NOTE: Every week or two I write a Client Note for my clients. For a limited time, I am allowing non-clients to sign up and receive it at the same time as my clients. You can sign up at the top right hand corner of the website. I will also be posting the notes on my blog with a time delay from time to time.
Originally sent to clients Tuesday March 1.
Beware the ides of March.
– Soothsayer to Julius Caesar, Shakespeare’s Julius Caesar
These investors have been double-traumatized. First in 2008 and 2009, they suffered until they said ‘I can’t take it anymore’ and sold all their stocks. And now they’ve had to deal with the trauma of watching the market go up and realizing that they’d be better off if only they hadn’t gotten out.
One of the most interesting developments of the stock rally since December is the beginning of a return to domestic equity mutual funds by individual investors.
The Investment Company Institute is the mutual fund industry trade group and it keeps very detailed records on mutual funds. According to their data, from July 2007 through December 2010, investors pulled $331 billion from domestic equity mutual funds. Over the same time period, they invested $671 billion in bond funds.
Through the first seven weeks of this year – through February 16 – this trend has started to reverse. Investors have put $18 billion into domestic equity mutual funds while inflows into bond funds are barely positive.
It appears that retail investors – who have largely missed the two-year bull run – can’t take sitting on the sidelines any longer. These investors are not investing on the basis of a rational assessment of the economy, stock market, valuations, etc… They are capitulating to the stock market’s relentless push higher. Their fear of missing out is starting to get the best of them.
In other words, we are starting to get to the point where everybody is All In.
Paradoxically, this is correlated with market tops. The reason is that when everybody is in the market, there is nobody outside of the market for them to sell to at higher prices. Put another way, there is potentially a lot of selling pressure from investors in the market who may want to get out, but little buying pressure from investors on the sidelines who may want to get in.
Adding to the risk equation, stocks are no longer unambiguously cheap.
No doubt you have heard many commentators on CNBC and in the press talking about how attractively valued stocks are. Many cite the S&P’s P/E ratio as 14.
But there are a few caveats.
First, this is the forward P/E ratio based on analyst estimates for 2011 earnings – not actual earnings.
S&P 500 companies earned about $84 in 2010. The forward P/E assumes 14% profit growth in 2011 to $96. The trailing P/E at the moment is 16.
That is not expensive. But it is not cheap, either.
Second, the value in the index is driven by the mega-caps. Huge companies like Chevron, Exxon, United Technologies, 3M, Intel, Cisco, Hewlett Packard and Walmart are trading at and – in many cases – below the market multiple.
Since the S&P 500 is market-cap weighted index, we can infer that many, many of the smaller stocks in the index are trading at multiples well above the overall market. A number of stocks come to mind here: Netflix, Salesforce.com, Chipotle, Priceline, JDS Uniphase, etc…
Last Thursday, Australian hedge fund manager John Hempton surveyed the market in a well-read blog post concluding:
Alas, when I look at small caps – even medium caps I keep finding expensive, dodgy and well promoted stocks. Small caps are a land of shorts (“A Small Hedge Fund Manager’s Lament”
, Bronte Capital, February 24).
It is also worth repeating that rising inflation is hurting corporate profitability.
This weekend Barron’s ran a cover story touting industrial giant 3M (MMM). I looked into 3M and – while the stock is interesting, pays a nice dividend and is not overvalued – it is also seeing margin pressure from rising commodity prices.
Gross margin declined to 47.3% in the last six months of 2010 from 48.4% in the year ago period. That decreased 3M’s pre-tax profit by $143 million or 12 cents a share after tax. 3M earned $2.81 in the last six months of 2010 compared to $2.67 in the year ago period. In other words, margin pressure cut profit growth in the period in half from 10% to 5%.
Next Wednesday the bull market will celebrate its 2-year anniversary. It’s been an incredible two years. At it’s closing high two Fridays ago, the S&P 500 was up 100% (1343 from 673) – one of the most spectacular bull markets in history.
But with extremely bullish market sentiment, full valuations and margin pressure from inflation, I suspect 2011 may not live up to the high expectations now priced in.
NOW IS THE TIME TO INVEST WITH TOP GUN: If you have been thinking about investing with Top Gun, now is a good time to give me a call or shoot me an e-mail. I am full of ideas and confident that I will be able to add value going forward in 2011.
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