Episode #41: “Valuation Tells Me I Should Be Lighter Than Normal on U.S. Equities and Tilting More Towards Foreign”
Guest: Doug Ramsey. Doug is the Chief Investment Officer of The Leuthold Group, LLC, and Co-Portfolio Manager of the Leuthold Core Investment Fund and the Leuthold Global Fund.
In addition to his CIO and Portfolio Management responsibilities heading both the asset allocation and investment strategy committees, Doug maintains the firm’s proprietary Major Trend Index, a multi-factor model which evaluates the underlying health of the markets, both domestically and globally. He is also the lead writer for The Leuthold Group’s highly regarded institutional research publications.
Date Recorded: 2/23/17
Topics: In Episode 41, we welcome Doug Ramsey from Leuthold. Meb is especially excited about this, as Leuthold publishes his favorite, monthly research piece, the Green Book.
After getting a recap of Doug’s background, Meb dives in. Given that we’re in the Dow’s second longest bull run in history, Meb asks how Doug sees market valuation right now.
Doug’s response? “Well, that’s a good place to start cause we’ll get the worst news out of the way first…”
As will surprise no one, Doug sees high valuations – believing that trailing earnings-based metrics might actually be underestimating the valuation risk.
This prompts Meb to bring up Leuthold’s “downside risk” tables. In general, they’re showing that we’re about 30% overvalued. Across no measure does it show we’re fairly valued or cheap.
Doug agrees, but tells us about a little experiment he ran, based on the question “what if the S&P were to revert to its all-time high valuation, which was on 3/24/2000?” That would mean our further upside would stretch to about 3,400, and we’re a little under 2,400 today. Doug summarizes by telling us that if this market is destined to melt up, there’s room to run.
Meb agrees, and makes the point that all investors have to consider the alternate perspective. While most people believe that the markets are substantially overvalued, that doesn’t mean we’re standing on the edge of a drawdown. As we all know, markets can keep rising, defying expectations.
The conversation then drifts into the topic of how each bull market has different characteristics. Meb wants to know how Doug would describe the current one. Doug tells us the mania in this bull market has been in safety, low volatility, and dividends. Overall, this cycle has been characterized by fear – play it conservative.
The guys then bounce around across several topics: small cap versus large cap and where these values are now… sentiment, and what a difference a year makes (Doug says it’s the most optimistic sentiment he’s seen in the last 8 years)… even “stock market returns relative to the Presidential political party” (historically, democratic Presidents have started office at a valuation of 15.5, leading to average returns of 48%, while republicans have taken over at a valuation of 19, which has dragged returns down to 25%). The bad news? Trump is starting at very high valuations.
Next, the guys get into the biggest problem with indexing – market cap weighting. Leuthold looked at what happens to equities once they hit 4% of their index. The result? It becomes incredibly hard to perform going forward. It’s just near impossible to stay up in those rarified market cap tiers. So what’s the takeaway? Well, Doug tell us that he’d bet on the 96% of other stocks in the S&P outperforming Apple over next 10 years.
This episode is packed with additional content: foreign stock valuations… value, momentum, and trend… the Coppock Curve (with a takeaway that might surprise you – higher prices are predicted for the next 12-24 months!)… The best sectors and industries to be in now… Why 2016 was the 2nd worst year in the past 89 years for momentum…
Finally, for you listeners who have requested we pin our guests down on more “implementable” advice, Meb directly asks what allocation Doug would recommend for retail investors right now.
What’s his answer? Find out in Episode 41.
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Transcript of Episode 41:
Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
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Meb: Good afternoon podcast listeners, we have a very special guest with us today all the way from The Great White North, Minneapolis. Doug Ramsey, welcome to the show.
Doug: Thank you, Meb. Thank you for having me.
Meb: So this is gonna be a lot of fun today. A quick intro for a lot of people that may not be familiar. Doug is the CIO of the Leuthold group and, in addition to CIO and portfolio management duties, writes one of my all-time favorite quant research pieces that comes out once a month with his team, and it’s called “The Green Book.” If you’re a quant nerd like me that likes fundamentals and chart porn and technicals and everything else interlaced even with a few jokes, this is like Christmas coming once a month. So, I’m really excited in prep for this interview, much to the dismay of my office mates, I printed out the last six months of “The Green Book,” which they clock in about 80 pages each. So we’ll recycle these, listeners by the way, but the office table in conference room looks like kind of a beautiful mind with about 50 charts.
So, Doug, why don’t we get started. Tell us a little bit about your background. I know you kinda went to school in the Midwest, played a little hoops, and how you found yourself at Leuthold, and then a little bit about what you guys do there.
Doug: You bet. Well, I grew up in Cedar Rapids in Iowa and ventured off all of the six miles to Coe College right there in my hometown and played division three basketball. I mean, for three division three, we’re not scholarship, but I’ll tell you what, it’s still…well, it’s a big part of my recollection of the college experience and it was a pretty big share of time for six out of the nine months of the school year. So, it kept me out of trouble, I think it helped me with time management. I got very interested in Economics while I was there and ended up…I received a graduate fellowship in my senior year, and the fellowship had to be used for a doctoral program of some sort. So, of course, the economics professors at the school were all twisting my arm and those of others too to go on and pursue our PhDs in Economics. So I got involved with one those programs at Ohio State.
At Ohio State, I guess I had an interest. Well, I had some family history there. My dad and grandfather had gone to school, but they had a very strong macroeconomics department and that was clearly my interest. But as I went on, it just got incredibly mathematical. I mean, maybe if you go on and study history of economic thought or some of the other softer disciplines within economics, you’ll actually learn more about the economics but there’s sort of a funny slam on the discipline that economists have developed physics-envy. That’s sort of what I learned. I mean, I got my Master’s degree and more or less kinda stumbled into the business. I wasn’t looking for a job. I was gonna go on in that doctoral program and just slog my own way through the math, but I had an opportunity go to work for a firm that was led by an economist. They had more of a top-down group rotation with some moderate market timing involved back in my hometown, so I got pretty lucky. That was back in 1990.
