have the discipline to stick with your underlying strategy particularly when it’s not going in your favor, it’s nothing. It’s data on a page.”

If you want to match the Splendid Splinter,  you must take what the market is offering. Wait for the right pitch.

This week, we’re joined by Chuck Carnevale himself. Chuck is one of our favorite sources of market wisdom and stock ideas, with a heavy focus on long-term earnings trends, cash flow, and balance sheets.

Review

Our last Stock Exchange considered how to trade a market with a lot of headline risk. If you missed it, please check back and catch up on this important topic.

Market Tech Take

Last week we introduced our proprietary indicator, the market health index (MHI). This is a specialized combination of breadth and strength in our own trading universe. The index remains strong. For contrast, we are looking for alternative technical measures. What is your own favorite indicator?

 

Let’s turn to this week’s ideas.

This Week—Finding Trading Ideas in a Low Volatility Market

Holmes

Holmes: Proofpoint Price (PFPT) is my pick of the week. The price on this one has been shifting sideways for months, which creates an attractive buying opportunity.

PFPT pricing is down near the 200 day moving average, and the stock 12% off its all time highs. I’m confident we could see significant gains here over the short term.

Chuck: As a fundamental long-term oriented investor, I like good businesses.  Proofpoint is a young mid-cap company with a lot of debt and a weak earnings record.  But operating cash flows have historically been growing at enormous rates.  Based on cash flow growth, this company looks inexpensive for a high-growth stock. Free cash flow growth has been even better and the company also looks attractively valued based on this metric.

Holmes: I don’t know (or care) much about the mechanics of the business, but all that sure sounds encouraging! Jeff is usually harsher on us.

Chuck: Let’s not get ahead of ourselves. It would be hard to call this a prudent long-term investment.

Holmes: That’s fine by me. I’m only looking at the next few weeks.

Chuck: Well, at least you’re sticking with your method.

Holmes: It’s been working well for me so far.

Felix

I’m buying into a long-term position in Sprint (S). Much like last week’s pick, this is another one where the stock is up near its all-time highs. For that reason, I understand I might be criticized for jumping in here. It’s not my ideal situation; but for a long-term investor, this is what opportunity looks like right now. Let’s check the chart:

The trend lines on the 50 and 200 day moving averages  have been steadily rising for almost a year now. I certainly don’t expect the price to triple again anytime soon, but from my perspective this looks like a winner.

Chuck: Sprint reminds me of the old adage “price is what you pay – value is what you get.”  To me the price is high – but the value low.

Felix: Ouch. Isn’t there anything here you like?

Chuck: Not so much. As Kenny Rogers so aptly put it “You gotta know when to hold ’em, know when to fold ’em, know when to walk away, know when to run.”  As a fundamental value investor I believe that the “dealin’s done” on this one.

Oscar

Ted Williams is one of my favorites! I’ll help clarify your broader point: he always watched the first pitch, but he had a good reason for doing it. He wanted the most information he could get about a pitcher’s performance on a given day.

Here’s where the analogy breaks down. Once you’ve clicked through an order on your Trader Work Station, you’ve probably got the mechanics down. Naturally, I agree with the idea of waiting for the right pitch.

On to business, my pick this week is the Software Cloud and Computing sector. First Trust has an ETF for this, which captures the kind of growth and performance I expect.

For what people are calling a “sideways” market, this sector has been a clear outlier. These stocks are growing faster in 2017 than they did in 2016, and they’re doing it without a significant bump in November.

Chuck: Trying to find the best investments in cloud computing is a cloudy endeavor (pun intended).  You have pure growth stocks such as Amazon, Salesforce.com and Google.  In contrast you have stalwarts such as Microsoft, Oracle and IBM.

Oscar: That makes sense to me. How would you break these down?

Chuck: The trick here for fundamental investors is valuation.  IBM and Oracle are reasonable; Microsoft has gotten very pricey as has salesforce.com and Google.  Amazon has scant earnings but generates prodigious levels of cash flow.  To me, it’s tough to find a consistent investment theme in this sector.

