A Sign of a Bottom in Stocks?

Earnings season begins... A sign of a bottom in stocks?... Why we remain cautious... Ferris: The market is still extremely overvalued...

Fourth-quarter earnings season unofficially kicks off this week...

And expectations are markedly different than they were just a few months ago.

Last fall, S&P 500 companies reported a massive 25.9% year-over-year increase in third-quarter earnings. This was the strongest quarter in eight years, and the fourth straight quarter of 15%-plus earnings growth.

As recently as September, analysts expected the streak to continue. S&P earnings were projected to grow 17% year-over-year. But that is no longer the case. As the Wall Street Journal reported last night...

Dimmer expectations for global growth and disappointing holiday sales have forced many companies to slash their forecasts, pushing the estimated earnings-growth rate for the quarter closer to 11%, according to FactSet.

The drop-off in estimates – the steepest since 2017 – is the latest sign that U.S. corporations, from retailers and airlines to phone makers, are losing momentum after several quarters of standout growth...

Of course, what remains to be seen is whether estimates have come down enough...

As regular Digest readers know, several notable companies have warned of slowing growth. If Wall Street analysts have become too pessimistic as a result – and companies report better-than-expected numbers – we could see the market react positively.

On the other hand, if other companies confirm the slowdown reported by consumer-electronics giant Apple (AAPL) and others of late, recessionary fears could grow.

In the meantime, the mainstream financial media is pointing to a potential sign of a bottom for stocks...

Namely, one particular data point says investors are currently holding more cash than they have in years. As financial-news network CNBC reported this morning...

Assets in money market mutual funds have swollen to $3.066 trillion, their highest level since March 2010, driven by retail investors. The money fund assets had spent much of the last decade in the $2 trillion range but tracked above $3 trillion again in mid-December, coinciding with a late-2018 market downturn that resulted in the S&P 500 posting a 6.2% drop for the year, it's worst showing in a decade.

Mom and pop investors "blinked," said John Stoltzfus, chief investment strategist at Oppenheimer, who pointed to the trend in a note Monday.

Sean Collins, chief economist at the Investment Company Institute, which tracks the data, said the move could reflect a combination of factors: Investors are wary about the stock market volatility, but higher short-term interest rates are also making money market funds more attractive for those who want a short-term asset. Money market funds have long been considered as safe as cash savings accounts at banks.

But Stoltzfus said the money flows more likely reflect the whim of skittish investors reacting to the markets on their own. Nearly three-quarters of the $183 billion that has flowed into money market funds since the end of the third quarter of last year was to retail funds, not institutional, according to ICI data.

Now, maybe the media is right...

Maybe this move is a sign that individual investors have "capitulated," and the bull market is set to resume immediately. But we're not so sure...

First, we'll point out that even according to this data, absolute cash levels remain far closer to their lows than to levels seen at significant bottoms in the past. For example, at $3.066 trillion, money-market assets are less than 10% higher than they were through most of 2017, during one of the most complacent market periods in history.

However, you may also recall that during the financial crisis, investors fled from traditional money-market mutual funds after one of these funds "broke the buck" and nearly went under in early 2008. In other words, comparing this data point to its post-financial crisis peak may not be as useful a measure of investor sentiment as suggested.

And indeed, some other similar measures paint a different picture. For example, according to brokerage firm Charles Schwab, client cash levels fell to an all-time low of just 10.3% last September. Despite the correction of the past few months, they still remain well below the long-term average of roughly 15% today.

For comparison, at the last two major market bottoms in 2003 and 2009, cash levels among these same individual investors surged more than 20% each time.

We'll also remind you that several other measures we follow are sending a similar message today. In short, while the recent rally could continue awhile longer, we still haven't seen the clear signs of investor panic that typically accompany a long-term bottom in stocks.

But this isn't the only reason we remain cautious on the broad market today...

In the latest issue of Extreme Value, our colleague Dan Ferris reminded readers about one of the most important. As he explained...

The guiding insight and rationale for this month's report is one of the most important lessons I've learned in 30 years as an investor and more than 21 years as a published analyst.

It's worth repeating here, and anyone who's read Extreme Value for the past few years will recognize it...

There are two times when you need to pay lots of attention to the overall stock market: when it's near extreme lows of valuation (like back in early 2009) and when it's near extreme highs of valuation (where it's been since late 2016).

