Which Way Is The Wind Blowing?

Cover Story, by Mark Robertson, Managing Partner April 1st, 2013

Is the market going up or down tomorrow? How about for the rest of the year? What about the next several years? What’s the outlook for the rest of my investment time horizon?

Is the market going up or down tomorrow? How about for the rest of the year? What about the next several years? What’s the outlook for the rest of my investment time horizon? The parade of pundits on the financial tube are pressed with these or similar questions pretty much perpetually. We sometimes hear them from our audiences. And the answer is the same. We don’t know. Nobody does. Do you believe in market timing? We don’t. But we do believe that we can monitor some key indicators, seeking prudent guidance based on the lessons of history. This quest came into sharpest focus during the extended period from 2003-2007 where the overall return forecast stalled at historical lows just prior to the Great Recession. We’re baaaack at those levels now.

“The not-so-good news is that the market’s return over the next four years is likely to be somewhat below average, at least according to a market-timing model that has exploited the stock market’s long-term predictability to turn in an enviable record.” — Mark Hulbert, WSJ MarketWatch (1/18/2013)

We think it’s the ultimate in bottom-up forecasting. We don’t invest in “markets” or sectors very often but we do believe that the collective result on display when we add (average) our collection of long-term return forecasts for ~2000 companies is worthy of consideration. Mark Hulbert agrees. He recently shared our analysis of the Value Line low total return forecast history and trends via MarketWatch (Wall Street Journal).

In the accompanying chart, we see the quarterly return forecasts for the Value Line Standard Edition (1700) plotted versus the actual results four years later. There’s pretty good correlation and it’s the shape that matters. As the first quarter of 2013 comes to a close, another quarter is in the can. Back on 3/31/2009, the collective long-term return forecast was 20% — at historical highs as we were mired in the teeth of the bear market at the time. Fast forward four years later … and we see that the Value Line arithmetic average has delivered an actual return of 28.6%.

Market Barometers (Extended Edition) We monitor several key indicators including but not limited to the aggregate return forecast (MIPAR & VLLTR), earnings trends and forecasts, GPS tracking of the (mostly) institutional investing herd, a dash of sentiment signals because supply-and-demand matters …and a few other economic factors. Some are published pretty much continuously (see Sweet 16, monthly) and Value Line weekly updates but extended lists are published in the MANIFEST Forum and http://expectingalpha.com — our blog.

The current level of the Value Line median low total return forecast is 6.8%, approaching the low forecasts of 2007. Is it time to cue the Jaws soundtrack?

Much Whittling, Not Much Slashing (Yet)

There are two ways for the aggregate forecast to change. It can increase if (1) stock prices drop or (2) fundamentals (think EPS expectations) or a combination of the two.

And the reverse is true. When stock prices advance when they “don’t deserve it”, forecasts droop because the stock prices are basically getting ahead of themselves. Or even with relatively constant prices, any deterioration in EPS forecasts delivers a downward correction in long-term return forecasts.

Turning to the early days of the second quarter of 2013, the earnings reports will be filing in shortly. As the days roll by, we’ll likely get another look at European impact and the continued persistence of a domestic weak employment condition and weakness in disposable income that comes home to roost in retail.

Profitability: History & Trend. The median margin for the VL industrials has gently increased over the last ten years. The impact of the 2008-2009 recession is clear, as well as the recession-like sluggishness of 2012.

The accompanying chart on profitability is probably our second favorite chart. What’s left untold about this chart is that generally we see much more optimism baked in to the 2013E and 2014E forecasts at this point in the year. It has been common for these forecasts to be 1-2% higher at this point in the year — a symptom of natural and generally typical optimism — to be followed by some atrophy as the calendar pages turn.

The next chart takes a look at the year-to-year change in earnings and illustrates even more how 2012 was relatively weak. The stock market has been bolstered by the Federal Reserve (QE) actions. Sustainability and/or diminishing returns are certainly in question.

From Blue Chips To A Blue Line

Let’s be clear. First of all, if you’re a growth investor with a very long time horizon, you probably don’t need to worry about this. If we’re talking about your investment club — with an infinite time horizon, by definition — then you probably don’t need to worry about this.

Annual EPS Change. The average year-over-year change in EPS is approximately 10% with the recessionary impact of 2008-2009 clearly shown here. Again, it’s customary for the 2013E and 2014E forecasts to display a little more exuberance and optimism at this time of year.

But if you’re taking care of a personal nest egg, you should give the subject careful consideration. If you’re an investor who has either arrived at or are approaching what Bob Brinker calls the “Land of Critical Mass,” capital preservation could be very, very meaningful to you — depending on your personal situation, your margin of safety and your time horizon. George Nicholson believed and counseled that Balanced Investing (asset allocation including cash equivalents, etc.) could well be critical and frankly, quite rewarding. Under current conditions, we think it’s probably prudent to raise concentration in deep blue chips (e.g. raise the overall average quality of your portfolios) and trim the lower-quality non-core holdings in your portfolios if/when their PAR drops below MIPAR. It’s the blue trend line in the accompanying New Highs vs New Lows chart … and we’ll be watching if the rhinos change speed or direction. Note the market levels when the warning signal would have sounded back in 2007. We’re watching.

Watching Rhino Walk, Not Rhino Talk. If you believe supply-and-demand matters (and you should) then the collective actions of the herd have bearing. By monitoring the relationship of new highs vs. new lows, we get an early warning clarion that signaled as Halloween 2007 approached. Current $USHL is still solid.

Mark Robertson

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.