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What Works on Wall Street - In Reality

| March 11, 2015
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If you've never experienced a roller coaster in the dark - Try Space Mountain


The economy from many respects is strong.  Recently the labor report showed continued improvement and energy prices are down.  Some of this recent data led many to believe that interest rate hikes may come sooner rather than later which caused short term selling on Friday and the first part of this week.  These factors typically do not precede a significant drop in the markets.  Recessionary precursors such as an inverted yield curve or significant slowdowns in other areas usually cause us concern, but we are seeing the opposite currently.

However, we are getting to the point where investors are starting to get overly confident. The primary sentiment indicator we follow registered a reading of 235.90 last week.   Typically a reading above 240 signals a market high and a reading below 130 signals a market low.  We are still in the seasonally strong period of the year which give us more confidence, but many factors give us pause.




Whereas we feel we are not at the Euphoric top of the market yet, we feel we are much closer to the top than to the bottom.  The roller coaster is getting close to the top of the incline, but unlike at the amusement park we cannot visually see the top, just the signs that we may be approaching the top. 


These are some of the signs:

·        Cash on sidelines is very close to the 20 year lows last seen in 1998.

·        We are in month 72 of this current bull market which is past the median of 50 months and the average of 67 months.  The longest lasting bull market of the past half century was 153 months.

·        Corporate buybacks are still strong but insider buying is generally weak.  Strong insider buying usually signals market bottoms and weak insider buying generally signals market tops.

·     Valuations are rich in the United States.  The good news is that other parts of the world are cheap in relative terms.  Based upon recent data, European equities are the most undervalued versus U.S equities that they have been over the last 30 years.  Some of you may remember how European stocks greatly outperformed U.S. stocks in the mid 1980's.  Valuations are even better today overseas relative to the U.S. than was the case at that time.  For the first time in several years, Warren Buffett is buying overseas. The European Central Bank also just commenced their version of Quantitative Easing which has them buying $65 Billion worth of Euro-denominated bonds each month.



Here in the U.S. the dollar still continues to strengthen and the markets are still trending upward.  A strong dollar is bad for exports which may hurt some of our multinational companies but may not be particularly bad for some that focus just within our borders and did not participate in last years narrowly defined large U.S. company out-performance.  Year to date, overseas investments, smaller companies and the tech-heavy Nasdaq are performing best. 

A couple of weeks ago we had another "Tomorrow's Blue Chips Today" session.  We have sent video recordings of the luncheon to many who had wanted to attend but were unable.

We covered the three primary dimensions of evaluating good long term equity holdings and delved into these as much as we could in the short period of time that we had available.  This led me to re-read some books that I have had on my bookshelf for a while and revisit different strategies and how they compare to our methods.


One of these books was "What Works on Wall Street" by James O'Shaughnessy.  Many of our initial screening criteria was influenced by his work back in the 1990s.



THE "KING OF THE VALUE FACTORS"

O'Shaughnessy found that low Price to Sales ratios were much better determinants of stronger investment performance than any other Value metric from as early as 1951.  Over the 50 year plus period that he studied the 10% of stocks with the lowest price to sales ratio outperformed the S&P 500 index by 5.75%. 

Investing in equities with the lowest Price to Sales ratios would have outdone the market in all decades since the end of 1951 except for the 1990's.



MOMENTUM - WINNERS CONTINUE TO WIN

In the book, he also found that those stocks that are in the top 10% in price performance over the last 12 months perform better than all other stocks over the time period he studied.  Momentum investing worked particularly well in the 1960's, 1980's and 1990's but not as well in other time periods (under-performing the S&P 500).



UNITING THESE TWO STRATEGIES

Based upon the book, if we first take the stocks from the low Price to Sales category and then take only the top 10% based upon price performance over the last 12 months, the results are even better.  Investing in the stocks based upon these two factors outperformed the S&P Index by 6.25% based upon his research and the results were slightly more consistent than either of the other strategies alone based upon only Value or only Momentum factors.

An interesting side note to these studies is that Mr. O'Shaughnessy started his money management firm in the late 1990's just in time for his back-tested strategies to not work as well as they had in the past.  His firm was bought by Hennessy Funds during a period of under-performance and has done remarkably well since then.  He, like many investors, did not have the patience to see it through only to have these strategies work well like they had in the past after he had thrown in the towel.




WHAT O'SHAUGHNESSY DID NOT CONSIDER

In the first edition of "What Works on Wall Street" many factors were not considered or, in our opinion, studied from the wrong frame of reference.  He did not take into account how companies with large share buybacks perform versus the markets as a whole.  To date he has not done any studies that we have seen on Insider Buying and what to look for.  He made note of studying earnings growth and his studies found that they had little use to him, but he did not look at earnings acceleration and the immediate impact of upward revisions and surprise announcements.  His studies, further did not uncover factors to look for to weed out potential bankruptcy candidates or accounting shenanigans, although the price to sales ratio does this to a certain degree.  Lastly, very little study was conducted concerning what makes a quality company that will be a great investment for many years to come.  Almost all the emphasis was placed on the next year's performance based upon Value and Momentum factors.


QUALITY FACTORS - WHAT THE LEGENDS CONSIDER PARAMOUNT


In our luncheon, we spent much of our time discussing investment catalysts.  However, most of our time was spent discussing what makes a quality company and many of Warren Buffett's tenets in considering companies to hold "forever".  Many of these qualities can be uncovered using quantitative tools and screens much like those listed above.  Many qualities are evaluated more subjectively.  We plan on covering more of this in future newsletters.  For those who would like to read through these tenets, we would recommend picking up a copy of "The Warren Buffett Way" by Robert Hagstrom.  I would consider this book required reading for those who are serious about evaluating equity investments.


 

 Data as of March 9th, 2015


Important Disclosure Information for the "Backstage Pass" Blog

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Franklin Wealth Management), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Franklin Wealth Management.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Franklin Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of Franklin Wealth Management’s current written disclosure statement discussing our advisory services and fees is available for review upon request.  


Joe D. Franklin is President and Founder of Franklin Wealth Management.

 He is the writer of the Franklin Wealth Management "Backstage Pass" Blog and former host of the Financial Focus radio show on Ruby, WDOD (1310 AM) 

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