Archive for the ‘Analysis’ Category

21 Lowest and 21 Highest Cost US Large-Cap ETFs In The Current Expenses Price War

Monday, May 1st, 2017

There is a price war going on among fund sponsors with some ETFs now having expense ratios from 3 basis points to 5 basis points.

Keeping costs low is key to long-term returns generally, and specifically to index funds.

Here is a list of the 21 lowest expense ratio and 21 highest expense ratio US large-cap ETFs that have at least $100 million of assets under management.

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The largest ETF (the S&P 500 tracker, SPY) is among the least expensive at 9 basis points, but more expensive than two other S&P 500 ETFs (IVV at 7 basis points, and VOO at 4 basis points).

For a $1 million position, 1 basis point amounts to $100 per year; or $200 extra return per year with IVV and $500 per year extra return with VOO.

If all you want to do is buy and hold the S&P 500, VOO probably is the most sensible approach.  On the other hand, if you want to be able to sell covered options on your S&P 500 position for income, you need to stick with SPY.

Schwab has a US large-cap and a US broad market (also large-cap) ETF at 3 basis points.

Before you know it, some very large ETFs may have zero expense ratios — it could happen.

How so?  Two things possibly:

  • Some sponsors may chose to offer “lead funds” such as a US large-cap fund at zero expense (operating at a loss) to gather assets on the assumption that if they can capture a core assets, they have a good shot at capturing other assets that are operated profitably — certainly that has been the case with money market funds for the past 8 years.
  • The combination of mega-size and revenue from securities lending should make is possible to operate at least marginally profitably on some funds to either gather assets, or compete to retain assets against others who lower fees to gather assets.  When funds lend securities, they earn a fee, which is shared partially with the manager in most cases (not shared at Vanguard).

iShares, for example keeps from 15% to 28.5% of the securities lending revenue on it funds.  If sponsors could live off of the lending revenue share alone, and also make certain competitive asset gathering or retention decisions, expense ratios on some funds could go to zero.

Here is some of what iShares published about securities lending by ETFs:

2017-05-01_ishare sec lending dist



Whether sponsors do or do not keep a share of securities lending fees, as expense ratios approach zero (and 3 basis point to 5 basis point expense ratios are approaching zero in effect), the impact of securities lending begins to have a significant effect on the tracking error of an index fund — such that on occasion the fund could outperform its benchmark even with the drag of a management fee.

Other important factors that impact tracking error include the amount of cash held for liquidity; the effectiveness of sampling if index replication is not used; and the timeliness and accuracy of rebalancing and reconstitution.

Anyway, we are approaching the time where Warren Buffet’s concern about Wall Street drag on returns, and the damage to investors, may be approaching an end for large index funds.  It is typically said that you cannot buy an index, only a fund tracking an index.  Well, they two are approaching the point of being one and the same.

Overall, the highest costs US large-cap funds, with expense ratios from 48 to 64 basis points did not do worse than the lowest costs funds.

In fact if you simply average the returns (not asset weighted), the highest cost group did a little bit better than the lowest cost group.  That was not due to better management, but to somewhat specialized large-cap strategies that did better, such as technology oriented NASDAQ exposures.

That shows that it is possible for higher fees to be justified in some cases by deviating from the broadest indexes, but that is a case-by-case situation.

If you are buying broad indexes, pay really close attention to expenses as one of the primary drivers.  For specialized funds, category relative expenses can be important, but absolute expenses may not be as important as for broad index funds.

Securities Mentioned In This Article:








Breadth Character of the US Stock Market

Monday, March 27th, 2017
  • Major stocks indexes still in intermediate-term up trends
  • Breadth indicators suggest problems underneath with prospect of near-term corrective move
  • Maintain current reserves in anticipation of better entry point for broad index positions


Stock market breath indicators  measure the degree to which the price of a market-cap weighted index, such as the S&P 500 index, and the broad equal weighted market are changing in harmony — looking for “confirmation” or “divergence”. With confirmation, expect more of the same. With divergence be prepared for the path of the index to bend toward the direction of the path of the breadth indicator.

It works in a way similar  to the physical world as described in Newton’s First Law of Motion, which says that an object in motion continues in motion with the same speed and direction unless acted upon by outside force. The object is the stock index price. The force is the breath indicator.

There are multiple forces acting upon the object (the stock index), and it is the sum of those forces  that determine the speed and direction of the  index. Breadth indicators are among the more  powerful forces, because they reflect the effect of other forces (such as earnings and growth prospects and microeconomic news) on each of the index constituents separately.

Breadth indicators tend to be more effective at signaling impending market tops than market bottoms.

As more and more of the broad market issues move in the opposite the direction of the market-cap weighted stock index, the greater is the probability of reversal in the direction of the stock index.  The breath indicator represents the equal weighted broad market, which normally peaks before the market-cap weighted indexes peak..

Additionally, when breath indicators reach extreme values in the same direction as a market-cap index,  the market-cap  index is thought to be overbought or oversold, and subject to moderation back toward the moving average.

Let’s look at a few breadth indicators that we follow weekly to see what they might be suggesting at this time about the Standard & Poor’s 500.


First, let us stipulate that the S&P 500 is in an uptrend. Actually most major indexes around the world are currently in up trends (see a recent post documenting trends around the world).

Figure 1 shows our 4-factor  monthly intermediate-term trend indicator in the top panel in black (100 = up trend, 0 = down trend, 50 = weak or transitioning trend).  (see video explaining methodology, uses, and performance in a tactical portfolio since 1901).


(click images to enlarge)

2017-03-27_SPY trend



Percentage of S&P 1500 In Correction, Bear or Severe Bear

We  look for divergences between the direction of the combined constituents of the S&P 1500 broad market index with the direction of the S&P 500 index.

In Figure 2, we plot the percentages of constituents  in a 10%  Correction or worse;  in a 20% Bear or worse;  and in a 30% Severe Bear or worse versus the price of the S&P 500.

This measure’s how much bad stuff is happening in the broad market.  The weekly data is a bit noisy, so we also plot the 13 week ( 3 month) average shown as a dashed line over the weekly data.

Leading up to the 2015 correction, these indicators (particularly the 10% Correction or worse indicator) gave an early warning of developing risk of a market reversal.

After the 2015 correction, those indicators continued to deteriorate, event though the &P 500 recovered; once again giving a signal that not all was well, which led to the 2016 correction.

After the 2016 correction,  those indicators improved rapidly  until the period before the 2016 election where concerns were rising. After the election, the indicators once again improved very rapidly, but now those issues in Correction, Bear  or Severe Bear  are rising again, suggesting caution about the possibility of another market reversal.

(click images to enlarge)



Percentage of S&P 1500 Stocks Within 2% of 12-Month High:

In Figure 3, we plot the percentage of S&P 1500  constituents within 2% of their 12 month high, versus the price of the S&P 500.   This measures how much good stuff is happening in the broad market.

