Complacency, elections and year-end rallies
John Mauldin's Outside the Box

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Introduction

Once again we look at one of my favorite analysts and behavioral finance thinker, James Montier of Dresdner Kleinwort Wasserstein in London. James wrote a fascinating book two years ago called "Behavioural Finance: A User's Guide" and puts out ongoing research like what we will enjoy today. Long time readers will recognize the name because I have discussed many of his ideas in my weekly e-letter "Thoughts From the Frontline," my book "Bull's Eye Investing" and in "John Mauldin's Outside the Box."

This report by James explores many of the global markets to determine if they are overvalued or undervalued. We get an inside look into some historical data and financial models, plus a non-US perspective on the current condition of several world markets. Enjoy this week's "Outside the Box."

Complacency, elections and year-end rallies

US: Condition IV (unfavourable valuation and unfavourable momentum  sell equities signal)

Chart 1

Condition I: valuation favourable, momentum positive = buy equities

Condition II: valuation favourable, momentum negative = buy equities

Condition III: valuation unfavourable, momentum positive = buy equities

Condition IV: valuation unfavourable, momentum negative = sell equities

Valuation is defined as the dividend yield relative to its long run average. If the current yield is above the long run average, then valuation is said to be favourable. Otherwise, it is characterised as unfavourable.

Momentum within the model is defined as the current yields in the bond market, the money market and the equity market all relative to their six-month averages. If current yields are below their six-month average then momentum is positive. For overall model momentum to be positive, we require the equity market, and at least one of the other two markets to have positive momentum.

Last month, our US TAA model generated another condition IV sell equities signal, but unfortunately the market generated a total return of 4%. This is an usually large gain for a condition IV signal. In fact out of 185 condition IV signals since 1954, only 32 have resulted in gains of more than 4%.

As the distribution overleaf shows, condition IV has a long left skew so when losses occur they can often be very sizeable. Essentially, investors simply aren't being compensated for the risk they are taking on under condition IV. In recognition of this fact, the model continues to show a condition IV sell equities for December.

Chart 2

This month also sees our irrational valuation models move into the overvalued zone. Remember these models are designed to capture the way investors perceive valuation rather than the way they ought to see valuation (see Global Equity Strategy, 31 July 2003 for details of these models).

The Asness model allows both the nominal bond yield and the relative volatility of bonds and equities to influence the perceived fair value of the market. This model suggests that the perceived fair value PE (based on a Graham and Dodd 10 year average earnings measure) is 29.6x against a current actual Graham and Dodd PE of 30.1x yielding a perceived undervaluation of 1.5%.

Chart 3

Our second irrational valuation model, the myopic PE, shows equities to be perceived as overvalued. This relates the perceived correct PE to the bond yield and analysts' long-term earnings growth forecasts. The model is designed to track how investors might value the market using the IBES 12 month forward PE.

Given the current bond yield and the long-term earnings growth forecasts from analysts, the myopic PE model suggests that the perceived correct PE is 15x, against a current 12-month forward PE of 16x, yielding a 6.6% overvaluation.

Chart 4

Chart 5

Despite these emerging signs of trouble ahead, most measures show investors to be remarkably complacent. Implied option volatility remains very low, a mere 13%, the put to call ratio is very low, and bullish sentiment is high (see the charts overleaf). All in all, everyone seems relaxed about the outlook for equities. Given the extended nature of valuations and a slowing cycle we regard this sanguine attitude as severely misplaced.


Chart 6

Chart 7

Chart 8

A year-end rally?
Of course, some investors are betting on a year-end rally. Indeed the table below shows the average return from investing in December and the average return across all other months. In general December returns do appear to be higher than those in other months.

However, before dashing out and betting the ranch on a rally this month, it might just be worth casting an eye over the column labelled t-stats. This is a test of statistical significance of the difference between December and the other months. i.e. is the difference actually meaningful given the volatility of returns. Sadly none of the t-stats suggest a high degree of statistical significance. The apparent outperformance of December returns is a statistical illusion.

Chart 9

Presidential cycle
If you thought this year has been dull, then perhaps you might not like to cast your eye over the chart below. Jeremy Grantham of GMO has made some exceptionally good tactical calls based around the market performance over the presidential cycle. We decided to investigate. The results are not pleasant reading. The chart below shows the cumulative returns over the four years of a President's term. The first two years see essentially flat markets!

Chart 10

A simple trading strategy of sitting out the first two years of a President's term since 1953 generates a 2.96% p.a. CAGR of price returns, whereas a buy and hold strategy would have been 3.2% p.a. CAGR of price returns. However, the volatility of the returns was markedly lower for the strategy which missed the first two years (3.6% vs 4.9%), so leveraging up the sitting out strategy to the same level of volatility of returns as the buy hold strategy would raise returns to 4%.

Japan: Condition IV (equity sell signal)

Chart 11

Our Japanese TAA model had a bad month in November. A condition IV signal was rewarded by a 1.4% increase in the equity market. Despite the continuing enthusiasm for Japanese equities amongst investors, our TAA model continues to suggest selling the equity market.

The fundamental picture continues to deteriorate by the day. Indeed a Japanese recession is certainly not beyond the realms of possibility (see Ian Harwood's forthcoming weekly for an assessment of the state of Japanese growth). Our economists' surprise indicator continues to show Japanese data consistently coming in below market expectations (consistent with a marked slowdown in growth).

Chart 12

Despite this, investors seem to remain stubbornly optimistic about the future path of the market. It is perhaps a telling sign that Japan hasn't featured heavily in our conversations with clients over the last couple of months, in contrast to the early summer months when every one wanted to talk about Tokyo. Could this lack of discussion be a precursor of growing investor realisation that Japan is just as cyclical as it ever was in the post bubble period? Only time will tell, but we remain at our maximum underweight.

Chart 13

Chart 14

Chart 15

Chart 16

UK: Condition III (equity buy signal)
November saw a 2.4% total return to investing in UK equities, a good result for our TAA model which recorded a condition III buy equities signal for the month. This month, once again, the model has generated another condition III signal.

Chart 17

Chart 18

Germany: Condition III (equity buy signal)
Last month, the German TAA generated a condition III equity sell signal. The German equity market witnessed an outstanding 4.1% total return on the month, nearly three times the average monthly return for a condition III signal. Of the 81 condition III signals recorded since 1973, 30 have seen month gains of 4% or more. The signal for December remains a condition III momentum inspired buy equity signal.

Chart 19

Conclusion

Maybe some of what James has to say will make you think twice about what the market cheerleaders will tell you.

Your looking the world markets over analyst,


John F. Mauldin
johnmauldin@investorsinsight.com



Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

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Posted 12-06-2004 4:03 AM by John Mauldin
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