This article is a follow-up to a series of articles I wrote in 2019 about how to avoid losses and how to profit from sentiment cycles. If you are already familiar with the strategy, feel free to skip down to the “Free Share Gain Winners” section and read from there. If you are new to the series, I’ll explain the background and goals of the series in the next few sections to get you up to speed. Part one of the series, “Ignore Sentiment Cycles At Your Own Risk,” explained what sentiment cycles are and how even the stocks of high-quality companies can sometimes become overvalued enough to sell. I also shared a working theory of the factors that I think contribute to the formation of a sentiment cycle with any particular stock. In part two, “Mitigating Sentiment Cycles,” I shared a long-only investment strategy that can help investors avoid some of the losses associated with a sentiment cycle by rotating out of the overvalued stock and into a more defensive position; then, when the price of the overvalued stock comes down, rotating back into the stock and being able to own more shares than when you sold it without spending any extra money.
For example, let’s say one owns the stock of company XYZ, and it trades at $100. The business is a great business, but the price has become so expensive that the implied future returns if someone bought the stock at that price are so low that it makes sense to sell it. Now, let’s say there is a defensive ETF like the Invesco S&P 500 Low Volatility ETF (SPLV) which also trades at $100 but is likely to trade with much less volatility than the market and unlikely to fall as far and as fast as an overpriced stock under most conditions.
Let’s say someone sells XYZ and rotates into SPLV while both are priced at $100. Then, over the course of the next several months, the price of XYZ comes down to earth and falls to $80, while SPLV stays at $100. If one owned 100 shares of XYZ initially, they can now sell their SPLV shares and buy 125 shares of XYZ because the price is cheaper. This results in a 25% “free share gain” compared to if one had just held the stock of their great business throughout this entire period.
That’s a basic explanation of how free share gains and a long-only rotational strategy work. Back in 2018, I wrote a long-running series about how to do this with highly cyclical stocks, and I continue to update that series each quarter. The current series you are reading now is about the stocks of businesses whose earnings are not highly cyclical. These businesses will all have earnings with low-to-medium earnings cyclicality, but they will be stocks that have become overpriced mostly due to the sentiment changes of the market.
Outline of the Simple Rotational Approach
In “When To Sell And When To Buy Back Again,” I explained several different levels of sophistication an investor can take while using a long-only rotational strategy. If you would like more details on the strategy, give that article a read.
For this series, I am sharing what I call a “simple mixed rotational strategy.” The main goal, other than warning investors that their high-quality stocks will probably not produce great returns if they are held at high prices, is to demonstrate the usefulness and effectiveness of the rotational strategy in real-time rather than using a back-testing approach. Back-tests can be useful, but not nearly as useful as watching how a strategy works in real-time when unique and unpredictable situations arise, like, say, COVID-19.
Now, let’s outline how the strategy works.
The first step is identifying a high-quality business with a great long-term history of consistent and steady earnings growth. All of the stocks in this series are stocks that I am interested in owning at least for the next 10 years. These are not low-quality, short-selling candidates. Occasionally, I eventually find something I don’t like about the business and hold off buying it even after the price falls, but initially, all the stocks in this series appeared of high enough quality to interest a potential purchase. My primary audience when I share the articles are investors who already own the stocks. My goal is to let them know if their stock is overvalued enough to sell, with the ultimate goal of buying it back at a lower price and increasing the number of shares they previously owned for free.
The second step is to identify if the stock is expensive enough to sell. In April 2019, I started specifically examining stocks that looked overvalued on the surface to see if they were sell-worthy based on their expected 10-year forward returns. I call these articles “10-year, Full-Cycle Analyses.” About two-thirds of the stocks that I examined last year did turn out to be “sells” after closer examination, and these are the stocks you’ll find in this series.
My current standard to declare a stock a “sell” is that if the 10-year forward return expectations are lower than a 4% CAGR. All of the stocks in this article will have had a 10-year CAGR expectation of less than 4% at the time I wrote about them, or eventually had their prices rise after I wrote about them to prices that would have produced CAGR less than 4%. (You can find links to the original articles on my profile page. Type the ticker symbol into the “filter by ticker” box and it will pull up the articles I’ve written on that ticker. You will need an SA Premium subscription to read many of them, but you can check the publication dates if you’d like to double-check my work or see my sentiment rating at the time.)