So I was that firm for five years and then I moved to the big city in Iowa, moved to Demoine later that decade where I initially worked on value portfolios. And then sort of what was the big break for me in terms of what I like to do more of a macro and quant focus, is I became a Tactical ASL Allocation Portfolio Manager, and this was at Principal Global Investors back in ’99, 2000. I was there through about the middle of the decade. While I was there I developed a number of disciplines, learned a lot, had a lot of time to learn and sort of run into dead ends on my own, which…I mean, that’s valuable. You know, in this day and age, you come of school, traditionally, and went through your MBA, and if you haven’t produced something, a good idea in the first two or three weeks, the PMs are already mad at you. So don’t underestimate the value of having a little bit of playtime just to let your mind wander and latch onto different things. So I was very appreciative. That was a great experience.
While I was there, I started to talk to the good folks at Leuthold Group. I had been a Leuthold research client from day one. You know, my firm back in my hometown, that was one of the things waiting for me on my desk on my first day in business in 1990. So I’d filed the research for years and we just started chatting maybe in…I don’t know…2002, 2003. I came up here in 2005 and I have to say, you describe this as The Great White North, but I’m looking out over the landscape today from my window and it’s all brown. I mean, if this global warming is for real, we’re in a pretty good spot in the country. It was 60° yesterday. I mean, we’re going back down in the deep-freeze, 12 to 18 inches of snow tomorrow, so it would be The Great White North again temporarily. But, you know I came up here to…you know, a good time was Steve Leuthold and some of the veteran old Green Book contributors still around. Jim Floyd was Steve’s sidekick for…boy…had to be 35 years, Andy Engel. So I’ve had several good years with sort of the men who were the folks who helped build the shop over the years. And, you know, we’re in a transition period or I’ve been with some new faces.
I became CIO in 2011. Steve Leuthold officially retired at the end of ’12. I have a good relationship with Steve, we will still talk markets pretty often. But it’s a full bit of the younger staff than maybe where we stood 10, 12 years ago. We did bring in a former colleague of mine from Principal, Scott Absol. He was CIO of the entire equities unit at Principal Global and he joined us last summer. Fortunately, he had some sort of a Minneapolis linkage, otherwise it’s hard to recruit people here with the weather and the lack of professionally played sports. We have professional sports teams, they just don’t play quite the professional level other than the hockey team this year.
Meb: Our biggest recruiting advantage is we just take people for lunch down by the beach on the first day and usually it knocks off about 20% off their salary requests. All right, let’s start to get into some of the research ideas because I would love to keep you for about three hours but I know we have limited time. So, we stand today in 2017, one of my favorite charts of y’all’s looks like a starburst, I think I’ve poached it and used it on my blog before. But it shows the length of Dow markets back to essentially 1900 or so, and we are now on the second-longest bull market in as of…what’s today…mid-February, if we get about one more month, we’re gonna have the longest Dow bull market of all time. Not the largest, but one of the longest. And so, I thought that it would be a good segue to start talking about first the US market in general and then we can go off and do a bunch of different tangents, but starting with maybe valuation and the where…kinda you guys see where we are in the world today with stocks.
Doug: Well, that’s a good place to start because we’ll get the worst news out of the way first by discussing valuations. You know, I’m not one that tries to get creative with the valuation work to make some sort of a long-term valuation or buy-and-hold argument for stocks, I just can’t get there, and we could spend three hours on that topic alone. But we look at roughly 30…well, more than that, but in our formal major trend index, we look at about 30 valuation measures. The idea that in any given cycle, you might have a distortion in a handful of those measures that happen with the dividend yield for example during the tech bubble. No one, in sharp contrast to today, where dividends of any sort or coveted, you couldn’t give away a high-yielding stock in the late 1990s.
So the dividend yield, which historically had rarely dropped much below the 3% level, got all the way down and it was like 1% or 1.1% when the market peaked in 2000. So that was one measure that just got just completely blew up as a valuation measure during the tech bubble. In this cycle, oddly enough, it’s some of the earnings-based measures, whether you’re talking forward PEs or trailing PEs, or even our five-year normalized PE, while those numbers are high, I think they actually understate the true valuation risks in the stock market. And that’s because they reflect, historically, very high-profit margins. And people like to say today, “Well, obviously, S&P trailing earnings are depressed by the weak results in the energy sector.” Well, the energy sector is really not all that big in terms of its contribution to S&P earnings.
And even factoring in that weakness in the energy sector, S&P 500 profit margins are still historically very high. I mean, I think the latest figure, and this is just from memory, I think the latest trailing four-quarter net profit margin using GAAP earnings on the S&P 500 is 7.9%. The only times that you’ve been higher than that historically, other than this business cycle or just a few quarters surrounding the top back in ’06, ’07. So even though the profits are down somewhat trailing, I’m talking trailing reported GAAP earnings, they are down, but they’re not necessarily depressed. I mean, margins are still very high. So I think some of these PE numbers are actually…they sound high, they understate the markets’ true overvaluation.
Meb: And the cool thing that you guys do, there’s a piece that comes out every month, it’s called “Estimating the Downside,” and it looks at all sorts of different valuation indicators. And we talk about this a lot where we say, “Valuation is a very blunt tool, and in general, the indicators should be lining up on the same side particularly at extremes.” And we talk a lot about CAP. But I often say I don’t care which one you use, but in general they shall be on the same side and they usually are. And so looking at a lot of y’all’s chats, they say, “Hey, look, you know, you measure it first of all back to the 1950s with the S&P and then also back to the ’20s with the industrials.” Then the ballpark is something like, “Look, if we went back down to normal valuations, maybe it’s a quarter 30% loss, if you went…” and the cool thing you guys also split it out in between low-inflation periods and high inflation. And the result of these charts…and hopefully knock on wood Leuthold will…well, the compliance department will let us post some of these to the to the blog, we’ll see. But it shows a difference where the decline is even much worse when there’s high inflationary periods, but across almost no measure does it show that the market is fairly valued or really cheap.