That breadth indicator  began to decline months before the 2015 correction and continued to decline even as the market recovered from that correction, portending the early 2016 correction.

The 13 week average turned down before the larger part of the corrective move preceding the 2016 election and rose after the election, but now it is  rising again, suggesting the possibility for a corrective move in the near term.

FIGURE 3:2017-03-26_2pct

S&P 1500 Net Buying Pressure:

Figure 4 presents another breath indicator, which recall “Net Buying Pressure”.

It measures the flow of money into rising and falling prices of the constituents of the S&P 1500 for comparison with the  direction of movement of the S&P 500  index.

The chart below plots  the Net Buying Pressure for 3 months, 6 months, and 12 months.

We multiply the price change in Dollars of each of the 1500  constituents each day, and multiply that change by the volume of shares traded each day. We sum  the negative products, and sum the positive products.     We then divide the sum of the positive products by the sum of the positive and negative products combined. If the ratio is more 50%,  that means there is more positive product than negative product, which we called Net Buying Pressure.   If the ratio is less than 50%,  that means there is less positive product than negative product, which we call Net Selling Pressure.

You can see in the chart that Net Buying Pressure began to decline in advance of correction in 2015 and continued to decline even as the index recovered before going into a second correction 2016. Since then net buying pressure has risen until just recently, when it has begun to decline again. That suggests to us trend in the S& 500  is not well supported by the broad market, and may be ready for a corrective move.




Bottom line for us is the view that the broad market foundation of US stocks is materially weakening, making the major market-cap indexes (dominated by the largest stocks) increasingly, visibly vulnerable to a material corrective price move; which suggests a better time later to commit new capital than now.




Equity Market Conditions Assessment & Portfolio Allocation Intentions 2017-03-17

Monday, March 13th, 2017

This note has three parts:

  1. Short summary of our current market view and portfolio allocation implications
  2. Bullet point outline of details behind our thinking in 5 segments (Trend, Valuation, Sentiment, Breadth, Forecasts)
  3. Supporting graphics for most of the bullet points provided in 24 charts and tables.

The short summary is of our market view and intended allocation actions for discretionary accounts, and recommended actions for coaching or “prior approval” accounts

For those of you who want a feel for why we have our market view and why we believe the allocation changes are appropriate; the bullet points will help.

If you want to see what data is behind most of the bullet points, you will want to look at the 24 supporting graphics.

There is an unfortunate need to use some jargon in the bullet points and graphics which may be unfamiliar to some of you, so please call or write in to have any of them explained; and to discuss their significance to portfolio decisions.


Major world equity markets are in up trends — but there is mounting evidence that the US markets are over-extended and significantly vulnerable to a meaningful downward adjustment based on a combination of valuation, breadth, possible turmoil from key elections in Europe; and as Goldman Sachs puts it “rhetoric meets reality” in Washington.

Downside risk exists, but while the trend remains upward, we are remaining invested.  However, we are not committing additional assets from cash positions to US equity risk positions at this time (except for dollar-cost-averaging programs) due to the elevated vulnerability of the US stocks market.  We will be transferring some of the US equity risk assets in portfolios to some international markets that are in intermediate-term up trends that offer better valuation opportunities.

Portfolio changes or recommendations will be framed within the strategic allocation policy level of each client which varies based on individual needs, goals, stage of financial life, preferences, risk tolerance, and other limits or factors.

Based on valuation and long-term forecasted returns, US stocks exposures will transition from the higher end of individual portfolio policy allocations to the long-term strategic objective levels, or a bit below.  We are currently underweighted non-US developed markets and emerging markets allocations, which we will gradually raise to the long-term strategic allocations levels of each individual portfolio’s allocation policy.

Emerging markets have a more attractive valuation level than other non-US international stock markets (although they pose significantly more volatility), and allocation to them may be raised somewhat above strategic target levels within individual permitted allocation ranges.

For determination of intermediate trend status, we relay on our monthly 4-factor indicator. For more information about our trend following indicator and its performance implications, click here to see our descriptive video.


  • TREND (see Figures 1-6): The intermediate-term stock trends are:
    • United States – UP
    • Non-US Developed Markets – UP
    • Emerging Markets – UP
  • VALUATION (see figures 7-12): Based on history:
    • United States – Expensive on Price-to-Book and Price-to-10yrAvEarnings and not expensive when earnings yield is compared to Treasury yields.  However, when rates rise the comparison will worsen, making stocks more expensive.
    • Non-US Developed Markets – Moderately expensive on Price-to-Book and moderately inexpensive on Price-to-10yrAvEarnings
    • Emerging Markets – Significantly Inexpensive on Price-to-Book and Price-to-10yrAvEarnings
  • SENTIMENT (see Figures 13-17): for US stocks are:
    • Institutional Investors – are reducing equity allocations (a Bearish indication)
    • Investment Newsletter Writers – Bullish at record high levels (a Bearish contra indication)
    • Individual Retail Investors – strongly Bearish this week but neutral last week
    • Options Market – complacent to mixed (jargon terms defined below):
      • Volatility Index – below 200-day and long-term average (complacent, expects smooth ride next 30 days)
      • Skew Index – above 200 day average and long-term trend line (nervous about possible large downside move, next 30 days)
      • Individual Equities PUT/CALL ratio – is 9% above its 200-day and its 10-year average (more cautious that institutional investors)
      • Index PUT/CALL ratio – is 7 % above 200-day average and 4% below its 10-year average (cautious but mixed signal)
  • BREADTH (see Figures 18-21) the trends are:
    • Percent of S&P 1500 stocks in Correction, Bear or Severe Bear have decidedly turned up (Bearish)
    • Percent of S&P 1500 stocks within 2% of their 12-month highs have decidedly turned down (Bearish)
    • The net flow of money is into S&P 1500 stocks over 3 month, 6 months and 1 years, but the leading edge of those flow has turned down
    • The net flow is explained by the net Buying Pressure declining substantially more than the Selling Pressure; and both measures are at levels below the 12-month average indicating reduced overall force driving the market
  • FORECASTS (see Figures 22-24):
    • “Street” consensus 2017 S&P 500 earnings growth 8.9% on revenue growth of 7.2%
    • “Street” consensus 2018 S&P 500 earnings growth of 12.0& on revenue growth of 5.1%
    • Consensus 3-5 year earnings growth for S&P 500 is 8.89%
    • Consensus 3-5 year earnings growth for MSCI non-US developed markets stocks index is 8.76%
    • Consensus 3-5 year earnings growth for MSCI emerging markets stocks index is 10.37%
    • Consensus 3-5 year earnings growth for MSCI core Europe stocks is 8.11%
    • Consensus 3-5 year earnings growth for MSCI Japan stocks is 9.43%
    • Consensus 3-5 year earnings growth for MSCI China stocks is 7.13%
    • Bank of America/Merrill Lynch just raised its 2017 S&P 500 price target from 2300 to 2450
    • Research Affiliates (leading factor based investor) forecasts 10-year real (after inflation) returns:
      • US large-cap stocks 0.7% (with 14.4% volatility)
      • US small-cap stocks 0.5% (with 19.6% volatility)
      • Non-US Developed Markets stocks 5.4% (with 17.0% volatility)
      • Emerging Markets stocks 7.0% (with 23.3% volatility)
    • GMO Bearish Mgr (lowest min fund investment $10 million available) forecasts 7-year real returns
      • US large-cap stocks – negative 3.4%
      • US small-cap stocks – negative 2.7%
      • Large International stocks – positive 0.2%
      • Emerging Market stocks – positive 4.1%
    • BlackRock (fund manager in the world) forecasts 5-year nominal returns
      • Large US stocks 4.1% (with 15.5% volatility)
      • Small US stocks 4.1% (with 18.7% volatility)
      • Large International stocks 5.5% (with 18.5% volatility)
      • Emerging Markets stocks 5.5% (with 23.3% volatility)