The third step after one sells is to decide what to do with the proceeds of the sale. I call this one’s “default position”, which is the place money sits while it is waiting to be invested in individual stocks. It is often assumed that a cash equivalent is the default position, but I actually prefer to stay invested unless it is clear we are headed into a recession in the very near future. Up until the end of February, I did not think a recession or serious economic slowdown was imminent, but at the end of February, I did determine that a recession was imminent. So, since the beginning of March, we have been holding cash instead of the defensive ETFs I usually hold late in the economic cycle (more on this in the next section).
So, we identified a quality business, sold the stock because it was expensive, and put our money in either a 50/50 mix of SPLV/XMLV or SPLV/RSP, and then, at the end of February, moved that money to cash. The next step is rotating back into the target stock and gaining free shares. For the simple mixed approach, there are two ways we go about buying back the original stock. The first way is to rotate back in whenever a 20-25% free share gain presents itself. And the second way is to rotate back in whenever the expected 10-year forward CAGR expectation reaches 8% for the stock in question, which I consider the long-term market average and “fair value.” I’m going to use a mix of both ways in this series as a way to demonstrate how they work, and the benefits and drawbacks of each approach.
Over the course of the past 17 months, an interesting thing happened with the low volatility and utility ETFs I started suggesting were good defensive alternatives to expensive stocks in January 2018: they got expensive themselves. The market correction of late 2018 caused many investors to pile into low-beta and steady-earning stocks in 2019, including the ones that comprise the ETFs I was using for defense. That was good for me because I already had a large allocation to these funds, so I benefited from rising prices due to the late arrivals. The problem then became that I couldn’t find anything defensive in equities that wasn’t already pretty expensive itself. So, in March 2019, about a year ago, I put out a “recession strategy” in the Cyclical Investor’s Club, whereby if two (mostly) objective conditions were met, the default ETF positions would be moved to cash.
On 2/28/20, I judged that those conditions were met, and the default ETF positions were moved to cash (investments I had made in individual stocks remained invested, though). The next day, I wrote a blog that explained the history of all this and the thinking behind it. It’s titled “Recession Mode Is Here,” and I suggest everyone who follows this series read it. This plan wasn’t anything new, and I had been tracking these conditions every month in the Cyclical Investor’s Club because I knew the market was expensive (including the stocks that composed the defensive ETFs), even if I did not know it would be a virus that would push us over the edge into recession.
Since March, in addition to using percentage returns, I have tracked the growth of a theoretical $10,000 investment in the target stock and compared it to cash held as of the end of February in order to determine how many free shares could be gained as of June 30th. Read the February update for a full run-down of where each position stood at the end of February if you would like to see where the cash totals for each trade came from. I have the historical performance charts in that article.
A big part of this series is about the demonstration of various levels of reward versus opportunity risk. There are two main reasons I’ve found that investors are reluctant to sell high-quality stocks even when they admit those stocks are very expensive. The first reason is usually that they are worried that they may never be able to buy the stock at a lower price. The second reason is that they don’t want to pay taxes on their capital gains, or they think once capital gains taxes are paid, any share gains they might get wouldn’t be enough to offset those taxes.
Taxes are highly personal, but I wanted the simplest approach in this series to at least be able to offset most long-term capital gains taxes, and I also wanted it to have a very high probability of success. My estimates were that I could have an 85-90% success rate at achieving a 20-25% free share gain with this group of stocks, and I estimated that should be more than enough to cover long-term capital gains taxes and also offset about 10-15% worth of “losers” (stocks that never achieve a 20-25% free share gain opportunity). The point of choosing these levels as a goal was to demonstrate this strategy is viable even when taking into account long-term capital gains and the occasional mistake. This is geared toward investors who are really attached to a stock and have probably owned it a long time, and who are worried about not being able to buy it back at a lower price if they sell. The goal is to demonstrate the basic viability of the strategy for this group of people.
The next layer of the strategy has to do with the “fair value” approach. This part of the strategy is meant to aim for greater free share gains, but with those potential greater gains, it also includes greater opportunity risk that a stock might not trade at “fair value” again for a long period of time. In this sense, there is a trade-off – the stocks that do “hit” will usually produce greater gains, but a greater number of the stocks may not hit fair value, therefore inflicting a greater opportunity cost. I don’t have an estimate of what the opportunity cost might be for the stocks in this series using a “fair value” approach. For stocks whose earnings are more cyclical, I have had about an 80-85% success rate, but part of this series is indeed an experiment to see what sort of a “fair value” success rate I can get. I define “fair value” as an expected 10-year CAGR of 8% using my full-cycle analysis.