From late August to late September 2018, stocks hit the "most offensive valuation extreme in their history, on the basis of measures best correlated with subsequent returns," according to economist/asset manager John Hussman.

We used a chart of Hussman's five metrics in our October 2018 issue. It's the best way we've found to track the overall stock market's valuation.

Here it is again, showing a clear, late-August 2018 high...

As Dan noted, today we're roughly 13% below that August peak...

In other words, despite the steep selloff in stocks to end the year – including the worst December since the Great Depression – stocks are still unusually expensive today. Dan used an example to put this in perspective...

The Salvator Mundi is a painting of Jesus Christ by Leonardo da Vinci. The Abu Dhabi Louvre museum bought it for $450.3 million in 2017, making it the most expensive painting in history. Take 13% off $450 million, and you get roughly $392 million. That's still nearly $92 million more than the second-most expensive painting in history, Willem de Kooning's Interchange, at $300 million.

So even if it sold for a 13% discount, Salvator Mundi would still be the most expensive painting in the world by far.

As Warren Buffett has said, you don't have to guess a person's exact weight to know if they're fat. You don't have to know anything about art to know it's crazy to pay hundreds of millions of dollars for a painting. And you don't have to be Warren Buffett to know 13% below the most expensive moment in stock market history means stocks are still expensive.

To be clear, Dan isn't telling his readers to avoid stocks altogether...

But like us, he believes you must be careful and deliberate when putting new money in the market today...

If you buy stocks – and I'm not saying you shouldn't buy if the price is right – make sure you do so with caution.

At today's elevated valuation levels, it's more likely you'll pay too much for any given stock and either permanently lose money or experience mediocre long-term returns, which would likely include years of riding out painful drawdowns.

Since this is the most overvalued market in history, it would make sense for the ensuing bear market to fall further and longer than ever before.

Dan also reminded readers that despite what you might hear about most stocks being "on sale" today, the reality is likely far different. While there are some bargains out there, he believes many stocks – even those of high-quality companies – remain overvalued. And as he noted, even the highest-quality companies can be risky investments if you pay too much...

Asset quality won't save you when assets are vastly overvalued, like they are today. That means when the market is near all-time high valuations, you should expect the share prices of the very best businesses to get destroyed just like any other stock...

Longtime readers are familiar with this insight. The most popular assets – regardless of quality – will tend to perform extremely poorly when the market cycle turns.

During the Nifty Fifty bubble of the late 1960s, people viewed companies like Avon, Xerox, and Polaroid the way Amazon and Google are viewed today. Nonetheless, they fell 80%-90% in the ensuing bear market. Their popularity turned them from good investments into toxic waste, as often happens in a manic market.

Another example... No. 1 dot-com darling Cisco fell 89% from its 2000 high to its 2002 bottom.

Cisco was a cash-gushing business with little real competition at that time and a great balance sheet. It was widely viewed as having one of the world's best management teams. Yet it's been nearly 19 years since the share price peaked, and the stock still hasn't broken even...

If you think it's impossible to lose 80% or 90% of your money buying the best businesses today, you're wrong.

Buying great assets regardless of valuation can't save you. But buying great businesses at big discounts to intrinsic value can give you the fortitude to ride out the storm.

Again, Dan isn't suggesting you sell all your stocks today...

In fact, he admits that we see could further upside – even a "Melt Up" as Steve Sjuggerud has predicted – before a true bear market begins. But based on history, a severe bear market is likely over the next couple of years, which means proper risk management is more important than ever.

As always, what this means in practice will depend on your individual circumstances. For conservative, long-term investors, Dan recommends four simple actions...

1. Hold plenty of cash.
2. Avoid buying expensive stocks, especially if you think the business is a "no-brainer."
3. Sell short deteriorating businesses, but only if you can tolerate the extra risk of short-selling.
4. Buy stocks whenever you can get a significant margin of safety.

We agree.

Of course, if you can afford to take a little more risk with your money, there's no reason you can't make a calculated bet on the Melt Up, too. Just be sure to limit these more speculative positions to a small portion of your overall portfolio and follow Steve's advice closely.

New 52-week highs (as of 1/11/19): DB Gold Double Long ETN (DBP).

A quiet day in the mailbag. What's on your mind? Let us know at feedback@stansberryresearch.com.

Regards,

Justin Brill
Baltimore, Maryland
January 14, 2019