Options Jargon Description:

VIX: VIX is the options pricing implied volatility of the S&P 500 index over the next 30 days, based on at-the-money options

SKEW: SKEW measures the relative options “implied volatility” (essentially price) of S&P 500 out-of-the-money PUTs versus out-of-the-money CALLs with strike prices the same distance from the market price – essentially measuring the perceived “left tail risk” (tail risk is the probability of prices going below the level that is predicted by a normal probability Bell curve).

Portfolio managers are predisposed to buy PUTs for protection and sell CALLs for yield, which tends to increase out-of-the-money PUT premiums and depress out-of-the-money CALL premiums.

SKEW of 100 means the market expects equal implied volatility (essentially prices) for out-of-the money PUTs and CALLS.  SKEW greater than 100 means the market expects higher implied volatility (prices) for PUTs relative to CALLS – more perceived large downside risk.

The record low SKEW was 101.9 on March 21, 1991. The long-term average SKEW is around 115, and the high is around 150. The current 200-day average SKEW is about 130, and the current level is about 140. That means there is a heightened concern about a greater than typical risk of a large downside move in US stocks.

INDIVIDUAL EQUITIES PUT/CALL RATIO: The Equities PUT/CALL ratio is the PUTs volume divided by the CALLs volume on individual stocks. This tends to be reflection of actions by retail investors; and is often a contrary indicator.

INDEX PUT/CALL RATIO: The Index PUT/CALL ratio is also the ratio of the volume of PUTS and CALLS, but tends to be a reflection of the actions of institutional investors; and is not considered a contrary indicator.


(click images to enlarge)


Over the past year, US stocks (VOO), non-US Developed Markets (VEA) and Emerging Markets (VWO) are generally in an up trend, although the US is way out front.

Over 3 years, the three regions are up, but the US is way ahead, and did not have as severe down moves as the other two regions.

As you will see the outperformance by the US is related to its current overvaluation, and the weaker performance of the other markets, is related to their more attractive valuation.
Our 4 factor monthly trend indicators ranks each of the three regions as in an up trend.
This time series of our trend indicator for the US shows the up trend established since March 2016.
The up trend in non-US Developed Markets was established in November 2016.
The up trend in Emerging Markets was established at the end of December 2016.


On price-to-book basis the US is very expensive (at the top of its 10-year range). Non-US Developed Markets are “normally” valued (at just above their median level). Emerging markets are inexpensive (price significantly below their median level).
In terms of the Shiller CAPE Ratio (price vs 10-year inflation adjusted average earnings), the US is very expensive relative to is long-term history. Developed Markets are inexpensive, and Emerging Markets are significantly inexpensive.
Based on a variety of valuation metrics the US is expensive. The Developed and Emerging Markets inexpensive by comparison.  Emerging Market have more attractive valuations than the Developed Markets.

In terms of profitability, the US is tops, which partly explains the higher valuation. Developed Markets are less profitable than Emerging Markets.

Emerging markets have competitive dividend yields and the lowest payout ratios.

Emerging markets seem to be a bit less leveraged than US stocks, and the Developed Markets are the most levered.

In addition to the price-to-book and Shiller P/E to their respective histories, several other valuation metrics for the US should be considered; almost all of which suggest the market is very expensive

The “equity risk premium” [(stock earnings / price) – (10-yr Treasury yield)] is the only key valuation metric that suggest that stocks may not be overvalued; and that argument depends of the current historically low Treasury yields.


Current equity risk premium for the 10-year inflation adjusted earnings-to-S&P 500 price is 0.90%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  That suggest modest overvaluation.

However, since the risk premium first went negative in 1964 (except for 4 months in 1929), the equity risk premium was only higher than now 30% of the time — a Bullish suggestion.

The question is whether the 135 history, or the 52 year history is the more important to consider. If the long history is more important, then the S&P 500 is somewhat expensive relative to the yield on 10-year Treasuries; but if the shorter history is more important, then the S&P 500 is inexpensive relative to Treasury yields.  However, Treasury yields are suppressed, and if they normalize to something in the 3% to 4% range before profits increase a lot, then stocks are expensive.
Current equity risk premium for the 12-month trailing earnings-to-S&P 500 price is 1.17%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  This also suggests moderate overvaluation.

However, since that risk premium first went negative in 1967 (except for 1 month in 1921), the equity risk premium was only higher than now 29% of the time — a Bullish indication.

The question is whether the 135 history, or the 49 year history is the more important to consider. The same logic applies as it does for the equity risk premium based on the 10-year inflation adjusted earnings yield.

S&P 500 GAAP earnings are not much higher than they were 4 years ago, yet the price of the index is a lot higher. That means much of the rise in the price of the index is merely paying more the what you get, not getting proportionately more for paying more.

10-year Treasury rates in 2013 more than doubled from less than 1.5% to more than 3%, yet the S&P 500 continued to rise in price faster than earnings.

Once again 10-year Treasuries have risen in 2016 from less than 1.5% to more than 2.5% and the price of the S&P 500 has continued to rise, even in the face of flat earnings, with falling earnings close behind in the rear view mirror.

If interest rates should make it to 3% in the near-term (not an unthinkable event), the equity risk premium on trailing 12-month earnings would drop from 1.17% to about 0.75%. Since 1881, the risk premium has been higher than 0.75% more than 70% of the time; and since 1967 it has been higher 64% of the time.  That would be Bearish.

This suggests valuation vulnerability in the face of probable moderate interest rate increases.


The State Street Investors Confidence index is a behaviorally measured sentiment index — a measure of increases or decreases in public equity allocation in actual institutionally managed portfolios, a real measure of market sentiment by large institutions.

The rate of increase in their public equity risk allocations began a decline in around 2 years ago.  They began actually decreasing their public equity allocations in 2016 and continue to do so.

