September 30, 2013

Market Summary – 3rd Quarter, 2013

The work of one who uses a paint-by-numbers kit will never be confused with that of Pablo Picasso. There is no creativity, no real depth, no judgment used to make the piece stand out. The only skill required of the painter is to stay within the lines. The finished piece is nothing more than an artistic imposter that may appear to have merit from a distance, but upon closer inspection proves to be the work of an amateur.

The investment equivalent of paint-by-numbers is found in index funds and exchange-traded funds¹ (ETFs). They attempt to replicate the performance of the broad market² or subsets of the market³, and allow investors to be in or out of the market at a moment’s notice. This tactic, referred to as “passive investing”, is a misnomer and is the antithesis of investing. It requires no judgment and gives no consideration to the merits of the individual businesses that are included in the investment product. As we have seen throughout the history of the financial markets, ignoring the valuation of the actual businesses that one is investing in is a surefire way to lose money.

Passive investing strategies have ballooned in popularity over the past four years as global macroeconomic and geopolitical events have dictated the movement of the markets. Consider that the percentage of passive dollars in the U.S. equity markets has surged to 33% from under 20% just 10 years ago. Still smarting from the global credit-crisis-driven market correction of 2008, investors appear to be leery of committing their money to the stock market for any reasonable period of time. These investors are consumed by headline news and are committing the proven sin of eschewing fundamental investment analysis in favor of the ability to be either in or out of the market at a moment’s notice. Today high profile market strategists call this tactic “risk-on/risk-off”. In reality this is simply a euphemism for “market timing” – a strategy successfully employed by few (we know of none, but they may be out there) that usually costs investors more in missed gains than is saved in avoided losses.

This trend of investing based on the headline du jour has made it challenging for active managers to separate themselves from the broader market. Stocks have recently been trading in lockstep with the rest of the market, regardless of the individual merits and valuation of specific companies! The flow of money into index funds and ETFs benefited stocks across the board regardless of their underlying fundamental value. Despite this temporary environment, an unassailable fact remains – successful investing requires the avoidance of excesses brought about by the animal spirits of the masses. One should never aspire to follow the market or subsets of the market through an index fund or an ETF, as it does not discriminate between quality investments and those of dubious worth.

The fact that stocks have performed well in recent years is, at least in part, recognition of the growth of corporate earnings and expanding valuation multiples. This is a fundamentally sound reason for stock price appreciation. A serious consideration for passive investors going forward is how sustainable the upward movement in the broad market is given that valuations of many low quality stocks and overbought sectors such as utilities have reached dangerously high levels. That’s what happens when investors are indiscriminate in choosing stocks (the modus operandi for passive investment strategies).

As the size of the ETF market grows, each incremental dollar invested will have less of a positive impact on prices. Passive investors continue to pour money into overpriced stocks in an effort to trace the market’s movement. This scenario is not dissimilar to the housing or dotcom bubbles of recent history. Once an inflection point is reached where returns fail to live up to expectations, investors stop buying and start selling. Without strong underlying fundamentals to support their relatively lofty valuations, the ordinary and unattractive companies are most at risk of experiencing significant price declines. At the same time, the great companies whose valuations have been depressed because they have been tethered to weaker components of the index will finally be rewarded based on their individual merits.

This sequence of events is inevitable, and hardly unprecedented. The great value investor, Benjamin Graham, long ago made the famous assertion that, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, the popularity contest is winding down. Investors are turning their attention to fundamentals of investing, and will give more credence to stocks of substance. This is an important transformation for which investors need to prepare – a time when judgment and skillful stock selection will once again reign supreme.

Correcting the delusion
Evidence that this decoupling of quality stocks from lesser stocks is already underway can be found in something called the CBOE S&P 500 Implied Correlation Index (“Correlation Index”). The Correlation Index is an indication of the options market’s expectations for how closely individual stocks in the S&P 500 Index will track to the index itself. As seen in the following chart, stock correlation has been in a steep downward trend since peaking in late 2011, when the market was at its most fear stricken following the debt-ceiling debacle (of 2011 vintage) and the looming threat of a break-up of the Euro. In fact, the gauge of stocks’ linkage to the broader index is close to levels not seen since before the financial crisis. The point is that correlation among stocks is down significantly. The market is no longer treating all stocks as essentially equal. This is a wonderful development for skillful stock pickers. The recent headline events of our government shutdown and debt ceiling squabbles are, in our estimation, a last breath of the multi-year trend of emotional anxiety driving heightened correlation among stocks in the market.