Doug: Yeah, that’s true. And, Meb, I don’t know, maybe it’s a sign of the times with this entire lengthy bull market is finally getting to me, but a couple times now in the last 3, 4 months, I’ve actually run an exercise…just for illustration, I’ll emphasize that…but speculating, you know, we look at reversion in valuations. What if the market were to revert to median valuations or what if it were to revert to bottom quartile historical valuations. So I put on my rose-colored glasses and ask, “What if the S&P 500 were to revert up to all-time high valuations seen on March 24th of 2000?” Now, you’re picking the single most overvalued day in the history of the stock market and saying, “What if we go there again?” I mean, this is highly irresponsible not something that should be done by listeners at home, but it does imply further upside in the S&P 500 to about 3400, and we’re little under 2400 today.
So, rather than saying, “Hey, we think there could be that much upside left,” I think it’s a better illustration of just how insanely overvalued the market was back in the March of 2000. But, I mean, it reinforces what we said in the last several months that, “Hey, if this market is destined to melt up, there’s some further room.” And even if we got a third of the way, you know, between 2400 and 3400, that’s significant.
Meb: I think that’s really important point because a lot of people they tend to get their opinion and the way they think about markets, whether they’re bullish or bearish or whatever it may be, and they don’t look to the other possible scenarios and they don’t… You know, the phrase you hear a lot with the news media today is “echo chamber,” The bears sit in their echo chamber and just read all the bearish research all day, and the bulls, the opposite. But to be a thoughtful analyst you have to at least understand that there is the possibility that the markets could go up a lot more. And there’s good chart that you guys have and it shows. I mean, there’s potential of course that the market could go even higher than the valuations we saw in March of 2000. You know, it’s remote and our job as performing managers is to try to put the odds in our favor. And so in general the odds say that, “Yes, valuation is much more of a headwind.”
But you touched on a couple more interesting pieces and one comment is how various markets and bull markets have different flavors and they’re never quite the same. So you mentioned the late 1990s, early 2000s was that market cap bubble. And then in this one, you guys have a great chart where it shows the PE ratio of the cheapest S&P sector. And then also there’s a great chart of small-cap to large-cap ratios. Maybe you could talk a little bit about just how each bull market has different characteristics and then kinda what are the ones we’re seeing with this one as we’re reaching year nine.
Doug: Sure. I agree with your characterization in that late ’90s bull markets. It got very lopsided in terms the overvaluation concentrated in maybe just top 50 stocks. So if you avoided that bubble, you actually came out really well over the ensuing 10, 15 years. An astonishing fact that…this just happened from the last four, six weeks…I didn’t even know this index existed until recently, but there’s a Russell Top 50. It’s pulled from the Russell 3000 and the Russell 1000, but there’s a Russell Top 50 index that only in the last month or so finally eclipsed the high it made in 2000. I mean, that’s almost 17 years of going nowhere thanks to the incredible overvaluation.
The mania in addition to those mega-cap stocks was growth. I mean, you couldn’t pay too much for evidence of growth back then. Whereas the mania in this particular bull market I think has been with safety, low volatility, and in dividends. Not even necessarily high dividend yields, but just stocks with predictable records of dividend increases, and that would be the S&P 500 dividend aristocrats. I mean, they’ve done incredibly well. I mean, really sensed the breakdown of their growth bubble in March of 2000. On relative basis, they’ve done, well, not only during bear markets but also they’ve outperformed on the upside during both the 2002 to 2007 and the current bull market up until about the last year. They peaked on a relative basis last July.
But I guess the narrative, like weave along with it is, you know, in the 1990s we had strong economic growth, and consequently, the interest in the stock market was for companies with evidence of solid topline growth, and you’d pay a virtually infinite PE multiple if you thought that growth was sustainable. And you had all these wacky valuation measures like price-to-page-clicks and things of that nature. This cycle, on the other hand, has been characterized by fear. I mean, it’s been a very low confidence and sluggish economic recovery, therefore the mantra has been to play it as conservatively as possible, and that has been through these low volatility stocks. You know, most of them are economically defensive business models like the package food stocks or the big drug stocks. I mean, certainly, the electric utilities have been like the sweet spot in terms of lack of price volatility, lack of business model risk…you know, a stable business with the product for which demand is pretty inelastic, and then a premium dividend yield.
So these electric utility stocks are trading at 20 to 25 times earnings and they still look very expensive, but to me, that’s been where the enthusiasm has been. So where I see the valuation risks within this market. Again, they’re fairly concentrated, but the high PEs reside in these bond-like so-called safe low-volatility stocks. And we’ve run the chart and I’m sure you’ve seen it, Meb, showing our own low volatility universe to median PE in about 21 or 22 times still, even though they’ve fallen out of favor somewhat in the last few months, and then our high baby universe trading at a much lower PE relative to its history. I mean, that’s a glaring disconnect within the market.
Meb: I’m actually looking at the volatility PE chart for median PE on 12 months for…and it takes it back to the ’80s and this stocks used traded at PEs of 10, 13. In ’07, it got up in the high teens and then back down to the low teens in the ’08, ’09 and then now like you mentioned up into the mid-’20s which is kind of insane when you think about it. And you mentioned that the aristocrats really have gotten hammered. And we’ve been talking about warning off people from dividend stocks for a while because you’ve seen this rush into yield, you probably see it a little bit locally in the Midwest over the past number of years with even plate things like farmland. But the dividend stocks that peaked really last summer, a lot of people don’t…they assume dividend stocks and how yielders do well in a rising rate environment, and historically that’s not been the case. And then add on top of that they are still very expensive, I think there’s potential for a lot of disappointment.
One of your charts, we’ve been including as well. So you look at different parts of the US equity market. Another area that I think interesting is the small versus large-cap and you guys have a chart of historical PE ratios. And we were using it in the last couple years to say, “Hey, look, small caps are pretty expensive on a historical range at least up to large caps.” But then that really sold off over the past few years. Where do we stand now and that spectrum? Is it everything is more expensive? Is one much more expensive than the history? What is it look like?