This is not an endorsement of current stocks markets.
Investors Intelligence monitors 100 leading investment newsletters to gauge the Bullish or Bearish sentiment of those writers. Extreme peaks in sentiment tend to be contrary indicators (not perfectly, of course), but when “everybody” is Bullish or Bearish, a trend is often about to be exhausted; because there are few additional people to join the point of view and bring move more money in the direction of the trend.

The current Bull-Bear spread is among the most extreme Bullishness of the last 10 years.  This suggests that a corrective action is likely nearby.

The American Association of Individual Investors conducts a continuous online survey of it members — essentially the retail investor.  Last week when this chart was created, the Bull-Bear spread was 2.29%, barely on the Bullish side of neutral.  In the subsequent week it turned on a dime dropping to negative 16.5%; strongly Bearish.

The chart suggests that this data is more a coincident indicators than a forward indicator, so the drop in sentiment parallels the recent weakness in the up trend.
TD Ameritrade publishes the Investor Movement Index.  It is Bullish at this time.  Here is what they do to make their index.

Each month Ameritrade calculates a short-term Beta (volatility relative to a benchmark such as the S&P 500) for each security.
Then it takes a sample of hundreds of thousands of customer accounts with at least $2,000 in their account and in which at least 1 trade was done the month, from its approximate 6 million customers.
It measures the total equity allocation and the aggregate short-term Beta (volatility relative to volatility of the S&P 500) of the equities in each portfolio (and other undisclosed factors) to develop the risk level of each portfolio.
Then equal weighting each account without regard to size or number of trades, it finds the median equity risk exposure, and puts that on its index scale (scale parameters not disclosed), and plots that versus the S&P 500.
The level and direction of the index is an indication of actual retail investor behavior instead of what they might say about their sentiment.

The options market reveals the actual risk taking behavior of investors in terms of the pursuit of gain (buying CALLs) or seeking protections (buying PUTs).  Here are 4 measures of options market behavior.

VIX measures the expected volatility of the S&P 500 over the next 30 days.  At under 12, the VIX is well below the 10 year average of about 20, and among the lowest levels of the past 10 years.  This is complacency.  Complacency is probably like everybody being on the same side of a boat, which makes the boat prone to tip over.  Volatility is a mean reverting measure, which suggest more volatility in the relatively near future than in the relatively near past.

The SKEW Index (defined above in the jargon section) is a measure of the concern over the size and probability of an unusually large downside move.  That measure is elevated, which gives reason for caution.

The Equity PUT/CALL index (defined above in the jargon section) is a measure of the relative “protection seeking/opportunity seeking” behavior of mostly retail investors.  That ratio is slightly elevated versus average levels, indicating a mildly increased relative pursuit of protection.

The Index PUT/CALL index (defined above in the jargon section) is a measure of the of the relative “protection seeking/opportunity seeking” behavior of mostly institutional investors.  That ratio is slightly lower than average, indicating a mildly lower than average relative pursuit of protection.
This is one of our favorite measures, and one that we directly measure weekly since the beginning of 2014.  Breadth measures the condition or behavior of the overall membership of the broad S&P 1500 index and compares it to the price level of the market-cap weighted S&P 500 index — in other words, it checks to see if the rank and file members of the market are going in the same direction as the mega-cap leaders of the market.

For example, the price movement of Apple and Exxon have a lot more impact of the price of the S&P 500 or the S&P 1500 than 100’s of smaller members of the S&P 500 and S&P 1500.  If the rank and file are going in the same direction as the leadership, that is Bullish breadth.  If they are going in the opposite direction, that is Bearish breadth.  The leaders can only go so far for so long without the rank and file coming along.

The percentage of S&P 1500 index constituents in a Correction or worse (grey line — down 10% or more from their 12-month high) rose dramatically before the November presidential election, then dropped off just as steeply to among the lowest levels in the past 3 years.  Just recently, however, the percentage in Correction or worse sharply turned up — still in “normal” range, but the direction change is a negative for the current stocks rally.

The same is true, but to a lesser extent for the percentage of S&P 1500 stocks in a Bear or worse (blue line — down 20% or more), or in a severe Bear or worse (red line — down 30% or more).
The percentage of S&P 1500 stocks within 2% of their 12-month high was declining prior to the election, turned up sharply to reach the highest level in the past 3 years immediately after the election, but has since declined to the “normal” range with a current downward direction.  The provides a note of caution about the current rally.
The Net Buying Pressure (Buying Pressure / Sum (Buying Pressure + Selling Pressure), which has been net positive since the bottom of the early 2016 Correction, began to decline before the election; resumed growing strength after the election; but has recently been losing steam.  This is not supportive of the current rally.


The separate Buying Pressure and Selling Pressure components of the S&P 1500 stocks Net Buying Pressure in the figure above are shown here.

The rising S&P 500 price in 2016 was not matched by rising Buying or Selling Pressure, showing waning enthusiasm for equities.  After the election both Buying and Selling Pressure rose, but Buying Pressure rose more than Selling Pressure.  Recently however, the decline in Net Buying Pressure noted above, is the result of Buying Pressure declining substantially, while Selling Pressure has declined far less.

These data also suggest the fuel of the rally may be running low.

Looking way down the road with 5-10 year forecasts, and supporting our view that a shift in allocation more toward international equities, and less in US equities is appropriate, are forecasts by Research Affiliates (a noted factor-based asset manager), by GMO ( a Bearish asset manager for the very wealthy — $10 million and up to invest in their funds); and by BlackRock (the largest fund manager in the world).
Research affiliates studies factors with focus on the current Shiller CAPE Ratio (Price divided by the inflation adjusted 10-year average Earnings) relative to its historical median, and historical highs and lows.  They find that to be a good long-term indicator of opportunity.  They view the CAPE Ratio as mean reverting over the long-term.

Based on CAPE and other factors, this chart shows how they see the real (nominal less inflation) return and the volatility of US, non-US Developed Markets (“EAFE”) and Emerging Markets (“EM”) working out over the next 10 years on an annualized basis.  They definitely see international equities as the place to be — but with more volatility.

GMO does not disclose their forecasting methodology, but they are among the most Bearish institutional manager, so worth noting for that.  Over the next 7 years, they see the real return on US large-cap stocks as negative 3+%; the real return on large international stocks as barely positive; and the real return on Emerging Market as positive 4+%.  They also see negative real returns on US and Dollar hedged international bonds, but positive 1+% real returns on Emerging Markets debt.

Over the next 5 years, BlackRock sees nominal return on US stocks as very low, and much lower than international stocks.  They see non-US Developed Markets stocks as generating nominal return  at about the same level as Emerging Markets, but with volatility similar to that of US small-cap stocks; whereas they see much higher volatility for Emerging Market stocks.




Intermediate Trend Status of All Stocks, ETFs and Mutual Funds (Feb.’17)

Wednesday, March 1st, 2017

Warren Buffet wisely said,

“Be fearful when others are greedy, and be greedy when others are fearful.”