Oscar: Point well taken. I have my own special mix of this sector, so I’m reasonably sure I can hit those value picks.

RoadRunner

(Commentary translated from various pecks, rapid movements and beeps).

I like Incyte (INCY), but only for the next 10-20 days. The pattern of growth is very attractive to me here. I can handle a brief lull if it’s capped off with a nice spike, and that’s exactly what we’re seeing here.

It may be a bit optimistic, but I’m anticipating that this most recent bump will bring us back to the $150 range.

Chuck: There are no fundamentals supporting this biotech company at all.  This is purely a hope and a dream speculation.  Maybe some of their pipeline will eventually bear fruit.  Nevertheless, the company has suffered losses for years but did begin earning a little money since 2015.

Road Runner: What if I’m approaching this like a short term trader? I might only be holding onto this position a few days.

Chuck: Earnings growth could accelerate in future years but not enough to support current levels.  This is a pure momentum play, a.k.a. a musical chairs stock.  Therefore, you better be sure to have a chair if and when the music stops.

Road Runner: Tough but fair.

Athena

Micron Technology (MU) is on a roll. The mid-march pop in price leads me to believe more short term gains could be significant. Is the price high? Sure. That’s my method, and I’m sticking to it.

Chuck: This stock is way too cyclical for my taste.  However, this might make it a short-term trader’s dream stock.

Athena: That’s the idea.

Chuck: Earnings go from losses to huge rates of change of earnings growth and stock prices tend to react over the short run.  I would consider this the classic sardine company that works like this.  I buy a can of sardines for $.50 and sell it to Oscar for $1.  He in turn sells it to Jeff who is hungry for $1.50.  Jeff opens the sardines and finds them rotten.  He complains to Oscar that he sold him rotten sardines.  Oscar then informs Jeff that he doesn’t understand sardines.  There are 2 kinds of sardines, Oscar says, there are eaten sardines and there are traden sardines.  I sold you traden sardines.

Athena: I think I just lost my appetite.

Conclusion

Despite the prevailing mood about the current market, there are plenty of opportunities for goal-oriented investors. The key, again, is to take what the market is giving you. Investors with a robust method should stick to it, even if it’s a bit harder to find new positions. Investors without a robust method probably shouldn’t be making any trades at all.

Chuck’s approach is value based, and that makes his recommendations extraordinarily consistent. Reading between the lines a bit, it’s clear that there’s some upside even in the companies he wouldn’t consider for his portfolio. What’s right for Felix and Oscar might not be a good fit for Holmes. There’s nothing wrong with that. After all, every batter has their own favorite pitch.

Stock Exchange Character Guide

Character Universe Style Average Holding Period Exit Method Risk Control
Felix NewArc Stocks Momentum 66 weeks Price target Macro and stops
Oscar “Empirical” Sectors Momentum Six weeks Rotation Stops
Athena NewArc Stocks Momentum One month Price target Stops
Holmes NewArc Stocks Dip-buying Mean reversion Six weeks Price target Macro and stops
RoadRunner NewArc Stocks Stocks at bottom of rising range Four weeks Time Time
Jeff Everything Value One month or long term Risk signals Recession risk, financial stress, Macro

Background on the Stock Exchange

Each week Felix and Oscar host a poker game for some of their friends. Since they are all traders they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Questions

If you want an opinion about a specific stock or sector, even those we did not mention, just ask! Put questions in the comments. Address them to a specific expert if you wish. Each has a specialty. Who is your favorite? (You can choose me, although my feelings will not be hurt very much if you prefer one of the models).

Getting Updates

We have a new (free) service to subscribers to our Felix/Oscar update list. You can suggest three favorite stocks and sectors. We report regularly on the “favorite fifteen” in each category– stocks and sectors—as determined by readers. Sign up with email to “etf at newarc dot com”. Suggestions and comments are welcome. In the tables above, green is a “buy,” yellow a “hold,” and red a “sell.” Each category represents about 1/3 of the underlying universe. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!