Risk-On for Stocks!

I caught an interview with Dennis Gartman, author of “The Gartman Letter”, on CNBC the other day. Dennis was talking about the recent initial public offering (IPO) of El Pollo Loco. He said that the 125% pop in the stock on its first two days of trading might be an ominous sign for the overall market. Gartman said, “Is the market really healthy when an IPO with the name El Pollo Loco…the Crazy Chicken…is a blowout success and trades to a swift premium immediately?” While I have no idea what El Pollo Loco is worth, I do pay attention to contrary indicators such as speculative fervor in the IPO market. I agree with Dennis that many investors are once again starting to throw caution to the wind.

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Source: Bloomberg

A few of the metrics we at Farr, Miller & Washington track to gauge investor sentiment are 1) the performance of stocks by credit rating; 2) the performance of stocks by valuation; and 3) the performance of stocks by industry sector. Taking a look at the first metric, we obtained credit ratings for the companies in the S&P 500 from Bloomberg. Bloomberg reports long-term credit ratings for 441 of the 500 companies in the S&P 500. Next, we obtained the year-to-date returns (excluding dividends) for these stocks, arriving at the distribution in the chart below. It should first be noted that within the S&P 500, there are only three companies with AAA-rated debt and only three companies with B-rated debt. Therefore, these small sample sizes can effectively be disregarded. Looking at the remaining 435 companies for which Bloomberg provides ratings, it should be obvious that investors have favored lower quality companies so far this year. Why is this important? Because the willingness to buy stock in companies of weaker financial standing represents a willingness to assume more risk. Contrarians believe this is a bearish indicator.

A second metric we look at is the performance of stocks in the S&P 500 by valuation. For our purposes, we will use the ratio of stock price to forward earnings (P/FE), as reported by Bloomberg, to gauge valuation levels. The results of our analysis are displayed in the chart below. The stocks in the most expense quintile (top 20%) by P/FE ratio are represented by the “1” in the chart. These stocks, which currently trade at an average P/FE of 23.4x, have increased by an average of nearly 13.5% so far this year. At the same time, the stocks in the least expensive quintile, represented by a “5” in the chart and trading at an average P/FE of just 15.6x, have increased just 3.1% so far this year. Those in the middle three quintiles have increased 7%-8% on average. We get pretty much the same story from valuations as we got from credit ratings: Investors are favoring (or a pessimist would say “chasing”) stocks that are relatively expensive. This too could be a signal of speculative excess.

Source: Bloomberg

Source: Bloomberg

There is one last thing worth mentioning. From time to time in the past we have written about relative performance of the various industry sectors within the S&P 500. Recently we have noticed that the Industrials sector of the S&P 500 has been performing especially poorly relative to the index as a whole. In fact, since the Industrials topped out on June 9 of this year, the sector as a whole has declined over 4%. This compares unfavorably to the +1.5% increase for the S&P 500 as a whole and very unfavorably to the best-performing sector, Telecom (+5.7%). Why is this important? It seems to me that if investors really thought we were in for a period of accelerating global GDP growth, the Industrials would not be the worst performing sector.

Source: Bloomberg

Source: Bloomberg

Are any of these metrics a fool-proof guide to identifying market tops? Of course not. These are just incremental pieces to a puzzle that suggests some degree of caution is warranted. The best argument for caution remains that stocks are expensive if one considers that profit margins are 50% higher than the long-term average. If and when profit margins revert back closer to the mean, it is unlikely that investors will be willing to pay a multiple 50% higher than today’s S&P 500 multiple of a little over 16x.

Peace,

Michael