Clearly, you should only be greedy for fundamentally “good” assets, which requires fundamental analysis as the first level of decision-making.

However, determining “when others are greedy” and “when others are fearful” is a matter of technical analysis, which is a good companion to fundamental asset selection and allocation.

Investors as a whole are most greedy at the top of an up trend, and most fearful at the bottom of a down trend.

To follow Buffet’s advice, you must choose between predicting the tops and bottoms of cycles (market timing), or measuring that a top or bottom has just occurred (trend following).

Trend following is the rational choice in our view.

  • Market Timing is based on unspecified or variable information and opinion inputs – it cannot be defined, automated and back-tested.
  • Trend Following is based only on price and volume behavior – it can be defined, automated and back-tested.
  • Market Timing is opinion; subjectively derived about what someone thinks the market ought to do next.
  • Trend Following is factual; objectively derived by observing what the market price and volume have done.

Diagram Mkt Timing versus Trend Following

The “QVM 4-Factor Trend Indicator” is an intermediate trend following method. It is meant to be a technical companion to fundamental asset selection and allocation.

A video explanation of the indicator methodology, including back-testing results with the S&P 500 and precursors from 1904  follows in this video.

It is reasonable to be in or overweight those securities in confirmed up trends; and to be out of or underweight those in confirmed down trends.

If you are considering certain securities for entry, it is reasonable to enter only in a confirmed up trend.

Why enter during a down trend, since you don’t know where the bottom is.  If those securities you intend to own are currently in a down trend, it is reasonable to wait for that down trend to change to a confirmed up trend before committing capital.

The principle value of trend following in practice is not outperforming in up markets, but rather outperforming in down markets (“winning by not losing”) — having a low capture ratio in down markets and a reasonable capture ratio in up markets.

Each month, we measure the intermediate trend status of thousands of listed stocks and ETFs, and over 1400 retail level mutual funds.

For February 2017, we measured the trend status for 8,020 securities.

  • 74% of both the S&P 100 and S&P 1500 stocks were in demonstrated up trends
  • 61% of the 6,578 listed securities were in demonstrated up trends.
  • 78% of the 1,442 mutual funds were in demonstrated up trends.

While this is a monthly subscription data service, the February data package is available to anyone without charge.  Download the full 2017-02-26 trend data spreadsheet here.


This article will show you the current trend status of key securities, but first, here is the structure of  what is in the data package.

Full Spreadsheet ColumnsView Annotated

Each tab in the spreadsheet has:

  • the overall trend determination, and the status of the 4 components of the measurement
  • a strength measure for the trend
  • the position of the price versus its trailing high and its trailing range
  • an Overbought and Oversold indicator
  • the price change over the past 3 months and 12 months
  • the average Dollars traded per minute for the security (except for mutual funds which have no volume data)
  • and links per security to multiple third-party information sources (Morningstar, Seeking Alpha, Yahoo, StockCharts, & BarChart)

This is what the trend data looks like:

This is what the other data looks like:info2This is what the third-party information links look like:


If you would like to inspect your portfolio holdings in terms of their intermediate-term trend condition, download the February data package.  The tab for the 1,442 mutual funds most likely has any fund you may own.  The tab for all listed securities with sufficient data (about 28 months of existence) will most likely have the vast majority of the listed securities you own.

CAUTION: Bond funds are included in the study, but the trend determinations may be less clear for them, as bonds do not tend to change direction as often or as dramatically as equities — and this methodology has not yet been back-tested for bonds.  Bond funds are included for completeness, but may not all be appropriate for such analysis.  Long-term and low quality bond funds are probably more appropriate for this method of analysis than short-term and high quality bonds funds.


Here are some of the data points that may be of general interest about the state of the markets:


All of the members of this group from Vanguard (the largest purveyor of target date funds) for retirement years 2015 – 2055 are in demonstrated up trends.

tgt date

Vanguard target date funds are composed of 5 funds in different allocations along a glide path — one fund each for:

  • US stocks,
  • International stocks,
  • Aggregate US bonds,
  • Short-term US Treasury inflation protected bonds,
  • Aggregate Dollar hedged international investment grade bonds


These and most US asset categories are in up trends.  Some are in or near overbought condition as the “Buying Pressure Level” column shows.

styles and sectors


More are in up trends than down trends. This list is of the country funds in up trends. Interesting to see that Argentina is in the second strongest trend, as measured by Buying Pressure Level.

countries up

This is the list of country funds in down trends.  Mexico is in that group, which may be partially a Trump effect.

Countries down

The other country funds are rated 50 either because they have weak trends, or because they are in transition from one direction to the other.


74% of S&P 100 stocks are in up trends.  Here are the 25 of those in the strongest up trends.  They are mostly all in or near overbought condition.



SP100 down


Most liquid ETFs (defined here as trading at least $15,000 per minute) are in up trends or rated 50 for a weak or transitional trend, but here is the complete list of those non-bond, non-levered, liquid ETFs that are in down trends.

LquidETFS down


The ETFs in this list represent commonly held asset categories in portfolios:

  • total US stocks
  • large-cap developed markets ex US stocks
  • large-cap emerging market stocks
  • US REITs
  • intermediate-term US Treasuries
  • short-term US Treasury inflation protected securities
  • US aggregate bonds
  • Dollar hedged investment grade international bonds
  • Dollar denominated sovereign emerging market bonds
  • gold bullion.

The David Swensen Portfolio components were referenced in his 2005 book, “Unconventional Success –  a Fundamental Approach to Personal Investment”.  The allocation he used (as updated in 2015 to 5% more emerging markets and 5% less REITs), was 30% US stocks 15% developed markets ex US stocks, 10% emerging markets stocks, 15% US REITs, 15% intermediate-term US Treasuries, and 15% US Treasury inflation protected securities.

He termed it a “reference portfolio” because it is merely a starting point for personalization based on goals, needs, circumstances, and the ability to stick with the portfolio over time.

Swensen is the long-time CIO of the Yale endowment.

2 simple portfolios

We hope you found this helpful and would be pleased to discuss with you how this methodology could be overlayed on your portfolio.  The monthly data subscription is $299 per year.



Intermediate-Term Technical Condition of Domestic & Int’l Stocks and Bonds

Tuesday, November 29th, 2016

There is more to consider than technical condition of markets and securities, but combining technical condition information with fundamental and macro-economic information makes for better decisions.

Let’s look at the intermediate technical condition of US large-cap stocks; EAFE (DM ex US large-cap stocks) and EM stocks; as well as Aggregate US bonds, DM Dollar hedged investment grade bonds, and EM Dollar denominated sovereign bonds.

We used SPY, VEA, VWO, BND, BNDX and VWOB to represent those major categories in Figure 1.



The red/yellow/green color coded scales in Figure 1 rate each category as trending UP or DOWN or in Transition.  If the category is in Transition, a horizontal arrow shows the direction of the Transition from Up to Down, or from Down to Up.  If the price has crossed the primary trend line in a direction opposite of the trend direction, the rating is noted with an “X”.