It is important to point out that neither of the two goals laid out in this series (a 20-25% free share gain goal, nor an 8% 10-year CAGR goal) is what I use as personal goals myself. I am a value investor, so I aim to purchase below “fair value” and with a margin of safety. In this case, for less-cyclical stocks, that means I aim to buy when the 10-year CAGR expectation is greater than 12%. This will occur more rarely than an 8% expected CAGR, but I make up for that fact by not getting attached to any particular stock. That way, if I sell an overvalued stock, I don’t have to wait for that particular stock to fall to value levels, and I put the money into any value stock that meets my standards. So far, this approach has worked well and opportunities have presented themselves. While I’m still holding lots of cash (about one-third of the portfolio), I was able to find 35+ buying opportunities during the March downturn, and since 1/12/19 when the Cyclical Investor’s Club launched its portfolio of ideas, it has returned +34.90% compared to the S&P 500’s +31.34% as of 10/2/20. To put this in perspective, at the beginning of 2020, the CIC portfolio was trailing the S&P 500 with the CIC portfolio returning +24.72% compared to SPY’s +26.63%. So, the stocks we were able to buy during the downturn have been very lucrative so far. (For what it’s worth, I didn’t own a single “big tech” stock going into the recession, nor did I own any popular consumer staple stocks like Costco (COST), nor did I buy any COVID-19-related drug stocks. None of that was necessary to beat the market so far this year. All I did was look for good businesses at great prices.)
Free Share Gain Winners
Many of these stocks fell too fast during the downturn for me to write update articles on them. In those cases, I have assumed the trade was over at the 25% goal I set for the rotation at the beginning of the series. As one might expect after experiencing the best several months for the market in many years, we didn’t add any free share gain winners since April, and that trend continued through September. Out of 43 stocks in the series, 32 of them have already met our free share gain goals, though, so we are doing quite well with the free share gain goals, with a current 74% success rate. Here are the “free share gain” winners so far in the series.
11 of the 43 positions we are still tracking. Here are the 11 stocks that haven’t yet crossed the free share gain threshold yet: Clorox (CLX), ResMed (RMD), Ball Corp. (BLL), Waste Management (WM), Church & Dwight (CHD), Texas Instruments (TXN), Procter & Gamble (PG), Brown-Forman (BF.B), McCormick (MKC), Northrop Grumman (NOC), and Walmart (WMT). I’ll post those charts later in the article.
Fair Value Winners
As of the end of last month, we had thirteen successful fair value winners: Union Pacific, Expedia, CSX Corp., Norfolk Southern, Starbucks, Stryker, CGI, Lowe’s, Automatic Data Processing, Paychex, Edwards Lifesciences, Mastercard, and Sherwin-Williams. So, we currently have 13 out of the 43 stocks that have met their fair value goal of 8% 10-year CAGR expectation, which is about a 30% success rate. Here are the free share gains for the completed trades so far.
|Ticker||Free Share Gains from Full-Cycle Analysis|
This leaves 30 stocks we are still tracking, waiting for the opportunity for them to trade at “fair value.” As I’ve done during previous updates, I’m going to break these down into different categories based on the free share gains possible as of the end of the month, and then I’ll aggregate those findings at the end.
Stocks with +10% to +20% free share gain
CME Group (CME) 12/11/19
When the ETFs were moved to cash, they would have been worth $9,349. If one rotated back into CME Group now, they would gain +10.29% worth of free shares. Currently, CME has a 10-year expected CAGR of 4-5%, so it still has a lot to fall before it gets to fair value.
Stocks with 0% to +10% free share gains
Northrop Grumman (NOC) 10/23/19
When the ETFs were moved to cash, they were worth $9,510. If one rotated back into Northrop now, they would have gained +6.08% worth of free shares. Currently, Northrop has a 10-year expected CAGR of 7.44%, so it’s still somewhat close to fair value, but not quite there. It’s possible we might not quite reach our free share gain goals with this one, even if the price falls to fair value, but it should produce some gains.
Stocks with 0% to -10% free share gains
Copart (CPRT) 1/21/20 (original 7/30/19)
When the ETFs were moved to cash, they were worth $8,918. One could now purchase -8.36% less Copart stock if they rotated back in. Currently, Copart’s 10-year expected CAGR is 0-1%, so Copart remains a “sell” based on expected forward returns.
