I am traveling this week so I don't have a full update. However, there is no change in my model's zero exposure to equities. Valuation was little changed last week. Earnings estimates were modestly higher looking 52 weeks out. Sentiment deteriorated somewhat as the aggressive managers associated with NAAIM actually took a small leveraged long position in equities. Basically, the risk/reward ratio still looks very poor and I am maintaining a hedged position.
Investors continue to be pushed into the stock market as the only game in town. And, at least so far, they are winning. Earnings expectations are still slowly increasing as the economy moves along at a snail's pace. But the problem continues to be valuation. We are now about 3% away from the highest median valuation for stocks since 1999. Nothing says that new records are out of the question but this valuation is high enough for me to maintain a hedged position. Sentiment remains neutral with a somewhat negative bias and investors that are buying are staying with high quality. With all the potential negatives and super high prices, I maintain a cautious portfolio mix.
What to do when valuation is too high but the market goes higher anyway? One answer would be to rethink the valuation parameters but consistency is needed in any model that will actually be helpful. So, I haven't changed anything but I recognize that overpriced stocks can get even more overpriced. I just don't want to play the "greater fool" game. Earnings estimates are still trending modestly higher and may get an added boost from the ability to go out to mid 2017 after this year's second quarter reports are final. Sentiment got much worse this week as small investors and speculators turned bullish when the major market averages hit new highs. The current situation seems fraught with risk and is light on return possibilities. I remain hedged.
Last Friday continued the uptrend, putting the major averages back very near their highs from last year. The Russell 2000 and the Value Line Geometric Average remain well below their previous highs. I have posted a chart in "Chart Of The Week" that shows the relationship between low grade bonds and high grade bonds since the year 2000. This chart shows that risk is still being avoided by bond investors. In order for the stock market to move higher, attitudes toward risk must change. Last week showed more deterioration in my valuation indicator and it is now as bearish as it was in the fall of 2015 before a sharp short-term decline. Earnings estimates remain in a modest uptrend but there is some evidence that estimates may be peaking unless the outlook given during second quarter earnings reports is better than expected. Sentiment remains neutral but, just looking at Friday, small investors and speculators turned much more bullish. I remain in a hedged position and would think that new highs in the major averages would present an excellent selling opportunity.
Almost all of the losses from Brexit were made back quickly. It was interesting to read in the WSJ that many individual investors have figured out that buying the dips is a great strategy. That may be true if you are a trader but the major averages have gone nowhere for the last year and the Russell 2000 is down around 7%. Nothing really changed as far as my model's indicators last week. Valuation got worse and is still negative, earnings estimates 52 weeks out continue to increase modestly and sentiment is neutral. Investors continue to look for the silver lining but, at these prices, I am not interested. I remain fully hedged.
Richard Moore, CFA
With my wife in Hawaii