Bring on the varsity
If the correlation among stocks is dropping and the era of passive investing is over for this cycle, the advantage shifts to active managers who can spot values and capitalize on them. Of course, this approach can be a minefield in itself. While the Correlation Index tells us that an increased number of stocks may be positioned to outperform the market, the other side of the coin is that an increased number of stocks are at risk of underperforming the market as well. The difference between choosing the winners and losers is what separates the varsity investors from the intramural squad. Once again, this is where valuations come into play. The greatest risks tend to be in stocks or sectors that become significantly overvalued during a bull market. By contrast, the most attractive potential can be found in stocks of good companies that are priced right, relative to the market as a whole. Not only do these stocks have the ability to generate higher returns in an up market, they are also better positioned to retain their value during those times that the market slides backwards.

This is the kind of environment we found ourselves in as the dotcom bubble came to an end in early 2000. A large number of stocks were cashing in on the “voting machine” phase of the market. Their appreciation became a self-fulfilling prophecy, as ascending stock prices attracted more buyers without consideration to valuations that had reached speculative levels. Back then, it was mostly technology issues that saw their price/earnings ratio reach stratospheric levels, which contributed to the excessive valuation of the entire S&P 500 Index.

At that time, overzealous investors continued to pour money into stocks like these, with no regard for their excessive valuations. At MPMG, we saw the valuation trap that was being laid for passive investors. Rather than follow the masses in this temporarily-successful popularity contest, we maintained our disciplined value approach. It cost us performance compared to the broader market in 1998 and 1999, but the difference afterward was significant. We happily invested in the stocks of great companies that were trading at steep discounts to the market simply because the names of these businesses didn’t end with “.com”. These investments laid the foundation for the MPMG All Cap Value Composite portfolio outperforming the S&P 500 Index for 10 straight years and creating life-changing wealth for our clients.

It is a prime example of how an effective active management strategy can make all of the difference in creating wealth, as well as protect your portfolio throughout challenging markets.

The same kind of environment has emerged again today. A number of stocks have reached unsustainable valuation levels. The examples in the table below represent the extreme, but clearly, there are companies in the major indices that, thanks to the flow of passive investment funds, have become extremely unattractive from a valuation perspective.

We firmly believe that much like the late 1990s, the groundwork has been laid for quality stocks to move to the forefront. The choice no longer should be whether or not to be invested, but rather how to capitalize on the opportunities that are ready to be played out in the next phase of this bull market.

Room to grow
As the S&P 500 Index breaks through to new highs that were last set in 2007, some investors are wondering if the market is fairly valued. However, to view the market’s current price without giving consideration to its current and future earnings would be making a serious error in judgment.

The general market is currently trading at average to below-average valuation levels. While the S&P 500 Index is slightly higher than its previous high level last reached in October of 2007, the underlying earnings of the index are 14% higher. There would appear to be more room to run just based on this valuation disparity alone. However, when one considers that earnings are also projected to be 25% higher by the end of 2014, the market does not appear to be expensive on a historical basis. Moreover, when interest rates are below 8%, the average P/E ratio of the market is not 15x, but 19x. Currently the S&P 500 Index is trading at about 16x 2013 expected earnings and only 14.5x 2014 expected earnings. Therefore, the valuations of the broader equity market would indicate that there is further room for price appreciation.

This isn’t to say the market won’t experience significant volatility. There is little doubt that the stock market will become much more selective and once again reflect the Benjamin Graham “weighing machine”. Just as water seeks its own level, so too will individual stocks. Paying the right price for a business will make all the difference. Passive investors are in no position to do it. Active managers have the potential to “beat the market” rather than get average returns.

The future belongs to those who pay attention to valuations and use good judgment to identify well-positioned companies whose stocks trade at the right price. Similar to the painting-by-numbers faux Picasso, now is the time when the distinction between quality stocks and imposters will become much more evident.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.