Hershey (HSY) 9/11/19
When the ETFs were moved to cash, they would have been worth $9,465. If one rotated back into Hershey today, they would gain -2.30% worth of free shares. Currently, Hershey has a 10-year expected CAGR of 4-5%, so it still has a bit further to fall before it trades near fair value.
Waste Management (WM) 1/21/20
When the ETFs were moved to cash, they would have been worth $8,918. If one rotated back into WM now, they would gain -6.46% worth of free shares. Currently, Waste Management has a 10-year expected CAGR of 0-1%, so it is currently a “sell”.
Medtronic (MDT) 9/26/19
When the ETFs were moved to cash, they would have been worth $9,529. Rotating back into Medtronic now would produce -3.78% more free shares. Currently, Medtronic has an expected 10-year CAGR of -1% to 0%, so it is now a “strong sell”.
McDonald’s (MCD) 7/16/19
When the ETFs were moved to cash, they were worth $9,588. If the money was used to buy McDonald’s stock now one could purchase -9.46% less worth of free shares. Currently, MCD’s 10-year expected CAGR is -3% to -4%, so it’s a “strong sell” based on forward earnings expectations.
Equifax (EFX) 2/15/20
When the ETFs were moved to cash, they would have been worth $8,736. Rotating back into Equifax now would produce -9.96% fewer free shares. Currently, Equifax has a 10-year expected CAGR of 2% to 3%, so this stock is a “sell” based on expected forward returns. Interestingly, Equifax has declined in price since the June update, while most have gained.
Teleflex (TFX) 10/16/19
When the ETFs were moved to cash, they were worth $9,606. If one rotated back into Teleflex now, they have a -9.12% free share loss. Currently, Teleflex’s 10-year expected CAGR is 0% to 1%, so it is a “sell” at this price. However, last month, it was a “strong sell”. The change was generated by the price moving lower rather than earnings moving higher, so, at least for some stocks, the market is behaving somewhat rationally.
Stocks with -10% to -20% free share gains
Illinois Tool Works (ITW) 10/24/19
When the ETFs were moved to cash, they would have been worth $9,501. If one rotated back into ITW today, they would lose -23.26% worth of free shares. Currently, ITW’s 10-year expected CAGR is -1% to 0%, so the ITW is currently a “strong sell”.
Estee Lauder (EL) 8/19/19 (original 4/30/19)
When the ETFs were moved to cash at the end of February, they were worth $9,551. If one rotated back into Estee Lauder today, they would have lost -12.54% worth of free shares. Estee Lauder’s current 10-year CAGR expectation is -2% to -3%, so Estee Lauder is still a “strong sell” again.
Accenture (ACN) 9/12/19
When the ETFs were moved to cash, they would have been worth $9,430. If one rotated back into Accenture now, they would lose -19.74% worth of free shares. Currently, the 10-year expected CAGR is 0-1%, so Accenture is now currently a “sell” based on forward return expectations.
Roper Technologies (ROP) 1/9/20 (original 9/6/19)
When the ETFs were moved to cash, they would have been worth $9,119. If one rotated back into Roper now, they would lose -14.86% worth of free shares. Currently, Roper has a 10-year expected CAGR of 2-3%, which is low enough to make Roper a “sell”.
Stocks with greater than -20% free share gains
Brown-Forman Corp. (BF.B) 11/8/19
When the ETFs were rotated to cash, they would have been worth $9,369. If one were to rotate back into Brown-Forman today, they would have a loss of -20.60% worth of free shares. Currently, Brown-Forman has a 10-year expected CAGR of -2% to -3%, so it is now a “strong sell” at current levels.
Walmart (WMT) 11/19/19
When the ETFs were moved to cash, they would have been worth $9,369. If one rotated back into Walmart now, they could buy -21.07% fewer shares. The nature of the coronavirus seems to have propped the price of this stock up. Currently, Walmart has a 10-year expected CAGR of -1% to -2% and is a “strong sell.”
Procter & Gamble (PG) 2/21/20
When the ETFs were moved to cash, they would have been worth $8,810. If one rotated back into P&G now, they would have a -20.70% free share loss. Currently, the expected 10-year CAGR for P&G is 3-4%, so it is still a “sell” at these levels.
