Nasty Start to June

The TSX (^GSPTSE) closed at 11,513 at the end of May.  Since then it has fallen 2.7% in one and a half days of trading to 11,212.

The causes are reported as:

  • Weak May 2012 jobs report; and
  • Continued debt issues in Europe (the focus is moving from Greece to Spain).

Oil prices have slumped, gold is up, and stocks are down around the world.  This Summer is starting to feel like 2012.  Again, selling in May is looking good.

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Crisis? What Crisis?

Democrat and Republican leaders in the US failed to reach an agreement this weekend on raising the US’ debt ceiling. Markets around the world fell today on this news. The media are getting pretty excited about this issue, but is at really a big deal? Sure, the US defaulting on its debt would be novel, but would it really matter? The US can afford to pay its debts – failure to do so it a political issue, not a financial issue. So, with the exception of actual US Treasury bond holders, should anyone care?

I moved more heavily into bonds on 13th June. For a time this offered excellent protection against a drop in the stock markets, but it also means that I have failed to participate fully in the recent rally (see chart below).

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I currently have 41% of my portfolio in bonds, 6.5% in gold, 0.5% in cash, and 52% in stocks. I have been looking for the right time to increase the stock holdings back to the 75% level. Given the risk to bonds (real or imagined) now is the time. I will reduce my bond holdings to 19%, keep the gold and cash at current levels, and increase stocks to 74%.

  • SELL Bond Fund @ $205.48
  • BUY S&P Fund @ $103.03

POSTMORTEM

One month after these trades, on 25th August 2011, they look like a bad call. The S&P fund is down 12% while the bond fund is up 2%. I made a classic investing error here: after missing a rally, I tried to chase it and ran into a major pullback. I also deviated from my Investing Policy, which states that I will hold a minimum of 25% in bonds regardless of market conditions.

The lesson here is to stick to my Investment Policy at all times and never try to chase momentum. I will set my bond holdings to 30% of total holdings and leave it there.

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Moving Further into Bonds

Stock markets have continued their decline that began at the beginning of June 2011. The chart below shows the sharp decline in the DOW (^DJI) since 30th May and the pleasing incline in the DEX (XBB.TO).

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I have today increased my bond holdings from around 30% to around 40%.

  • SELL S&P Fund @ $102.07
  • BUY Bond Fund @ $202.64

POSTMORTEM

One month after this trade, on 13th July 2011, it looks like a bad call. The bond fund is up around 1% while the S&P fund is up 3%. I failed to predict a minor rally in the S&P that occurred in late June and early July. I don’t feel too bad about this: predicting short-term moves in the market is hard.

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Is the Price Right?

The fundamental method for valuing a stock, and the entire market, is the Price to Earnings Ratio (or PE Ratio). So what constitutes good value: what is a low PE Ratio? Historically, the PE Ratio of the S&P 500 has averaged around 16 over the past hundred years.

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But there has been a definite increase in PE Ratios recently (the entire bull market of the 1990s began and was sustained with PE Ratios above 16) so we need to look at recent examples of the market’s highs a lows to judge its limits.

What was the PE Ratio before major, recent crashes?

  • When the mortgage bubble hit its height in October 2007 the PE Ratio was 27.31. The market crashed shortly after.
  • When the dot com bubble hit its height in March 2000 the PE Ratio was 43.22. Again, the market crashed thereafter.

And what was the PE Ratio before major, recent bull markets?

  • When the market began its recovery in March 2009 (after the 2007 mortgage bubble and 2008 stock market crash) the PE Ratio was 13.32
  • When the market began its bull run on March 2003 (after the 2000 dot com bubble and 9/11, and their respective stock market crashes) the PE Ratio was 21.31

So we can conclude that PE Ratios above 27 are possibly high and the PE Ratios below 22 are possibly low. Of course, there are many other factors to consider before predicting future bull or bear markets, but the PE Ratio is a good place to begin. Today’s PE Ratio of 22.73 is quite low, but not indicative of the beginning of a major advance.

It is important to note that these limits are a means to judge the overall market (i.e., the entire S&P500) rather than individual stocks. Just because a stock has a PE Ratio of less than 22 does not mean I will buy it. In fact, as a value investor, my policy is never to buy a stock with a PE Ratio above 20 and I generally look for stocks with a PE Ratio of 17 or less.

What a Difference a Day Makes

I did my month-end portfolio update yesterday and things were looking pretty good. Then today there was a significant slide. My portfolio is down 1.42% in one day.

Actually my portfolio performed relatively well: the DOW (^DJI) is down 2.22% and the TSX (^GSPTSE) is down 1.99%. My capital was partially preserved by my 30% bond holdings.

Bear Alert

It’s time to take a look at the big picture. The Dow Jones Industrials Average (^DJI) has been running up quite consistently since its 2009 low, with one break in the summer of 2010 (sell in May and go away?). Now the 200d moving average (green) looks to be accelerating up to cross above the falling 50d (red) in a couple of months. This could indicate another summer of sideways or downward prices will soon be upon us.

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The S&P Toronto Stock Exchange Composite Index (^GSPTSE) is displaying a similar pattern to the Dow, but the cross seems to be coming sooner, perhaps in a month. (Note that the line colours are reversed in this chart.)

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So, if we want to lessen our exposure to North American stocks, where do we put our money? Bonds, of course (thank-you, Benjamin Graham). The iShares DEX Universe Bond Index (XBB.TO) looks like it’s ready for the 50d moving average (red) to cross above the 200d (green) in a couple of months, which is a bullish indicator for bonds.

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The bottom line? I will keep watching these three charts and, if the moving averages cross as expected, I will increase my bond holdings from the current 30% of total portfolio value.

POSTMORTEM

I predicted a bearish period. More specifically I predicted the the 50d and 200d moving averages would cross downward for the Dow (^DJI) and the TSX (^GSPTSE), and cross upwards for the DEX (XBB.TO) within two months. Now it’s July 19th 2011 how did my prediction work out?

The TSX did indeed cross – right on the two month mark.

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The DEX crossed upward way ahead of my two month deadline. This is great as I moved to 40% bonds in mid-June.

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The DOW did not cross. It has been a very choppy couple on months for the DOW and the moving averages have converged but not crossed.

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UPDATE

The DOW did eventually see its 50d and 200d moving averages cross in late August 2011.