Doug: I think you’re right in saying that everything is more expensive. We’re back to a market that is really broadly expensive. Now that work did look better on a relative basis as you suggested about a year ago. I would do fine like the internal overvaluation peak where just everything was very expensive in this bull market as being about three years ago, I mean, January of 2014. You can even mark it back to the first month of tapering where you started to flatten out those QE monthly purchases. I mean, that’s when you hit the highest broad market valuation per all measures. Like the median PE, median normalize PE, all that stuff peaked out about three years ago. And then obviously, I mean, the decline, the correction hit small caps almost doubly as hard as it did the S&P. I think the Russell was down 26.2, I believe, peak to drop in 15 and 16 versus 14.2 for the S&P.
So that did create a temporary opportunity and the small caps capitalized on it. I mean, they’ve…you know, not in the last month and a half-year to date, but they’ve been much stronger coming off the lows, but I do think they’re back to a pretty healthy valuation premium. Not as high as what they were three years ago, but I have a hard time making a relative case for small caps here on that basis. At times we’ll have a very strong call on small versus large, right now I’d say that we don’t.
Meb: And that’s fair too to say, you know, it’s like the old Teddy KGB in rounders where he just says, “Just check, check, check, you don’t have to play.” You know what is interesting is that looking at sentiments, about a year ago in January, we were talking about AAII sentiment at one of the lowest bullish ever because the market had started with one of the worst starts to the year in history. And it’s funny what a difference a year makes. I’m looking at y’all’s charts from the January and February green books and you have investors intelligence sentiment survey hitting extreme optimism, RIDEX ratio f mutual fund timers, all-time high. Name and equity exposure index, fully invested. Confidence post stock market confidence, 13-year high. And my favorite which I’ve never seen before is a consumer confidence survey that goes back 35 years on “Do you intend to take a vacation within the next six months?” and it’s the highest percentage ever recorded which I find fascinating. Do you notice this with your client conversations? Are people are starting to get a little giddy with the stock market or there’s still a lot of reticence there?
Doug: Yeah. I mean, I’d say it’s just overall for sure it’s… I mean, this is the most optimistic sentiment I’ve seen during the entire eight years. I mean, there have been little brief periods. I mean, we got one like in the spring ’11. I think I wrote about it and called it “The Ahah Moment.” Well, sure enough, you plunged into a 19.4% correction in the middle of that year. But, yeah, I can definitely…I can sense it. Not just clients, I do some of these retail perks around the country and I can certainly feel it perking up. So that’s troublesome. But, you know, there’s usually a phase in a bull market where the public is right for a while. It comes in and it’s rewarded for a while. It’s not like they’re an automatic contrary indicator.
And I would say the other thing, may have brought about our sentiment work, and we’re actually doing some work trying to partition within all the things that we look at within what we officially call our attitudinal category, is partitioning them between the survey evidence which is really through the roof. I mean, other than that, AAII, the American Association of Individual Investors, that one kinda flies around and does its own thing. Like consensus, market vane, investors intelligence, the name survey, the active investment managers, all of those are way up in marked bearish territory. Whereas other than the RIDEX ratio that you pointed out, some of the other money flow data that we monitor are not as extreme. In other words, opinions are now getting one-sidedly bullish, but it’s not yet been fully acted upon based on what we’re seeing in put-call ratios and some of the insider block selling measures that we monitor.
So maybe there’s a phase ahead where they’ve got all this post-election confidence based on some rhetoric that it’s been pro-business. It’s not all been pro-business, obviously. It’s been a selective filter where the Trump proposals have just been viewed favorably. Maybe you see that more than money flow data later this year and that will mark some sort of significant top, that’s what I’m guessing it will happen. But, really, that the worst looking sentiment data points are all survey-based, which we had to weight lower than the actual money flows. So we don’t have quite as an extreme a sentiment reading as I might have guessed given how far those markets have come in the last 12 months.
Meb: It’s interesting you mentioned Trump because you guys have a really fun table and in this month’s green book where it says you look at the stock market by presidential term but you look at the initial valuation when the president started, and then the subsequent returns over their term. And not surprisingly, listeners, if you look at the median valuation. So Democrats started around 15.5 and Republicans, the starting valuation is around 19. Sure enough, the return for the lower valuation for Democrats was 48% total return, for Republicans 25%. So obviously, valuations matter and the bad news for Trump, regardless of his policies, is that he’s starting with higher valuations.
I wanna touch on one more stock topic in the U.S. and then we can start to transition a little more into the momentum and trend and sectors and industries and all that good stuff. This is from last June and we talked about this and we’ve seen it mentioned elsewhere, where one of the biggest problems with investors indexing is the default. The market is always market cap weighted which means, listeners, that the largest stock gets the highest weighting.
If you guys remember a few years ago, all this noise about Apple becoming the biggest company in the market and, you know, is Apple gonna be the first trillion dollar company and all that stuff, Leuthold has a great piece, where they look historically at what happens in the U.S. to equities after they hit. And there’s no magical number, but in the U.S. at least this 4% number has kind of been this line in the sand where you hit that 4% number in the U.S. and it’s really, really hard to perform going forward. Do you want to talk a little bit about market cap weighting and kind of y’all’s thoughts about it at all or the study in particular?
Doug: Oh, sure. That’s just sort of a real thumbnail, you know, one page summary of work that we’ve done for decades. And the general theme, and as a matter of fact I can recall many of the titles. I think probably the first one ever writen was maybe back in the late ’70s, early ’80s when IBM was a big chunk of the S&P 500. So the lengthy study we wrote was “Is IBM forever,” and then, you know, when the tech bubble was being inflated, it was “Is Cisco forever,” “It’s Microsoft forever,” now it’s “Is Apple forever.” But the exhaustive studies we’ve done just show very high turnover out of the top 20 market cap stocks and we’ve got data going back to, I don’t know, 1917 or something like that. So it’s just very hard to stay up in those rarified market cap tiers, and that’s the way it should be in a capitalistic system.