Intuit (INTU) 9/5/19
When the ETFs were moved to cash, they were worth $9,434. If one rotated back into Intuit today, they could gain -23.05% fewer free shares. Currently, the 10-year expected CAGR is 0% to 1%, so Intuit is a “sell” at these prices based on forward returns.
Rollins (ROL) 4/22/19
When we rotated the ETFs to cash, they were worth $9,844. If one rotated back into Rollins today, they could gain -22.37% fewer free shares. Currently, the 10-year expected CAGR is -3% to -4%, so Rollins is now more overvalued and is now a “strong sell”.
Clorox (CLX) (2/14/20)
When the ETFs were moved to cash, they would have been worth $8,736. If one were to rotate back into Clorox now, they could buy -32.17% fewer shares than when they rotated out. Currently, Clorox’s expected 10-year CAGR is 1% to 2%, which makes it a “sell”. However, this is an improvement from last quarter when it was a “strong sell”.
ResMed (RMD) (9/23/19)
When the ETFs were moved to cash, they would have been worth $9,544. ResMed has been pretty volatile, but right now, if one rotated back in, they could buy -25.26% fewer shares than when they rotated out. This is actually an improvement since the last update, but it remains in the same category. Currently, the 10-year expected CAGR is 0% to 1%, which makes ResMed a “sell” at this price (an improvement from “strong sell” in June).
Church & Dwight (CHD) 1/22/20
When the ETFs were moved to cash, they would have been worth $8,921. Rotating back into Church & Dwight now would produce a -31.85% free share loss. Currently, CHD has a 10-year expected CAGR of 1-2%, which makes the stock a “sell”.
Cintas (CTAS) 5/16/19
When the ETFs were moved to cash, they were worth $9,544. If one rotated back into Cintas now, they could lose -36.46% worth of free shares. Currently, Cintas’ 10-year expected CAGR is -1 to -2%, so this stock is now a ‘strong sell’ based on forward earnings expectations and has gotten even more expensive since June.
Apple (AAPL) 1/30/20
When the ETFs were moved to cash, they would have been worth $8,946. Rotating back into Apple now, one would have -37.88% fewer shares. Currently, Apple has an expected 10-year CAGR of -4% to -3%, so it is now a “strong sell” based on forward expected earnings. None of Apple stock’s price appreciation has come from increased earnings. It is all due to market sentiment.
Fair Isaac Corporation (FICO) 8/7/19
When the ETFs were moved to cash, they would have been worth $9,570. If one rotated back into FICO today, they would have -21.10% fewer free shares. Currently, FICO has a 10-year expected CAGR of -2% to -1%, so it is still quite overvalued and is a “Strong Sell”. However, Fico’s improved earnings prospects, combined with the price leveling off, have helped improve those future earnings expectations from -5% to -6% last quarter.
Ball (BLL) 12/12/19
When the ETFs were moved to cash, they would have been worth $9,313. If one rotated back into Ball now, they could buy -29.39% fewer shares than when they rotated out. Currently, Ball’s 10-year expected CAGR is -2% to -1%, and it’s now a “strong sell.”
Home Depot (HD) 11/18/19 original 6/28/19
When the ETFs were moved to cash, they were worth $9,365. If one moved back into Home Depot today, they would lose -21.37% worth of free shares. Currently, Home Depot has a 10-year expected CAGR of 4-5%, so it has gone from a 1-2% CAGR expectation and a “sell” last quarter to a “hold” based on forward expectations this quarter. This shows that Home Depot’s earnings have actually improved during this recession. There have only been a few stocks in the series with this dynamic, where higher prices are actually supported by higher earnings.
Texas Instruments (TXN) 10/31/19
When the ETFs were moved to cash, they would have been worth $9,488. If one were to rotate back into Texas Instruments today, they would have a loss of -23.30% worth of free shares. Currently, Texas Instruments has a 10-year expected CAGR of 2-3%, so the TXN is currently a “sell” based on forward return expectations. Interestingly, TXN actually improved their CAGR expectation from last quarter, so their fundamentals are improving, and some of the stock price rise may be justified on that basis. For most of the stocks we are still tracking, their expected returns have diminished, even while the stock price has risen.
Nike (NKE) 9/18/19
When the ETFs were moved to cash, they would have been worth $9,514. If they were rotated back into Nike now, one would lose -33.93% worth of free shares. Currently, Nike’s expected 10-year CAGR is -3% to -4%, which makes it a “strong sell” at these prices. Nike’s earnings actually fell a lot, even while the stock price kept rising. This is one of the most overvalued of the group based on earnings expectations.
