This past week may have seemed full of your typical summer do-nothing, low-volume trading sessions. But in reality, it was a microcosm of what has been driving price action since the 2008 financial crisis abated.
The preceding Friday, the S&P 500
(^GSPC) closed at 1418, which was the highest weekly close of the year and of the bull cycle. Entering this past week, it seemed as if the market was poised to break out and challenge the 1422 intraday high that had been reached on April 2. With the backdrop of weak economic data, weak Q2 earnings growth, a Fed prepared to launch another round of stimulus, record low interest rates, European turmoil, and overall doom and gloom, the market continued to defy skeptics.
On Monday, Bloomberg
ran a story titled "Stocks Beat Strategists Seeing Best Over Amid S&P 500 Rally,"
which summed up this sentiment.
The 13% rally in the Standard & Poor’s 500 Index has lifted the gauge to its highest level
ever compared with strategists’ forecasts, a sign the best may be over for US equities in 2012. Shares have climbed 2.1% above the average projection of 1,389 from 13 firms from Morgan Stanley
(MS) to JPMorgan Chase & Co.
(JPM) tracked by Bloomberg. That’s the biggest premium on record for this time of year, according to data going back to 1999. Estimates by strategists in August have come true the last three years, with the S&P 500 rising 11% on average through December, the data show.
It was an interesting data point, but I wasn’t really focused on the fact that it signaled an end to the rally -- rather that it was yet another example that Wall Street was still skeptical and cautious. I didn’t think much more of the article until later that afternoon when I received an email from a friend. This email stated that Minyanville contributor and Raymond James strategist Jeff Saut
had called for the S&P to break out and challenge 1500. Then I learned that JPMorgan’s Thomas Lee had similarly noted the 1500 level.
stream was suddenly lighting up with calls for break-outs and melt ups.
Whoa, whoa, whoa... Get a hold of yourself.
I’m not saying these breakout bulls are wrong; in fact, I have been in this camp
for some time. But when you start to hear elevated break out chatter before
it happens, you have to believe that the market is potentially already positioned for such an event, which usually means it’s susceptible to a head fake. On Monday night, I Tweeted
a post from my blog titled "Late to the Party"
with a short note of warning:
the calls for a breakout in stocks and talk of 1500 price targets are getting a little loud for this old contrarian. I still think we make a move higher but we are likely not sustaining a breakout from these levels with momo indicators on the ceiling. In fact as much as we think the market sees higher prices the better r/r set up from these levels is from the short side.
it wouldn’t surprise us to see a gap above the 1420 level that runs stops and capitulates the late holdouts only to reverse in their face. I think we need to see momo on the floor prior to launching a breakout and with the Jackson Hole symposium in two weeks there is no reason to pile on now.
On Tuesday, we got the gap above 1420 only to reverse closing near the lows of the day. We followed up with a post entitled "Ex Ante Analysis
that’s how tops happen... time for defense down to 1360 and 1340 into Labor Day when the big boys come out to play..
The market continued lower into Friday, but with Friday's move into1400 on short-term oversold conditions and diverging momentum, the market staged a nice rally to finish out the week with minimal damage. Nevertheless, it was the first down week since July 6.
Now how did I do that? I don’t have a crystal ball and I don’t even work for some know-it-all hedge fund or on a Wall Street trading desk. It comes from experience in knowing how to think like a crook. The stop run flush at a key support or resistance level is the oldest trick in the book. When you have a level that everyone sees, it’s best to expect a head fake that takes out the last to capitulate.
When we wrote "Trading the Wrong Playbook Bubble"
citing the trading strategy of Billy Ray Valentine, this is exactly the kind of move we were talking about. It’s the proverbial “clearing out the suckers” trade.
While sitting in the dentist chair with a metal pick scraping my teeth on Wednesday afternoon, I was watching something equally as irritating: A technical analyst on CNBC’s Fast Money
butchering a chart of the S&P 500. In what has to be the most popular chart on Wall Street, the analyst was calling for an 8%-10% correction based on the inverse correlation with the VIX
(^VIX). It was like a kindergarten lesson with Magic Markers and coloring books.
Simply overlaying the VIX with the SPX and concluding an 8%-10% pullback is not analysis, technical or voodoo -- it’s guessing. Not to mention the fact that they had not discovered some new undetected relationship or correlation. That chart is so old and overused that Grandma has it posted on her bulletin board.
Why does it seem that the work coming out of Wall Street is so mediocre and elementary? Is it collateral damage from the financial crisis, or have they been so burned by being wrong that they have succumbed to the prevailing fear that they are responsible for causing?
With these questions in mind, I wanted to dig a little deeper into what is driving Wall Street strategists’ pessimism in the face of market performance. I went back to the Bloomberg article from Monday to break down more of the specifics. When you click on the link,
you can see a chart of the current average Wall Street strategist year-end estimate for the S&P 500. If you click on the chart tab on the left, you can pull up a more detailed chart with the ability to overlay the S&P, which is very similar to a chart that was in the Bloomberg story on my terminal.
In looking at the underlying numbers, the chart Bloomberg used understates the difference between the price targets and actual performance. Because the forecasts represent year-end price targets, I decided to run the chart with the S&P 500 at a 12-month lag. You get a very different picture with a massive discrepancy between target and price.
You can see on the chart that price targets get ratcheted up at the turn of the year. I decided to take each year-end price target and measure it against actual performance from the following year. What I found were some very interesting trends.