So the 4% threshold, it’s just tongue-in-cheek. I think when Apple first reached that back in maybe 2012, we just said, “Hey, Apple is now in the 4% club, 4% of the S&P.” That’s the club to which you should never aspire to be a member because no other company has been able to stick. Exon’s been there, GE, Cisco and Microsoft, and none of them are even close to that 4% threshold. So I suspect, you know, as great a company as Apple is, they’re being mimicked left and right. I wouldn’t bet on them being…I don’t know about absolute. It could well be the first trillion-dollar company someday. But I’d bet on the other 96% outperforming Apple on a 10-year bet.
Meb: You guys got another good chart…and we’ve said this about a hundred times… You guys got another good chart where you have the S&P since the market bottom versus basically the rest the world. And it is astonishing to me to see that essentially the US is the number one performing stock market in the world, and this includes little tiny countries like Sri Lanka, Morocco, Jordan and everything in between. What’s your opinion on foreign stocks? Is it a great opportunity from valuation? Is it something that there’s more to the story? What’s your thoughts there?
Doug: I don’t think there are…you know, we talked about…and maybe when I was complaining about valuations earlier, I should’ve been specific and saying that’s a domestic concern because most foreign valuations are not even into our initial overvalued zone. I mean, they’re still in this very wide fair value band. Certainly, that’s the case for the EU in general. So I think it’s pretty intriguing, but you gotta have a longer-term time price. And the other thing that troubles me, Meb, and this is sort of a highly notional concept we’ve been working with over about the last 12 months is not looking at, what’s was the catalyst for leadership turning points especially when it comes to U.S. vis-à-vis foreign stocks. What we noted, if you look at IFA relative to the S&P going back to 1970, there’ve been seven major inflection points in leadership where either the U.S. started to outperform IFA or vise versa. So seven of those inflection points.
Four them occurred while a cyclical bear market was going on in the U.S. and then a fifth of the seven turning points took place just two months after a bear market low. So if you wanna be a little looser in the criteria, you could say, “Hey, five of this seven turning points happened in conjunction with a bear market in the U.S.” I mean, what that tended to say to us was, “Hey, you know, a bear market is like a significant reset point from an economic perspective that may lead to a diversion in monetary policies in the U.S. relative to the rest of the world.” It’s also like a psychological reset point where, “Hey, we’ve been beating up these U.S. stocks, they’ve outperformed the rest of the world,” which is, by the way, that’s pretty unusual. If you look at the weightings on the S&P 500, the S&P has relatively heavy weightings in things like healthcare, consumer staples relative to the rest of the world. So it’s more defensive.
So for the U.S. to beat the entire rest of the world during a rip roar in a heat year bull market is really unusual. I mean, it does say that their troubles the rest of the world, but when you normalize these valuations and if you assume, “Hey, the US is got well above average profit margins,” you know, if they come down a little bit and the rest of the profit margins start to rise towards their long-term medians, then the valuation gap is even wider than what it superficially appears. So yeah, I’m a believer but we need five years to capitalize and that is the problem.
Meb: Good. We’ll have you back on in 2022 and see how all of our prognostications come out. You know, it’s interesting because we talk a lot about both valuation and momentum in trend on the podcast and in the writings, and you guys do a lot of work with trend following and looking at something like the U.S. which is in our opinion clearly overvalued market but one that’s going up and has the trend in its favor as now do foreign markets, but that hasn’t been the case really for the last nine years. Many of these foreign markets have, like you mentioned, vastly underperformed. And I was looking at…maybe you could explain. There’s one really one long term momentum signal you guys have that I think fired off a buy signal last summer and it’s called “Very long term momentum.” Could you talk a little bit about that? And I think it may even have some commonalities, I could be wrong, but with the COPPOCK curve?
Doug: The commonality is one-to-one.
Meb: It is the COPPOCK curve.
Doug: It is the COPPOCK curve. Way back when it was out there in the public domain I think beginning in 1962, the formula was published in the “Barrons,” and the Leuthold Group’s adaptation and where impacts us more than anywhere else is in our industry group work. So we run a VLT momentum COPPOCK curve calculation on all of our industry groups. It tends to lead you into this industry groups that had been long-term underperformed and washed out. So it’s a nice counterbalance to our other more traditional relative strength algorithm where the interpretation is, “Stronger is better.” And that certainly works over time but is more whipsaw prone at major market inflection points, particularly major market lows. So it’s a nice counterbalance to traditional relative strength.
But we also run VLT momentum and I’ll just call it that since that’s the moniker we put on it, but certainly feel free to Google the COPPOCK curve all kinds of good information. But what’s unique about the VLT buy signals is that they’re unlike a lot of technical studies that are short-term or intermediate-term in nature. When you get a low risk buy signal on VLT momentum, the implication is for higher prices for 12 to 24 months to come. And by the way, some people when we show them the study they kinda roll their eyes, it’s like “Well, gee, by the time this thing triggers, the market is often already up 20% to 25%.” As a matter of fact, I think the average slippage, so to speak, after a signal, or from a market low to the actual buy signal is like 20%. And it was larger last year because the market low was on February 11. You didn’t even get a VLT by signal until the end of May.
So the point is, this shouldn’t be the first thing that directs you back in the equities. And we were bearish throughout that correction and started to change strikes in March and April, and then when we got this belated VLT by signal at the end of May, you know, it just really cemented, validated the other bullish moves that we’d taken. So, again, you should be acting in advance of BLT, but the value VLT is that it tells you, “Hey, this could be more than just another rally leg. It could be something that lasts much longer than you think.” And again, when I look at valuations, when I look at the links in the cycle, that’s a difficult one to stomach. But certainly, that signal when we got it at first on the S&P at the end of May, and then on the Russell 2000, very belatedly at the end of July, it did force us to be more open-minded saying that, yeah, even though the initial valuations were high when we got the signals and the economic recovery is already lengthy by historical standards, we just had to say that, “Look, the market sees something here that it likes on a longer-term basis.”
