New York (HedgeCo.net) – As the second quarter has started and with many U.S. indices sitting at or near all-time highs, we asked the hedge fund managers that manage the models on theHedgeCoVest platform for their thoughts on where we have been and where we are heading for the rest of the year. Here are the responses we received.
CMJ Partners, LLC: CMJ Value Holdings Model
At CMJ Partners, we first assume a long term inflation rate and then add in historic normal risk premia to get our forecasts for interest rates as well as the appropriate equity market discount rate. With regard to the stock market, we further assume a normal growth rate for cash flows and then apply the market discount rate to get our estimate of fair value.
Currently, the Federal Reserve has a long term target inflation rate of 2%. The Philadelphia Fed’s survey of professional forecasters produces a similar forecast of 2.15%. So, using the Fed’s 2% target, we find that short term government interest rates should be near 4% and the 10-year bond around 5%, both substantially higher than today. As a result, we find bonds very unattractive at present. The equity market discount rate should be around 7.25% on our analysis. Combining that we an estimate of future growth in cash flows of only 5%, results in an estimate of fair value for the S&P 500 of 2,800, 30% or so higher than today! We are concerned at CMJ Partners that a long term inflation rate of 2% may be too optimistic, so we are being a bit more conservative than consensus at 2.5%. However, that still produces a fair value for the S&P 500 of 2,335 or so, 10% above the current level.
Our best judgment then is that the economy will continue to grow for the foreseeable future in line with the consensus of economists’ expectations which are now in the range of 2.5-3.0%. This is likely to result in an uptick in inflation and interest rates in the second half of the year although probably not all the way back to our expected normal levels in that short a time. Based upon the market analysis outlined earlier, we do not expect such an uptick to be viewed negatively by equity investors. In fact, given that we see the market as still somewhat undervalued and assuming that corporate earnings and cash flows continue to advance along with the economy, we expect stocks to continue to post good returns of 10% or so and potentially much higher if the global economy and geopolitical situation at least remain benign. Our portfolio recommendation then is for investors to continue to underweight bonds and overweight stocks.
Cognios Capital: Cognios Market Neutral Model
Valuation statistics indicate that equity markets are overvalued. The ratio of the total stock market value compared to U.S. GDP is a popular metric among analysts to gauge valuation of the market as a whole. The chart below uses the cumulative value of the Wilshire 5000 Total Market Index as the proxy for the total value of the U.S. stock market. Market observers tend to become concerned about overvalued equity markets when the ratio crosses above 1.00x. As the accompanying chart indicates based on market value and GDP data from Q1 2015, the ratio of market value to GDP is at an all-time high of 1.37x since the Wilshire 5000 Index was constructed in the early 1970s.
Price-to-earnings multiples also indicate that there may be an overabundance of capital invested in equity markets. Many equity analysts use trailing 12 months or estimated next 12-month results for the “earnings” portion of the ratio, but this approach can be flawed due to the cyclicality of earnings. A truer indicator of the long-term earnings power of a representative index of companies, such as the S&P 500, is to use the Cyclically Adjusted Price to Earnings (CAPE) ratio. At the beginning of 2015, the CAPE ratio was 26.79x. The table below shows the annualized price return for the S&P 500 based on the CAPE ratio at the beginning of the year over the last 87 years:
This table shows that the higher the CAPE is at the start of the period, the lower investment returns will be over the following five years and the greater the chance of having a negative return over those five years. Approximately half of the time when the investment period started with a CAPE over 25x, which it is today, the next five years delivered negative equity returns. Based on the historical evidence presented above, we believe that equity investors should lower their expectations regarding future returns from the equity markets.
Old West Investment Management: Old West Long/Short Equity Model
Our biggest holdings across our portfolios currently have tremendous value, and we are very excited about the next twelve months and beyond. We have built positions in companies that in some cases are at multi year lows, selling at significant discounts to their intrinsic value. These are great companies run by great owner/managers.
Many investors have piled into momentum stocks selling at ridiculous valuations, and that is a big reason why the overall market averages are so high. Let me give you one example, Salesforce.com, Inc. (Symbol CRM). CRM is projected to have $5.6 billion in revenue this year, and is projected to lose $200 million. The market has decided CRM is worth $46 billion today. They are projected to make $1.00 per share two years from now, but that would have the company selling at 70 times earnings in two years. Whenever you start hearing the talking heads on TV value companies at a multiple of revenue with disregard for profit, watch out! Recent valuations are reminiscent of the tech stock bubble of 2000. It is not in our DNA to invest your money in companies with such rich valuations. We are value investors through and through, and that is what will protect you when this six year bull market comes to an end.
Our team is excited and bullish about the holdings in our portfolios. Regardless of all the noise and problems in the world (Greece, China and more), we look forward to the second half of 2015 and beyond.
Pawleys Capital Management: Pawleys Dividend Modeland Pawleys Growth Model
Rising contagion in Greece and Puerto Rico drove U.S. equity markets lower as we closed out the second quarter and entered July. Although news sources reported on these situations with typical fervor, neither should come as a surprise, as both entities have both been running out of money for years.
The equity markets seemed to remember this quickly and shrug off concern. Within a week, the Dow marched back above 18,000. Simultaneously, the S&P 500 volatility index (VIX), dropped throughout the month of June. As of yesterday’s close, the VIX stood at 11.95. Over the past ten years, there have only been three notable periods when the VIX stood lower; spring 2006, late 2006, and last summer.
The VIX merely measures expected volatility in either direction. But this low level, combined with the market’s resilience to this summer’s geopolitical speedbump, is very possibly an indication that we have entered what will become a strong second half of 2015 for the equity markets.
There is a lot of focus on whether the Fed will first hike rates in 2015 or 2016. But history tells us that the S&P 500 has gained an average of over 15% in the 24 months following the first rate hike of a Fed tightening cycle, so Pawleys remains bullish for the remainder of the year. Our caution will be focused on astute stock selection, which we feel becomes even more important as we progress further through the current market cycle.
Probabilities Fund Management, LLC: Probabilities Long/Short Equity Model
Volatility returned with a vengeance in late June, with the CBOE Volatility Index (VIX) index rising 52% from its intra-day low June 23 through month-end. The broad market sold off in the final week of the month. Meanwhile bonds continued to weaken and the 10-year Treasury yield rose modestly over the course of the month. Oil prices were little changed, with the WTI futures trading below $60 at month-end. While the Federal Reserve Board has not yet changed its target range of 0-0.25% for the Fed Funds rate, Fed Chair Janet Yellen announced the board expects a rate tightening cycle to begin prior to year-end. The Conference Board Consumer Confidence Index made further gains in June.
The Probabilities Long/Short Equity model’s conservative position over much of the month caused it to outperform the broad market as equity prices weakened at month-end. Throughout the month the portfolio alternated between its baseline of cash, long equity exposure, and inverse equity exposure as dictated by strategy parameters.
The model continues to be positioned mostly defensively as we navigate our way through the bearish six-month period based on strategy rules and signals. During this period we expect to alternate between cash, partial equity exposure, and inverse equity exposure as signals dictate.
As an alternative model with historical low correlation to the S&P 500, the model will at times experience underperformance as its strategy does not mirror the index. The strategy goal is to produce long term results that exceed the S&P 500 on a risk-adjusted basis. On a short term basis, our performance reflects our traditional focus on principal protection in the risky months of the year. It is important to look at the model as a long-term investment and its role in the investor’s portfolio. As a portion of the investor’s total portfolio, the model is intended to improve the portfolio’s risk/reward by lowering downside exposure and leveraging upside exposure.
