Tag Archives: US equities

Valuation: Good for Long but not for Short

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Graphic courtesy Outcome/QuoteInspector.com.

By Noah Solomon

Special to Financial Independence Hub

As I have written in the past, valuations are of no use for determining broad market returns over the short term.

To be clear, I am NOT implying that valuation doesn’t matter. Historical experience demonstrates that it has been an extremely powerful predictor of average returns over the long term. Without fail, whenever valuations have stood well below average levels, strong returns ensued over the next 7-10 years. Conversely, highly elevated valuations have preceded anemic or negative returns.

For investors interested in shorter-term market movements, sentiment indicators may harbor greater potential than their macroeconomic or valuation-based counterparts. In this month’s missive, I explore some of the more commonly cited indicators that purportedly possess short-term predictive capabilities to ascertain:

(1) Whether the historical record confirms the presence of any predictive power, and
(2) What these variables are signaling for markets in the near term.

The VIX Index: Embrace the Fear

The VIX Index represents the market’s expectations of the S&P 500 Index’s volatility over the next 30 days. Its level is derived from the prices of S&P 500 options with near-term expiration dates. Dubbed the “fear index,” the VIX is often used to gauge market sentiment, and in particular the degree of fear among market participants.

Historically, the VIX has served as a good, if imperfect indicator of market turning points:

  • Although it failed to provide a clear “get out of dodge” signal before the peak of the tech bubble in early 2000, the VIX’s historically stratospheric level in late 2002 indicated a level of extreme fear that signaled that better times were at hand.
  • In early 2007, the VIX stood at very depressed levels, indicating the high degree of complacency that contributed to the global financial crisis of 2008. Unfortunately, it was far too early in signaling the recovery. In October 2008, extremely elevated VIX levels were signaling the type of abundance of fear that often precedes rebounds, yet stocks still had plenty of downside before ultimately bottoming in March of 2009.
  • More recently, the VIX failed to provide a warning signal of the market turmoil of 2022. However, its extremely elevated stance in late October of 2022 signaled that a rebound was imminent.

VIX Index Levels and S&P 500 Index Returns: 1997 – Present

Putting specific bear markets and recoveries aside, the above table demonstrates that elevated VIX/fear levels have on average preceded higher returns, and depressed VIX/lower fear levels have foreshadowed lower returns. The historical record lends credence to Buffett’s sage advice that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.”

Put Call Ratio: Beware Cheap Insurance

Like the VIX Index, the put-call ratio (PCR) is widely used to gauge the overall mood of the market. Put options provide the right to sell stocks at a predetermined price and are often purchased as insurance to protect portfolios from market declines. Call options offer the right to buy stocks at a predetermined price and are frequently bought to capture upside participation when stock prices rise.

The PCR increases when the market participants’ desire for downside protection rises relative to their desire for upside participation. Alternately stated, a rise in the PCR is indicative of a rise in bearish sentiment. Conversely, the PCR falls when people become more focused on reaping gains than on avoiding losses, which is indicative of a rise in bullish sentiment.

Since 1997, the PCR has been a contrarian indicator, whereby elevated levels (high fear/low greed) have on average signaled higher returns and lower PCRs (low fear/high greed) have heralded subdued or negative results. Continue Reading…

Was Inflation transitory?

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By Dale Roberts, cutthecrapinvesting

Special to Financial Independence Hub

Inflation is coming down in Canada and the U.S. And one can argue that the rate hikes have had little effect. After all, Canadians and Americans are spending money, and employment is strong. The economy has been very resilient. Perhaps inflation was transitory after all, caused by the pandemic and the invasion of Ukraine. This is not the traditional inflation fight script. The economic soft landing argument is getting more support. Was inflation transitory?

Total inflation in Canada is back ‘on target’ in the 2% to 3% range.

That said, core inflation is still sticky.

From this MoneySense post …

According to Statistics Canada, the June slowdown was driven primarily by a year-over-year drop of 21.6% in gasoline prices. Meanwhile, the largest contributors to the rise in consumer prices are food costs — which rose 9.1% in June — and mortgage interest costs (up 30.1%).

It’s likely a very good guess that rates are staying higher for longer. The bond market is certainly suggesting that as well.

The 5-year remains elevated.

Fixed-rate mortgage holders will likely be resetting at higher borrowing costs over the next 2 to 3 years – adding several hundred dollars a month to the typical mortgage payment. Of course, that takes money out of the economy and money that would have been spent on goods and services.

Next year may be sunnier than forecast

In the Globe & Mail, Ian McGugen offered a very interesting post. Ian looks to one of the most optimistic economists, and that is a growing group.

Jan Hatzius, chief economist at investment banker Goldman Sachs, has set himself apart from the crowd in recent months by declaring that the United States will not sink into a recession. Continue Reading…

The Rear-View Mirror and U.S. stocks: A Contrarian Indicator

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By Noah Solomon

Special to the Financial Independence Hub

As we have written before, sentiment and emotions can have an outsized influence on investor psychology and investment decisions. Relatedly, there is a powerful inclination among investors to perceive markets that have outperformed as being less risky than those that have underperformed.

Interestingly, this tendency exists not just among individual investors, but is also prevalent in the professional investment community. A 2008 study by finance Professors Amit Goyal and Sunil Wahal explored the performance of investment managers who had been fired by institutional investors. The analysis compared the managers’ performance in the three years before being fired with their subsequent three-year performance.  The results of the study are summarized in the following graph.

The Selection and Termination of Investment Management Firms by Plan Sponsors

On average, fired managers had poor performance in the three years preceding their termination, with average annual underperformance of 4.1% vs. their benchmarks. This figure should come as no surprise, as you wouldn’t expect that they were fired for knocking the lights out! However, what may be counter-intuitive to many is that these managers tended to subsequently outperform, with average annual outperformance of 4.2% over the three years following their termination.

Clearly, not only does looking in the rear-view mirror fail to prevent you from hitting something that is in front of you but may in fact cause it!

The other takeaway is that even seasoned, institutional investors can be swayed by short-term performance, which in turn can lead to decisions which are both ill-timed and economically perverse.

Beware the Mean Reversion Boogeyman

Last year saw a continuation of a long-established trend of U.S. stock outperformance, with the S&P 500 rising 28.7% as compared to 8.3% for the MSCI All Country World Index (ACWI) Ex-U.S.  From the end of 2008 through the end of last year, the S&P 500 rose at an annualized rate of 16.0%, producing a cumulative return of 587.3%. In comparison, the ACWI Ex-U.S. Index rose at an annual rate of 8.6% and delivered a cumulative return of 190.7%.

The outperformance of U.S. stocks argues for actively reducing U.S. exposure and increasing allocations to other regions, as the mean-reverting, contrarian nature of investment manager performance can also be applied at the country level. The following chart covers the period from 1970-2021 and includes the U.S., U.K., Germany, France, Australia, Japan, Hong Kong, and Canada. Specifically, it illustrates the results of investing every three years in a portfolio of country indexes based on their trailing returns over the previous three years.

3-Year Performance of Countries ranked by Trailing 3-Year Performance

The chart brings fresh perspective to the standard regulatory disclosure language in the marketing materials of investment funds, which states that “Past performance is no guarantee of future returns.”

Outperforming countries tend to become subsequent underperformers : those that have had superior returns over the past three years tend to produce relatively poor results over the next three years. Conversely, underperformers tend to subsequently outperform: those that have lagged over the past three years tend to outperform over the next three years. Continue Reading…