So those signals have been good, a bit less powerful than the average historical signal. Not a surprise given the point in the cycle where we got them, but yeah, it’s a unique tool. And the value is, historically, there have been very few failures. When you get one of this long-term low risk buy signals, it’s a longer term all clear for the stock markets. So we’re still operating under that sort of 12 to 24 month lookout period.
Meb: Well, let’s say there’s come investors listening and then they say, “Meb, we’re gonna ignore your valuations. We’re bullish, we’re romping stomping bulls.” But we wanna drill down a little bit/ We wanna know what are the best sectors in the industries. And so, you guys have done a lot of historical momentum or relative strength studies. Yeah, you call it “The Dreams,” “The Nightmares,” “The Bridesmaids,” a lot of fun names, but basically looking at momentum applied to sectors as well as industries as well as even asset allocation. And so maybe you could talk a little bit about how that works and also what those might be pointing towards today?
Doug: Well, we certainly use our relative strength in our group selection work, and we’ve got our own proprietary charts scoring algorithm along with VLT. But I have to say that the simplest momentum measures are pretty darn good. Whether you’re talking industry group rotation, sector rotation or even as you mentioned, you’re looking at multi-asset class frameworks. So a 12-month look back, there’s just something almost magical just historically about using 12-month momentum. I think there’s something than the investor;s psyche. They don’t know exactly how much they are up or down versus a year ago, but they have an innate sense that, “Hey, you know, I’m doing well versus about a year ago, at this time” And it’s uncanny. We can demonstrate this through stock momentum studies.
I just haven’t published all of this yet, but we’ve got industry group data including dead industry groups going all the way back to the late 1920s rebalancing portfolio using 12-month price momentum on industry groups. You can rebalance monthly, of course that’s costly and not that all tax efficient. You can rebalance quarterly, once every six months. You’ve even got Alpha if you only rebalance with 12 months momentum annually. So it’s powerful stuff. And then we tested all the other possibilities from one month out to 24 months momentum, and the 12-month momentum is hands-down the best. Absolute and risk-adjusted basis. So that’s a pretty simple way. You know, of course, you can somewhat improve upon that, but it takes a lot of work and a lot of what I think is largely curve setting.
Where we had some fun with that concept in “The Green Book” is a couple of portfolios that we’ve been publishing for many years in the back of the…actually, it’s in the front of “The Green Book” each January. We call them “The Bridesmaid Portfolios.” And this started with our work on the 10 S&P sectors. I just tinkered with some of the S&P sector history and found that…I just basically posed the question, “What if you knew nothing else about those 10 sectors other than last year’s total return performance?” In other words, you didn’t have good valuation data, you didn’t have a great sense of where we were in the business cycle, which may be true more often than we would like admit but you just knew last year’s total return performance. It turns out the optimal strategy is a momentum one and it’s to go with last year’s runner-up sector.
So the idea is, “Hey, there’s probably something going on fundamentally that’s favorable that has driven this sector to the number two spot in the performance rankings for the year yet, because it’s not the top, it’s not yet over owned and overexploited by the press. That sort of thing. So “Bridesmaid Sector,” we call it, has outperformed the S&P. I think it’s about know 400 basis points compared to the S&P back to 1990. Last year was not a good year. Healthcare was the bridesmaid holding for the third year in a row. So I should have suspected that, “Hey, that might be getting exhausted since it’s the third year in a row that we’ve held it.” This year’s holding is also unexciting. It’s the telecom sector. So I put a little bit of personal money into these Bridesmaid Portfolios. And I’ve gotten lucky this year because the…let me just pull this up. I’m gonna pull this up on the screen.
Meb: Telecom interestingly enough, you guys also have a study that shows, you know, basic valuations as well where you look at a simple sector asset location based on valuation and showed that, that works as well too, and I could be wrong, but I’m pretty sure telecom is ticking both those boxes, isn’t it the Bridesmaid’s plus?
Doug: It’s the twice blast sector this year because also there’s the momentum study, I mean Bridesmaid is pure momentum sort of like momentum that is not fully exploited. And then a couple of years after watching that strategy we said, “What about the opposite strategy where we just go looking for trouble?” Which in my mind is not looking for something that’s down the most in price, it’s looking for something that is absolutely cheap. So we ran a strategy in which we picked…and these are more…you know, again, I think they’re okay to do with a little of percentage to your portfolio more recreational, but really, you know, these are more illustrative saying that, “Look, there is merit to momentum at the sector level.”
And in the case of the cheapest sector strategy, you’re buying the lowest PE sector or lowest PE is defined as the S&P 500 sector with the lowest median trailing PE, that’s a better representation. You know, like in the financial sector if you have a big right off at Citi during an economic downturn that could wipe out all of their earnings for the financial sector and cause the PE to go to infinity. So we just said let’s have the representative valuation for each sector. So the median PE, it turns out that the telecom services was also the lowest PE strategy.
Meb: Well, it’s interesting, you know, when we talk about, by the way, valuation U.S. bulls…bears, excuse me, are gonna hate to know that the Bridesmaid Asset Allocation Strategy winner for 2017 is also U.S. large caps. so maybe we have one more year in this last gasp in this bull. Speaking of factors, you guys track momentum within the stock market, and the traditional way, the academics do it is on a spread basis, so the high momentum minus the low momentum. Most investors don’t necessarily employ it that way because it’s a market neutral portfolio, it’s hard to short yadi yada, but it does show how it’s working relative to the worst decile, and last year was the second worst spread in 89 years, the worst being 2009. Is that something you think is just a measure of randomness? Do you think that something has changed in markets or any reason that momentum on a stock level on the market neutral spread basis has really struggled twice the two worst years in the past 10?