Figure 2 presents the 4 essentially non-overlapping monthly factors in the QVM trend indicator, along with how they are scored and summed to an overall rating. The indicator is a price-only indicator, which does not consider distributions, which are part of total return.


(click images to enlarge)


There are 9 possible configurations of the 2-month leading edge of the Major Trend.  Figure 3 presents those 9 configurations graphically and how each is scored by the indicator.



We use a custom built program to plot a running rating for each security, which is shown in black in the top panel of Figure 4.

The middle panel in blue is ancillary information showing the distance of the price from the 12-month trailing high.

The main panel contains the 4 factors:  Major Trend in gold; Price in black, Buying Pressure in green; and Parabolic Pace in dotted red.




In a more compact way, and for easier comparison between charts, we also look at charts from that contain essentially the same, but not exactly the same data (see Figure 5) — the difference being that dividend adjustments made by StockCharts sometimes cause ratings to differ somewhat when the technical condition is close to a change.  Most of the time, for practical purposes, the StockCharts plots are sufficient.  The StockCharts plots, however, cannot calculate or display the actual rating.



Figure 6 shows the tabular output of our software showing how each of the 4 factors is rated, along with the overall trend rating, with some additional information (Buying Pressure level, distance of the price from the 12-month trailing high, and the position of the price within the 1-year high-low range).



It is important to note that value and technical condition are not always aligned.

Figure 7 shows the Shiller price to 10-year average inflation adjusted GAAP earnings (“CAPE” for cyclically adjusted P/E), as it relates to the long-term median of that valuation multiple; and the expected 10-year return based on a potential decade-long mean reversion.

Bottom line, US large-cap stocks are in the best current trend condition, and are the most expensive, with the lowest return if valuation revert to the mean over the next 10 years.  Non-US DM stocks and EM stocks are in poor trend condition, and are significantly less expensive, with substantially higher next decade returns in the event of valuation mean reversion (see Figure 7).

Note that US large-cap stocks and DM stocks have similar expected volatility, whereas EM stocks have much higher expected volatility.



A more graphical way to look at the relative valuation of US large-cap stocks versus DM and EM stocks is in Figure 8, which shows the extremes of CAPE valuation, the range where the valuation is most of the time (in green), and the current valuation (black dot).  US large-caps are very expensive by this measure, and DM and EM stocks are inexpensive.



Figure 9 calculates the percentage price change that would be required today for a full mean reversion.  It is unlikely to make such a sudden full jump, but the percentages are another good way to see the disparities in valuation; and the theoretical price gain potential (before consideration of various political, macroeconomic and other factors).  It also shows the Morningstar provided 3-5 year earnings growth expectations, and our calculation of the PEG ratios using Morningstar data.



Figure 10 provides the current QVM 4 factor trend ratings for the 10 sectors of the S&P 500.

Figure 10:



These data suggest that for those with a patient, long-term view, a little less US stock and a little more DM and EM stock should prove beneficial; BUT that requires accumulating assets that are in price decline, or maintaining an above average cash position to wait for DM and/or EM stocks to change to an intermediate up trend.  Even then EM stocks will provide a bumpy ride.

The cash holding to wait for a turn in DM or EM stocks is reasonable, because there is a distinct possibility (not necessarily probability) that US stocks could be in decline as DM and EM stock are ascending, in which case emotions may prevent the reallocation, or the gains and losses could substantially cancel each other.

All that is really being suggested here is rebalancing within the investment policy allocation range for each key asset type;, or using cash as in intermediary step between decumulation of one asset and accumulation of another based on trend evaluation.

Those near or in retirement need to make sure that in addition to any such long-term positioning, they maintain sufficient safe, liquid assets to be able to make withdrawals for a few years out of assets that do not fluctuate much in price, in the event of an extended or major market decline. The most vulnerable years are the 5 years leading to and 5 years after beginning to rely on the portfolio to support lifestyle.

In terms of sectors, the trend condition reports the obvious, which is that REITs, Consumer Staples, and Utilities are struggling with pending interest rate increases — and therefore should probably be kept at the minimum of the investment policy range for each portfolio until the trends recover.

The securities used in these trend evaluations were:

  • SPY – US large-cap
  • VEA – DM non-US stocks
  • VWO – EM stocks
  • BND – US aggregate inv. grade bonds
  • BNDX – DM Dollar hedged inv. grade bonds
  • VWOB – EM Dollar denominated sovereign bonds
  • XLB – basic materials
  • XLE – energy
  • XLF – financials
  • VNQ – REITs
  • XLI – industrials
  • XLK – information technology
  • XLP – consumer staples
  • XLU – utilities
  • XLV – health care
  • XLY – consumer discretionary

We will publish a similar review of country ETFs in a future article.



Lowered Long-Term Portfolio Return Expectations: Mean Reversion Impact

Tuesday, August 9th, 2016

QVM Clients:

  • Current stock and bond trends are mostly up and S&P 1500 breadth indicators have normalized
  • S&P 500 is approximately at consensus 2016 price level
  • Mean reversion risk is substantial but timing of realization is unknown
  • Institutional long-term asset return assumptions are lower and portfolio return expectations should be tempered
  • Specific mean reversion risks presented in charts

The current trend is generally up, with non-US developed markets struggling, and emerging markets transitioning to clear up trend. Here are the trend ratings for ETFs representing key asset categories commonly found in portfolios. The ratings are based on the monthly four factor indicator used by QVM:

  • Direction of tip of 10-month moving average
  • Position of price above or below the 10-month moving average
  • Net buying or net selling pressure
  • Price position versus a progressive threshold changing at a geometric pace

As additional information, the table provides the price percent below the 12-month high price; the price position within the 12-month high-low range, the overbought or oversold condition based on the money flow indicators, the positive or negative signal from the MACD signal line, and whether the MACD is above or below the center line.

Even though current trends are up, the Bull is aged and probably in late stages, with significant long-term risk associated with eventual withdrawal of central bank market distortions. Cautiousness and conservatism is warranted.

(click on images to enlarge)


Fear of loss and risk avoidance are important emotional and behavioral factors that are about twice as strong as satisfaction with gains and opportunity seeking emotions and behavior. That gives us some pause talking about long-term risks. We do not want to frighten anybody or cause them to, as Jeff Gundlach said, “Sell Everything”. Market performance problems that are certain to be upon us someday are not upon us now, and within reason, we must take advantage of current positive trends. But we want you to be aware of the nature of the problems that will most certainly be realized some uncertain time in the future. There are important setups of valuations that are too far from long-term mean levels to be permanently sustained, and that are the basis of multiple institutions cautioning investors of subdued returns over the next decade.


In June a survey of institutional investment strategist saw the S&P 500 ending 2016 at around 2100 to 2200. We are pretty much there now, suggesting not a lot of upside over the remainder of the year, which also dovetails with the likely reluctance of investors to be fully exposed to market risk during this unusual presidential election.



