Buy on a Dip!

Watch the financial news, search the Internet, read the financial press and the most common theme coming from those who are supposedly “in the know” is that the US stock market is ahead of itself. And while those same talking heads are longer term bullish most are waiting for pullbacks to put new money to work. In other words, they are buying on a dip! That likely explains why we have seen only minor corrections that last for milliseconds.

The world is awash in liquidity and interest rates are at or near zero. For most investors equities are the only game in town. So even in a slow growth environment inflation is alive and well in the US equity markets with the S&P 500 composite index at a new all-time high and the Dow Jones Industrial Average crossing 15,000 for the first time in its history.

Justification

There has been some justification for bullish enthusiasm as 62% of S&P 500 companies beat analysts’ bottom line expectations during the first quarter earnings parade. The drawback came from the top line where more than 60% of those same blue chip names fell short on revenue. Normally that would be a warning sign as it suggests that EPS numbers have more to do with cost cutting initiatives than with enhanced growth prospects. This time not so much!

Many analysts argue that stocks are a leading indicator which means that stocks at these levels may be providing a glimpse of more robust economic growth one to three quarters out. The bulls also believe that valuations are justified pointing out that stocks are not expensive when measured in terms of forward price to earnings metrics. In 2007 before the crash the S&P 500 was trading close to 20 times earnings. Today it is 15 times forward earnings. Further those lofty PE numbers in 2007 came at a time when interest rates were significantly higher than the current setting.

That said the biggest influence on higher prices may be sentiment. Assuming retail investors are not “in the market” – which is evident in most of the trading stats – it is unlikely that stocks have reached the point of irrational exuberance. The hitch is that institutional investors tend to follow a herd mentality which usually results in stocks doing what is least expected… in this case climbing a wall of worry!

Risk return trade-off

The dilemma is trying to balance potential return with risk. That requires an analysis of what we know that leads to a subjective assessment of outcomes based on applying probabilities to potential scenarios. Suffice it to say the objective is to assess the degree of influence a specific scenario might have on your portfolio.

In summary here’s what we know about US equities; the majority of large cap companies beat on reduced bottom line expectations. We know that management seems focused on returning capital to shareholders in the form of higher dividends or share re-purchase programs. And we know that large cap US companies have the cash in hand or the ability to access debt markets at historically low rates to continue those programs into the foreseeable future. None of these metrics should provide any comfort to investors.

We also know that the majority of large cap names did not beat on the top line despite lowered revenue expectations. And we know from most analyst conference calls that US executives were offering tepid guidance for the next two to three quarters.

To put meat on this skeleton let’s apply some math to the latest quarterly numbers. Assume for example that XYZ has ten million shares outstanding at $100 per share. That implies a $1 billion market cap.

Now XYZ is expected to generate $250 million in revenue which assuming a 20% profit margin flows $50 million to the company’s bottom line or $5 per share. Based on those numbers the company is trading at 20 times earnings ($100 share price divided by $5 per share earnings = 20 times).

Let’s assume that XYZ generates $200 million in revenue which given the 20% profit margin would flow $40 million to the bottom line or $4 EPS. To compensate for slower sales management could use its cash or access the debt markets to reduce the outstanding shares.

Suppose the company bought back 2 million shares at $100 per share. Under that scenario the company increases its leverage through either a reduction in the current cash position or an increase in corporate debt. But with only 8 million shares outstanding the company can report $5 EPS which at its 20 times PE supports the current $100 share price.

Companies understand the importance of maintaining the share price and multiple. It discourages potential takeovers by aggressive competitors and it provides a pool of capital (i.e. its publicly traded shares) to acquire symbiotic businesses that can be immediately accretive to its bottom line.

In order to maintain the share price metrics management must find ways to consistently grow per share earnings and beat analysts’ expectations. The challenge is maintaining the per share metrics in a slow growth environment where management expects a drop off in revenue. Exactly what happened to top line revenue in the first quarter!

The scenario used in the XYZ example is exactly what has been happening in the US equity markets over the past three years. The number of outstanding shares has been contracting at a time when central bank induced liquidity has been expanding rapidly. More money chasing fewer shares results in higher prices. Even if those numbers are not supported by the broader economy!

For those of us who focus on risk management the chasm between the macro economy and the performance of the stock market is a concern. The improving employment picture and the moribund rate at which money is changing hands (i.e. velocity of money) are not at levels one would expect at this stage of a recovery. And certainly do not support strong top line revenue numbers anytime soon.

Of course I could be wrong. Maybe the performance of stocks and the attendant wealth effect will be enough to encourage a pickup in consumption which would show up in the velocity numbers over the next one to three quarters. But that presumes that retail investors are getting the benefit of new highs which is not supported by the evidence.

Sentiment

If the wall of worry remains intact that may well be the most influential driver of the stock market for the remainder of 2013. Institutions have an obligation to deploy capital and since the predominant theme is to buy on the dip there is sufficient cash on the sidelines to prevent a wholesale sell-off in stocks.

The risk is that sentiment changes. Should the US economy or more importantly the European economy stumble bullish sentiment could quickly dry up. In my mind the European Union is the lynchpin because the total GDP of all the EU member states is greater than US GDP. If Europe stumbles it will have an effect on the rest of the world.

Never has there been so much division within the EU between the “have” and “have not” member States. A single currency prevents devaluation which reins in the government’s ability to manage through a crisis. The political divisiveness and extreme positioning that we are witnessing in Spain, Greece and Cyprus may be the tip of the iceberg. If this cannot be contained the EU will implode. At a minimum the EU of the future will look nothing like it did in the past.

Investment Strategy

What we know is that the global economy remains weak. We think we know that it is getting better but without a clear upswing in the velocity of money further growth will hinge on government spending programs and central bank largesse. Neither of which is a long term sustainable solution.

Investors sometimes expect their managers and / or advisors to buy as long as the market continues to rally. Take advantage when markets are roaring. The trick with that strategy is to exit in time to avoid the carnage that comes from a shift in sentiment.

Unfortunately this is likely the largest disconnect between how money should be managed and how individual investors actually trade. Fact is no one can time the market and long term investors should not be trying to play this game.

Even high powered hedge funds cannot consistently deliver performance based on momentum metrics! They are the most competent players in the momentum game and more than 80% of US hedge funds have underperformed their benchmarks year to date.

When you think about it record high stock prices come with elevated risk levels. Even if we accept the bullish wall of worry scenario, a theoretical valuation floor supported by the US $4 trillion cash-horde on corporate balance sheets and the theory that stocks are historically cheap! The point is you cannot look at a security’s potential without understanding the associated risks.

Your approach should focus on specific long and short term return objectives within pre-defined risk levels. Set out a series of longer term objectives which are sub-divided into calendar year mandates. The goal should be consistency… meeting short term mandates which flow into longer term solutions with minimal variability.

To that end, if a portfolio reaches its short term mandate in the first or second quarter of a calendar year you should consider pulling back on risk – i.e. selling covered calls or buying puts for protection – rather than ramping up exposure to a particular asset class.

Think about it as setting capital aside to well… “buy on a dip!”