As the article states, the data goes back to 1999. Since then, the average strategist target for the S&P 500 had missed the actual year-end price by over 10% both higher and lower in seven out of the 12 years. In the five years where targets were within 10% of the actual price, only in 2002 and 2003 did they hit “the swing,” which means that they caught the beginning of a trend. In fact, 2002 was the banner year in which the average target was for a 25% gain with the market actually returning 26%.
However, generally speaking, when you needed targets most, they failed the worst. When the market was entering a bear cycle in 2000 and 2001, the average target overshot by 27% and 33% respectively. In 2007, they overshot by 42% -- and in fact, in January 2008, they top-ticked the market with the highest year-end target of 1603, which was 48% above the year-end actual close of 825.
It wasn’t just the tops they missed; the largest deficits occurred when markets were entering bull cycles. In both 2004 and 2005, when the average target implied negative returns, they undershot by 10% and 15% respectively. In 2008 the year-end target for 2009 implied a 4% return, which undershot the 24% actual return by 19%. In 2009, the target implied a negative 4% return vs. the actual 13%, missing by 17%. At the end of 2011, the 2012 year-end target averaged 1282, which was projecting basically a flat year vs. the current return of 12%, potentially setting up for another double digit miss.
The bottom line is that when investors needed Wall Street strategists to be most cautious, they were the most aggressive -- and when investors needed them to be the most aggressive, they were the most cautious. The years when they were the most accurate (with the exception of 2002) are when you needed them the least. What is behind this consistent incompetence?
I can’t speak to each individual strategist's methodologies. But if I had to guess, I would suspect most work from bottoms up and determine a year-end earnings number for the S&P 500, and then assign a multiple to come up with a price target. What’s interesting is that if you examine the current range of earnings and targets, you get varying multiples, which begs the question: How do they calculate the multiple and then how does the market actually price it?
The two most bearish on price, Goldman Sachs’ David Kostin at 1250 and Morgan Stanley’s Adam Parker at 1167, both have the S&P earning $100.00 vs. the average estimate of $101.30. The most bearish on earnings, Bank of Montreal’s Brian Belski with a $98.50 estimate and Credit Suisse’s Andrew Garthwaite with a $99.60 estimate, both have a 1425 price target, which is actually equal to the median of the survey.
With the average earnings estimate at $101.30 and the median at $101.00, I think it’s safe to say that generally the strategists are in agreement with where the fundamentals are going to land. The difference is what price you are willing to pay.
What’s interesting is the highest S&P 500 target from Weeden’s Christopher Harvey at 1492 and the lowest target from Morgan Stanley’s Adam Parker at 1167 -- ironically, both estimate earnings to come in at $100.00 per share. Harvey assigns the highest P/E at 14.9x multiple while Parker assigns the lowest only an 11.7x. What input in their models would constitute a 28% difference in price of the same earnings? It’s likely in the estimate of the equity risk premium, which is the earnings yield spread over the risk-free rate or over corporate bond spreads. The lower the spread or premium, the higher the multiple and vice versa.
Ultimately, it doesn’t matter what each strategist's model assigns the multiple to be; it only matters what price the market assigns. There are likely several variables that go into the calculation, but it is the equity risk premium that probably exhibits the most variance between strategists. That’s because while sophisticated models can quantify discounted cash flows, the price of risk is not a function of math -- it’s a function of sentiment. Wall Street strategists aren’t miscalculating the math; they are misinterpreting the role of sentiment.
In the aforementioned "Trading the Wrong Playbook Bubble,"
I addressed this role of sentiment in the post-crisis market, which has been dominated by an activist central bank that has distorted the pricing mechanism.
By manipulating the yield curve to generate negative interest rates, Fed policy has taken the discount out of the discount rate and thus removed the ability for markets to correctly price assets. Fed policy has essentially turned all assets into commodities subject not to valuation but simply the supply and demand for the securities.
At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.
With Ben Bernanke having turned all assets into commodities, market price is not driven by valuation and growth based on models and forecasts, it’s driven by positioning and sentiment based on speculation and fear.
Over time, earnings in aggregate are going to grow at some rate based on nominal GDP growth. Market returns don’t come down to earnings growth -- they come down to the multiple. With the multiple a function of positioning and sentiment based on speculation and fear, it is virtually impossible to quantify. Yet the industry continues to rely on models and forecasts that purport to not only calculate the multiple, but predict what the market will pay 12 months in advance. These models are destined to fail by their inherent methodology.
Not all strategists are created equal; some like Jeff Saut (not among those sampled by Bloomberg) get it and understand how the market works. From last Monday’s post on Minyanville
citing sentiment and positioning:
Of course, the grind higher from the June 4 low has been accompanied by total disbelief among individual and professional investors. That is reflected not only in the flow of funds by individual investors out of equity-centric mutual funds
, but in the latest Commitment of Traders report that shows the “pros” have been caught heavily on the short side into a rising equity market. So the fuse is burning and I think it is just a matter of time until the SPX travels above 1422.
Perhaps other Wall Street strategists need an input variable in their price target calculation for the Billy Ray Valentine effect. The fact is that year-end price targets are basically worthless, yet they are given far more attention than they deserve. These guys get carted around like they are omnipotent and can lead your portfolio to the Promised Land. However, the implied “alpha” in their collective track record is not only atrocious -- it’s despicable. You constantly hear about how depressed the street is because of the lack of trading volumes and shrinking commissions. Maybe it’s just that investors are no longer willing to pay them for a product that is subpar.