We have been in the Great Distortion for years now, and “mean reversion” can gettcha if ya don’t look out. Unfortunately, while mean reversion is a near certainty, when reversion takes place is not. Wide deviations from “normal” levels can go on for long periods (but can also revert quickly). Our central bank and those of Europe, Japan and China have been doing things to prevent mean reversion for years now. Someday the forces of mean reversion will defeat the central banks if the banks don’t toss in the towel on their distorting efforts first.

Before a general look at overvaluation and mean reversion in the S&P 500, here from 720 Global is one of the worst cases today of yield chasing that has put utilities into rarefied territory with very strong mean reversion risk.

The image below shows the S&P 500 sector ETF (XLU) Price-to-Sales ratio is more than 3 standard deviations above its average since 1990; and the Price-to-EBITDA ratio is nearly 3 standard deviations above. Valuations 3 standard deviations from the mean have odds stacked well against them being sustainable.

The price would be cut in half to get back to average Price-to-Sales ratio, or cut by about one-third to get back to average Price-to-EBITDA. That is not an attractive risk for a slow-growing industry. This problem caused by the frantic search for yield that has raised the price of typically high yield or strong dividend growth companies to unattractive valuation levels.

The need eventually to move valuations back toward the mean levels in key asset categories is the reason so many forecasters see muted portfolio returns in coming years.

2016-08-08_02The current trends in US stocks, and bonds are up right now, which is itself unusual as a pair. They are all marching to the tune of ZIRP and NIRP (zero interest rate policy and negative interest rate policy), which cannot go on forever – a long-time yes, but not forever. When rates normalize (revert to mean), so too will stocks and bonds. Interest rates are at the base of most aspects of investing, and tend to drive valuation of other assets. Having some idea what normalization would be is important to setting expectations.

A wide variety of institutional voices have concluded and published their expectation of lower portfolio returns over the next several years, as a result of the significantly above normal returns of the past several years. They talk of interest rates rising, profit margins declining, revenue growth slowing or not accelerating, valuation multiples compressing, debt servicing costs rising, reduced stock buybacks resulting in less boost to earnings per share, and just general world GDP slowing or moderation.

Looking across their prognostications and generalizing, it seems they expect a 4% to 5% total return over the next 5 to 10 year for a 50/50 stock/bond balance portfolio.


McKINSEY & COMPANY (largest independent management consulting company)
In May of this year McKinsey & Company published a report titled “Diminishing Returns: Why Investors Need to Lower Expectations”. They see much lower asset returns, and therefore lower portfolio returns, in effect due to mean reversion.



Based on the mid-point of McKinsey’s view a 50/50 US stock/US bond portfolio would tend to return an approximate 5.25% nominal annual return over the next 20 years.

BLACKROCK (largest asset manager in the world – $4.5 trillion AUM)
BlackRock sees similar lower asset returns.


Based on BlackRock a 50/50 US stock/US bond portfolio should expect a long-term nominal annual return of about 2.55% over the next 5 years and about 3.5% over the “long-term” (undefined length of time).

VANGUARD (second largest money manager – $3.3 trillion AUM)
Vanguard had this to say last December with a less pessimism:

“Vanguard’s outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment …The growth outlook for developed markets, on the other hand, remains modest, but steady … our medium-run outlook for global equities remains guarded in the 6%–8% range. That said, our long-term outlook is not bearish …the high-growth “goldilocks” era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate “sustained fragility” … China’s investment slowdown represents the greatest downside risk.”

JOHN BOGLE (Founder of Vanguard Group)
6% nominal (non-inflation-adjusted) equity returns during the next decade; 3% bond return

Based on Vanguard’s view a 50/50 US stock/US bond portfolio would tend to generate a 4.5% annual nominal over the next 10 years.

STATE STREET GLOBAL ADVISORS (third largest money manager – $2.3 trillion AUM – sponsors of SPDRs including SPY)


Based on the State Street forecast a 50/50 US stock/US bond portfolio should expect an approximate annual nominal returns as follows over various time frames:

  • 1-year: 1.85%
  • 3-years: 3.60%
  • 5-years: 3.95%
  • 10-years: 4.4%
  • 30-years: 4.85%.

JP MORGAN ASSET MANAGEMENT (prominent high net worth, private wealth manager)

This is the long-term view from JP Morgan Asset Management as of their annual outlook for nominal returns over the a 10-15 year time frame:


Based on JP Morgan forecasts a 50/50 US stock/US bonds portfolio might expect an annual nominal return of 5.63% over the next 10-15 years.

NORTHERN TRUST (prominent high net worth private wealth manager)

“We expect developed market equity returns of 5.4% annually, bookended by emerging market returns of 7.3% at the top end, and US returns of just under 5% at the low end. … We expect real assets to perform relatively well, led by a forecasted return of nearly 7% for natural resources. .. We expect the US 10-year Treasury to support a yield of just 1.5% [over five years], capped by the German 10-year yield of just 0.5% and the Japanese 10-year at 0%. … We do expect an uptick in high-yield bond defaults, but project a 5% total return, which is attractive compared to the outlook for the equity markets. … While we expect to see some modest deterioration in corporate credit quality, continued low rates and strong investor demand should lead to further spread tightening for investment-grade bonds [that suggests continued gains as spreads to Treasuries compress]”

By interpolating/hypothesizing perhaps a 3% aggregate bond yield from Northern Trust comments, a 50/50 US stock/US bond portfolio may generate an annual return of about 4% over the next five years.

GOLDMAN SACKS (prominent high net worth private wealth manager)
Goldman Sachs “Last Innings” 5-year nominal return assumptions.


Based on Goldman Sachs forecasts, a 50/50 US stock/US bond portfolio (it’s a little hard to say because they do not specify US aggregate bonds or investment grade bonds), but let’s take the mid-point between their cash return and high yield return (2.5%) and tweak it up to 3%. That would give a possible 5-year expectation of about a 3% nominal portfolio return.

RESEARCH AFFILIATES (pioneer in “factor-based” investing)
1.1% real returns for U.S. large caps (the S&P 500) during the next 10 years; 1.1% real returns for the Barclays U.S. Aggregate Bond Index

Based on Research Affiliates forecasts a 50/50 US stock/ US bonds portfolio would generate about a 1.1% real return (perhaps 3% to 3.5% if inflation were to be in the range of 2% to 2.5%) over the next 10 years.


The 50/50 forecasts we estimate from the selection of institutions above are:

  • McKinsey 5.25% over 20 years
  • BlackRock 3.5% over the “long-term”
  • Vanguard 4.5% over 10 years
  • State Street 3.95% over 5 years
  • State Street 4.4% over 10 years
  • JP Morgan 5.6% over 10-15 years
  • Northern Trust 4% over 5 years
  • Goldman Sachs 3% over 5 years
  • Research Affiliates 3% to 3.5% over 10 years

Based on their range of thoughts, let’s go with 4% over 5 to 10 years and see how one might get there logically:

  • Stocks return 5% consisting of 2% dividend yield and 3% growth in earnings due to global GDP growth
  • Corporate bonds return 3% average interest, and no capital gains due to rising interest rates
  • 50% x 5% + 50% x 3% = 4% portfolio return.

