This note was originally published at 8am on March 16, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“The downside to thinking statements are more complicated than plainly stated, is that what is plainly stated is more often than not the truth when arrived at the long way around.”
Rob Shewchuk is a long time friend of Hedgeye and also many moons ago played junior hockey with our CEO Keith McCullough for the Pembroke Lumber Kings. If the moniker Big Alberta fits me, I think it is fair to say that Big Ontario fits the 6’3”, cowboy boot wearing Rob Shewchuk. Rob grew up in the mining town of Red Lake, Ontario and has parlayed his natural business instincts into becoming one of the top brokers in Canada, with a special focus on undervalued mining assets and emerging growth companies.
Rob and I were texting each other about a common business situation and he put on his Red Lake philosopher’s hat and sent me the above quote. As a bachelor who is still in full dating mode, I’ll be the first to tell you that text messages can lead to confusion, but I think the message Rob was sending was pretty clear: keep it simple.
In investing, complexity negatively infiltrates the investment process in a number of ways. One way is analysis paralysis. Undoubtedly, we’ve all worked with analysts that are guilty of this crime of complexity. The guilty analyst will have a 75 page spreadsheet analyzing a company down to the return on capital of the administrative assistant to the head janitor, but won’t be able to make a call on whether the stock is going up or down. The analyst knows so much, he or she is in fact paralyzed and unable to make a decision.
The other crime of investing complexity, which is more to Rob’s point, is when an analyst complicates simple things, like say valuation. A friend of mine from home says that when it is – 40 degrees Celsius out, you don’t need to ask how cold it is, you just know it is *expletive* cold. The same could be said for valuation. If a stock or asset is cheap, you shouldn’t have to argue it’s cheap, or justify that it is cheap. The valuation will be plainly obvious.
Yesterday, to the last point, I wrote a research note on the valuation of the SP500. Many stock market pundits are making the case that the SP500 is cheap based on future consensus earnings. Unfortunately, that analysis is not really all that simple, for the basic reason that consensus estimates are usually wrong. In fact, according to a McKinsey study from 1985 to 2009, SP500 earnings estimates were higher than the actual reported number 92% of the time.
So, obviously when making the simple valuation call, it depends on the complexity of the underlying estimates. When looking at the valuation of the SP500, we prefer to use CAPE, or cyclically adjusted price to earnings. CAPE is a metric popularized by Yale Professor Robert Shiller that looks at a market P/E that is adjusted for inflation and normalized for cycles. Currently, CAPE is showing that the SP500 is trading 21.9x, which is the highest level since July 2011 and in the top quintile of market valuations going back to 1880 (before even I was born).
CAPE hit a 35-year low in March of 2009 at 13.4x. This also coincided with a low in other stock market valuation metrics and the bottoming of the market. Stocks were, simply, and obviously, cheap. As for now, it is neither simple, nor obvious.
As of late, we’ve been flagging and harping on another simple indicator of the equity markets peaking, which is the VIX. The Chart of the Day today goes back exactly three years to the bottom in March 2009 and compares the SP500 to the VIX over that period. As the chart shows, a VIX level of 15-ish has coincided consistently with a short term top. To the simpletons at Hedgeye, that is a red flag worth emphasizing. More simply, the VIX at this level signals that complacency is setting in.
Over the last 24 hours, we’ve made a couple of simple moves in the Virtual Portfolio that should inform you on our current positioning:
1. Shorted Greece via the etf GREK – With “positive” catalyst of the Greek debt restructuring in the rear view mirror, Greek equities now have to deal with austerity headwinds and a population that is leaving Greece en masse.
2. Shorted SP500 via the etf SPY – Selling the SP500 at our overbought line has a high historical batting average and at 1,401, the SP500 is overbought. Yes, it can be that simple.
3. Shorted consumer discretionary via the etf XLY – With oil prices and inflation accelerating, this isn’t good for growth or discretionary spending. Historically, growth slows when oil reaches 5.5% of GDP. Simplistically, a Brent oil price of $116 equates to 5.5% GDP and Brent is currently at $123.
Henry Wadsworth Longfellow also had a great quote about simplicity (although he didn’t text it to me), which was: "In character, in manner, in style, in all things, the supreme excellence is simplicity."
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research