Doug: That 89 years statistic, I mean just one, I mean this is kinda getting into the weeds. That study was done on the 50 industry groups. So on an industry group basis the second worst…I’d have to look. I’d have to look at the equivalent numbers for stocks. I mean, it obviously was a very bad year. I don’t know if it was the second worst on a stock basis but it was on an industry group basis. But at any rate, I mean, there are all sort of a line. I mean if it’s a terrible year for momentum investing at the group level it’s not gonna be a good year for a momentum investing at the stock levels, so that was certainly true. But, I mean, one thing I would say, Meb, and this gets a little bit into the realm of factor timing which we certainly have lengthy discussion on here. I can’t say [inaudible 00:50:18].
Meb: What’s your take-away on that? You know, we’ve talked a lot about that on the podcast before, we had Robert Norton who talked…who is very favorable and pro-factor timing and there were others like Cliff Asness. Where do you guys fall on this spectrum? And explain what it is real quick to listeners and then where do you guys fall?
Doug: The idea would be that certain long-term known alpha generators among quantitative factors have return patterns that can be timed, in other words there are more favorable environment for value versus growth and momentum and vise versa, and that you can dial down exposure to a factor like momentum at cycle points where it may be more vulnerable. And I’m a believer that you should tinker with some of that. You know, the world is just getting smarter all the time and I think it’s just a little bit naive to assume that you’ll just be able to harvest a simple momentum factor at its historical alpha rate indefinitely into the future. So the markets evolve.
But that along with the fact that is, you know, market students here. I mean, there are historical junctures at which like momentum in particular is far more vulnerable than at other times. And we wrote about this in…initially, it was in the fall of ’08 and the phenomenon we were predicting was called the revenge of the nerds. And the notion is that a momentum hands-down over long periods, high momentum stocks beat low momentum stocks, high momentum groups beat low momentum groups. And again, I’m talking about a 12-month momentum number or you can use the academic form of momentum which is ten-month momentum as of two months ago, you’ll see that a lot in the literature that sort of thing. And you know, it really doesn’t matter, they’re all very good. But where that strategy is the most vulnerable is coming off of a major bear market low.
So you have a phenomena. And again, it’s the revenge of the nerds where the optimal strategy, assuming you could time a bear market low, would be to go into what’s down the most for the last 12 months, the low momentum portfolio. Again, that’s assuming that you can time market low. But you don’t have to be perfect. You know, obviously, the market was just getting crushed in late ’08 and we just observed, “Look, the more the market is down the larger this revenge of the nerds, this anti-momentum or momentum reversal effect is going to be.” And that’s what happened. It turned out to be one of the largest in history, which stands to reason because the market was down 57% from peak to trough. What was unusual about last year is we had a massive revenge of the nerds effect…again, momentum reversal…that occurred after only a fairly shallow decline in the S&P. Again, it was down 14.2% peak to trough.
In no way would we ever define that as a bear market. But the subsequent action in factor land specifically, this violent momentum reversal where nerds have their day in the sun, a 12 point losers were the best thing to own, it was on a scale that you will normally see only coming out of the other side of a bear market. Which is interesting because we were talking about the VLT momentum earlier. And again, that’s the signal that normally only comes after a major bear market. So both in factor land in some of our intermediate and longer-term technical work, we got signals following that February low that said, “Hey, that was a significant market decline.” Even though it was only 14.2% on the S&P. A lot of things said it was more significant, that it was a much more significant psychological reset for investors.
Meb: One of the cool things you guys do too, is that many investors are beholden to one indicator. And a lot of people would say, you know, “I use trend following, or I use valuation,” or whatever may be. And you guys have something called the major trend index. And it looks like it has like, I don’t even know, over 100 inputs. But everything from economic inputs, to attitudinal, to supply and demand, momentum breath and valuation. Could you explain just really quickly kind of the general concept there and, of course, what is it saying now?
Doug: Sure. The major trending, it’s 120…I’m sorry, 130 inputs. It’s gone on a diet since I took it over five years ago, I’m a minimalist so it only has 130 things now down from 103. Five categories, I mean, it’s everything that we think brings to bear on the intermediate term or the cyclical outlook for the stock market. So valuations are a piece of it. Liquidity factors, interest rates, Fed policy all those are rolled up into a category we call “Economic Interest Rates Inflation.” The investors sentiment, our name for that is “Attitudinal.” We look at the supply-demand factors, you know, like IPO flows, institutional buying pressure, that’s all under supply demand. And then the technical factors would be momentum breath of urgency.
Even within that category, there are some things that are anticipatory or predictive and others that are just sort of blocking and tackling trend following that we hope that they’re not the things that actually trigger a shift, but sometimes you just need them. I mean, you know, this forthcoming market top, I gotta believe after an eight-year bull market, we should have a fairly lengthy topping process, I would think, where cracks and market breadth and small caps in sector leadership maybe like the transports and the financials. Maybe we’ve already got some of that with what’s going on with utilities having under-performed now for several months. But the utilities would be the only crack I can see really in all of the technical work. The breadth is there, other leading groups are behaving well, obviously, all the trend following work is strong.
But that will be the challenges. I would suspect if this thing even loosely conforms to the historical pattern, we’ll get several months of more divergent fractured action within the market that will help lead us to a more defensive position. And, of course, that could be accompanied by more inflated sentiment or not sentiment. Just like almost every other market indicator, market sentiment is better at market lows that it is at highs. Stock market lows tend to be spike events. Market tops are much more dispersed, you know, rounding in nature where sort of one by one the leadership falls by the wayside. That’s what I’m expecting. If it doesn’t happen, then we’re just gonna have to rely on some of these more clumsy, I consider them clumsy, trend following indicators that will only get us out after…I don’t know, a 5 to 7% decline, I can’t say for certain, but that will depend…
Meb: If we’re lucky.
Doug: Yeah. It would…who knows. I mean, look at 1987. I mean, 1987 did have a lot of deteriorating evidence in advance. I mean, I think a scarier scenario, I mean, this is one we shared about sometimes on the asset allocation team, but I referenced that 2011 decline earlier, that was a 19.4% decline in the S&P, much deeper, and the Russell and the Value Line, things of that nature. For some reason, it’s not generally considered a bear market, but that was one that did not have internal forewarning from breadth or leadership. I mean, that decline started with over 90% of NYSE stocks above their 30-week moving averages, really unusual. The market was very internally strong into the end of April and yet, boom! You had this borderline bear market. So scenarios like that worry me. I mean, I would just be an out-of-the-blue scenario but they do happen, occasionally.