A 70/30 stock/bond portfolio with the same underlying asset returns would return 4.4% (70% x 5% + 30% x 3%).
A 30/70 stock/bond portfolio would generate a 3.6% return (30% x 5% + 70% x 3%).

One way to potentially do better is to own stocks that pay more than 2% (index level) yield and that are not terribly interest rate sensitive, and that can grow earnings (and revenue) at least at 3% over the next 5-10 years – to get more of the return in regular cash with less reliance on price change.

Another way might be to overweight less popular stock categories, with more favorable valuation, with at least the potential to growth faster than US stocks, perhaps such as emerging markets

A third way could be to have a non-core tactical component of the portfolio that, if successful, could outperform the core.


In great part, long-term assumptions come down to reversion to the mean whether analyzing core portfolios, or tactical opportunities — so let’s look at some prime examples of assets far enough from their mean that significant value changes are in store, when the forces of Great Central Banks Distortion are withdrawn.

Before the mean reversion sets in, there needs to be some sort of catalyst. Central banks are expected to provide that catalyst in one way or the other, either by raising rates, or cutting rates with minimal intended effects. Another catalyst could be investor recognition of obvious problematic divergences.

Figure 1 shows an important problematic divergence.

The S&P 500 price is in black and its reported GAAP earnings are in red. Trailing earnings are falling and the price of the index is rising. That is a divergence setting up for a reversion to the mean (unless of course earnings catch up with the strong price rise). Note that the last two time earnings declined for several quarters, the stock index declined significantly as well. This is a cautionary signal.



Figure 2 shows a problematic divergence based on forward operating earnings similar to the one in Figure 1 which is based on trailing GAAP earnings.
S&P 500 forward operating earnings expectations are relatively flat, but the price of the index rising significantly, This divergence is not normal and sets up for a reversion to the mean (a return to a normal relationship). This is a cautionary signal.



Figure 3 shows that not just earnings, but also profit margins are in decline, and are also above their long-term average. This is a set up for return to the mean, which would be a negative for the S&P 500. If all other valuation factor remained constant, profits (and presumably prices) would come down 8.3% for profit margins to reach their 10-year average.



Here are some important comments about profits and mean reversion:

Warren Buffet (1999) CEO Berkshire Hathaway
“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.”

Jeremy Grantham (2006) CIO GMO (Grantham, Mayo, & van Otterloo)
“Profit margins are probably the most mean-reverting series in finance…”

John Hussman (2013) President Hussman Investment Trust
“In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is … above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period …”

Jason Zweig (2013) writes Wall Street Journal, Intelligent Investor column
“… regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

Figure 4 shows aggregate public and private corporate profits as a percentage of GDP. There are way out of line with the norm. This is a setup for return to the mean, in a way that would reduce stock returns going forward. If all other valuation metrics remained constant, the value of American corporations would decline by 27% to reach the mean profits to GDP ratio.

Note the use of the 85th and 15th percentiles as indicator lines. When at the 85th percentile, there is 6 times more room below than above that level (5 times to the 15th percentile level); and at the 15th percentile, there is 6 times more space above than below (5 times to the 85th).



Price-to-earnings ratios are the most popular metric. Figure 5 shows the Shiller CAPE ratio (an inflation adjusted 10-year average reported GAAP P/E ratio). If all other valuation metrics remained constant, the price of the S&P 500 would have to decline by 33.6% for the CAPE to reach the mean.



Figure 6 shows the P/E ratio based on the 12-month trailing reported GAAP earnings. It too is way above normal and set for mean reversion. Such elevated P/E ratios may be justified in the short-term due to exceptionally low interest rates, but when rates eventually rise, as they must, the math used to set reasonable P/E ratios adjusts, and lower P/E multiples will be in order. Note that much of the increase in price in the past few years has been due to multiple expansion and not to underlying organic growth of the companies. When interest rates rise, some of those stock multiples must be given back.

To revert to the 25-year median, the S&P 500 would have to decline by 20% at the current earnings level. To revert to the 135-year median, the S&P 500 would have to decline by 40%.



Figure 7 shows the P/E based on forward operating earnings. Like the 10-year inflation adjusted GAAP P/E, and the 12-month trailing GAAP P/E, the forward operating earnings P/E is also well above its average. To revert to the 10-year average, the S&P 500 would have to decline by 16%.



Figure 8 provides a much longer view of the forward P/E ratio (courtesy of Dr. Ed Yardeni, Yardeni Research inc., Here he has plotted P/E isobars, representing what the index price would be at different P/E levels for the forward earnings view at the time. We added the color shading to make it a tad easier to see stages of valuation at different levels. This chart plots from 1979. You can see that the current forward P/E is in the elevated range (light orange) between P/E 15 and 20. That suggests mean reversion vulnerability.



Really it is easier to think of stock valuation relative to interest rates by expressing stock valuation as an earnings yield versus a Treasury bond yield (yield-to-yield, instead of P/E-to-yield). Earnings yield is simply the inverse of P/E. Instead of P/E it is E/P. Figure 9 shows the earnings yield (“EY”) of the S&P 500 for the past 135 years versus the US 10-year Treasury yield (precursors of S&P 500 before 1957 and precursors of 10-year Treasury in early years, based on data assemble by Dr. Robert Shiller of Yale).

As it turns out the earnings yield is just about right at the median level, meaning the index is properly priced for the current interest rate situation. But the current interest rate situation isn’t priced right and has to change eventually, possibly sooner than later. At that time, the S&PP 500 would be overpriced and prone to price reduction.



Figure 10 shows the US Treasury 10-year rate and precursors back to 1881 (135 years). The recent rate is 1.59% and the median is 3.76%. It has been all over the yield range for the past 60 years, showing its can go much higher under some circumstances. But it is currently at the lowest rate in 135 years, which suggests the only logical probability is up (even if down more for a while). When rates rise, all other investments will make adjustments for the relativities to this theoretically zero credit risk vehicle. As it approaches mean level (or shoots past the mean). Mean reversion will be the name of the game for other assets too.




Back to the present, the breadth damage done in the second half of 2015 and the first quarter of 2016 is healed, and breadth indicators support the current rally.

3-month (gray), 6-month (blue) and 1-year pressure within the S&P 1500 is net to the Buying side and rising after a long period of decline and into net Selling territory in 2014 and 2015.


The percentage of S& 1500 stocks in Correction, Bear or Severe Bear condition has returned to pre-Correction levels and is improving.


The percentage of S&P 1500 stocks within 2% of their 12-month high is in good shape.