Meb: Yeah. That would be the painful or scenario right now where almost, like you’ve mentioned, almost every market is in an uptrend and you have that sort of shock to the system and it’s possible, it certainly can happen. And so for the novice investors listening and they’re saying, “Meb, Doug, this is great. I love all this information. I’m not gonna be able to follow 130 indicators on my own, if I did, I wouldn’t even know what to do with it.” What’s gonna be your advice for implementation for say your average investor that’s listening to this podcast and is interested in putting together a portfolio but also trying to be a little active and protect themselves, you know, before this next bear creeps up on us whenever that may be?
Doug: You know, for those not attuned to the market day-to-day, I would not be at maximum equity exposure. I mean, the reason that we’re fairly close is because we do follow more of this shorter-term work, I mean, sentiments and market action. I’d be dialed back somewhat for maximum exposure. And then within, whatever your predetermined mix is for domestic versus foreign, I’d have more of an emphasis on foreign and in particular, emerging markets. Because in a retail setting, you know, with not a lot of flexibility or desire to do large and frequent moves, I’d rely more on valuation. And valuation tells me that I should be later than normal on U.S. equities and tilting more towards forum.
Meb: Well, listeners, you can just go buy a bunch of the Leuthold funds and be done with it, and Cambria. Doug, one or two more questions and I promise I would let you go, we’re not gonna keep you around all day. There’s a chart that I was curious that…I wasn’t quite what it was. You have a chart called “The Risk Aversion Index?” And it goes back to the early ’80s, and just from eye bulling, it looks like we’re arguably one of the lowest levels. What is that chart telling us and does it have any sort of forward-looking implications all?
Doug: The forward-looking implications are stronger when it high. In other words, risk aversion is very high. Getting back to what I mentioned about markets lows being sort of spike events or as markets tops can be rounding and you could remain at very low volatility, a very low investor risk aversion like we’ve had recently. But that risk aversion index was developed by our [inaudible 01:01:42], Sean Wong. And these risk aversion indices are fairly standard in the quant world. It lines up quite well with our own attitudinal category. And I think the mathematical difference is what Sean’s got with this, he calls it “The art of the risk aversion index, RAI” It’s range bound. So it got some nice statistical properties. But, he’s looking at things like credit spreads, the VIX, relative action between industrial metals and precious metals as sort of an inflation versus growth trade-off, the actual volatility of the market itself, I mean, several factors going to that RAI.
It’s actually decent on a trend following basis. We use that as part of a bigger macro model and then just three month moving average, the direction of three-month moving average on this risk aversion index is, it’s okay. Again, recognizing that, I mean, market lows can be violent. You can have a very vicious short-term rally and risk assets. So it won’t be perfect, but in longer-term…and a longer-term trend context, it’s pretty good. But is is highly related to our attitudinal category where we’re using more conventional measures of investor sentiment like put-call ratios and all of those investor sentiment surveys and flows into short funds, things of that nature.
Meb: It seems like you had time to be buying some cheap hedge insurance at this point. Some long-term puts perhaps with low vol, high valuations, I don’t know. Thinking personally, do you have in your career a most memorable good or bad investment or trade that you can think of? We used to ask that question where we said, “Do you have the most memorable investment?” And then asked, “Do you have what was your worst trade?” But for a lot of people that’s the same one. So we’re just asking the most memorable across the board these days.
Doug: Yeah. Well, I worked on maiden large-cap value portfolios in the late 1990s which was brutal. You know, all these great companies that just the market wanted no part of because their businesses were mundane. That was difficult but I was convinced the tech bubble was going to burst and rather than, you know, like a shortcut fund or a short internet fund, I decided to write some naked calls on eBay. So this was back in 2003.
Meb: Oh my God.
Doug: Yeah. So, of course, that was one of the ones that survived the entire bear better than almost everything else. I didn’t lose. Well, at the time it was a pretty significant chunk. But having the general theme right and just blowing it on the individual vehicle, that’s pulling the [inaudible 01:05:02] out because everything else was going down in a hurry and here are my eBay calls that I was sure where forcing margin calls. So that wasn’t fun. That’s one that sticks out.
Meb: The late ’90s was great, I mean I love bubbles. I mean there’s nothing fun than bubbles. I think people were probably gravitating towards Bitcoin now, I’m not sure. But bubble great a lot of opportunity on both sides. Doug, it’s been awesome. Where can people find more information on you and your writing if they wanted to follow you guys and learn more?
Doug: Sure. Leutholdgroup.com, research website and then leutholdfunds.com. We’ve got a family of five mutual funds. The bulk of our assets are in tactical strategies utilizing the major trend index driving the net equity exposure, and then our long equities are driven by quantitative industry group work. I’ve talked a lot about momentum, I mean, that’s one piece of it. It’s the piece that’s easiest to quantify. But we do have a value stock selection model that we pair with the industry group model that’s worked out well. And yeah, it’s been three, four years now we’ve been using this value overlay. So basically, cheap stocks and stronger groups, that’s been a good marriage. Helps insulate us when we have a momentum reversal like last year. But, those would be the two places to go.
Meb: I love it. Well, Doug, thanks so much for chatting with us today. It was a lot of fun. I mean, we have another stack of probably 50 charts that we’ll have to reserve for next time and we’ll have you back on in the future.
Listeners, thanks for taking the time listen to today. We always welcome feedback and questions. For the mailbag at firstname.lastname@example.org. As a reminder, you can find the show notes and hopefully, fingers crossed, lots of charts from Leuthold at mebfaber.com/podcast. You can subscribe to the show in iTunes. And if you’re enjoying the podcasts, a Jeff request, please leave a review. Thanks for listening friends and good investing.
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