McCormick (MKC) 8/26/19
When the ETFs were moved to cash, they would have been worth $9,630. If one rotated back into McCormick now, they would lose -21.39% worth of free shares. Currently, McCormick has a 10-year expected CAGR of -1% to 0%, so McCormick is now a “strong sell”.
Target (TGT) 11/18/19
When the ETFs were moved to cash, they would have been worth $9,365. Rotating back into Target now would produce -34.93% worth of free shares. Currently, the 10-year expected CAGR for Target is 0-1%, so it is a “sell” based on forward return expectations.
I have decided to share both where we stood last quarter, and where we are as of the end of September, so we could compare any changes.
Since each of the 43 stocks was divided into two positions, there are a total of 86 positions being tracked in this series. The chart below shows the distribution based on the percentage of free shares gained or lost. Out of the 86 positions, 44 of them are completed trades with free share gains of +20% or greater, and 1, UNP, was completed with a free share gain of 19%. So, over half of the positions now have their free share gains locked in, and the remaining 41 positions we are still tracking, and they will fluctuate each month.
This first chart is where things stood at the end of June:
And the second one below is how they look at the end of September.
As time goes on, we are starting to get more of a barbell shape to the performance.
One of the main reasons for the increase in the -20% category is that I decided to keep the funds that were rotated out of the overvalued stocks in cash instead of rotating that money back into the market via a market ETF in June. My decision to do so had to do with my expectation that coronavirus would have a fall resurgence in the US, additional government stimulus would be unlikely, President Trump was likely to lose the election in November, and I expected that this would all cause a lot of volatility in the market. Most of those predictions are on track to play out nearly as expected. President Trump added some wrinkles to the equation with a series of executive orders that suspended student loan payments until the end of the year and continued some limited unemployment benefits, while Nancy Pelosi now seems more willing to pass a stimulus deal. I think Trump’s executive actions bought the economy a little time, and it took some time for the economic effects of stimulus wearing off to start showing up in the economic numbers, and now with Pelosi coming to the negotiating table, I think the market (despite experiencing some volatility last month) has mostly priced in about a $2 trillion dollar additional stimulus deal getting done. If we get another 2 trillion dollars’ worth of stimulus between now and the end of the year, that should be enough to carry the economy into mid-2021, at which point I expect the effects of the virus to wane, and for most of the economy to be on a path to recovery. So, overall, I’m bullish on the economy over the next 12 months no matter what happens with the election. However, there could be a delay of that recovery, over the next 3 months or so, depending on how the politics and stimulus negotiations go. The Senate is still controlled by Republicans, and it’s unclear how much they are willing to spend.
Most of the time, elections don’t matter a whole lot when it comes to the market. I think this time might be an exception. When Trump won in 2016, he drew in many investors who had been on the sidelines during Obama’s presidency. I think there is a chance that if Trump loses, especially if Democrats sweep, many of these investors will exit the stock market because they will expect slower economic growth and higher corporate taxes from Democrats. This could create lots of volatility in November, December, and January, particularly if stimulus hasn’t been passed, yet. For these reasons, I have chosen to keep the ‘default money’ in cash until January in order to see if the expected volatility produces opportunities for some more rotations back into the target stocks. If we don’t get that, I’ll probably rotate the cash back into a market ETF in January.
This strategy closely mirrors my personal positions except that I have had about an 18% portfolio weighting in precious metals to go along with about an ~35% cash position (the rest is in individual stocks). I hope to deploy most of that cash before the end of the year if we get some post-election volatility. Due to all of the government stimulus we have had, and with the Fed holding interest rates low, I may have to loosen my standards and accept a lower margin of safety to do so, but my intention is to not still be holding large amounts of cash by the time February arrives. There has simply been too much money pumped into this economy to keep doing so.
The unique nature of the current recession has made drawing clear conclusions from this experiment more difficult. The ‘free share gain’ approach has mostly been a success already, with a 74% win rate. All of the government stimulus and help from the Federal Reserve, however, has greatly altered the ‘fair value’ approach. When interest rates are very low and large swaths of the economy have been propped up by the government, we simply aren’t going to get reasonable stock market valuations. If, back in March, the Fed and the central government had come in with stimulus two weeks later than they did, I know we would have already had a much higher success rate than we do now.
But that is real life.
This is the difference between a backtest and the real world. I think that because the coronavirus was judged to be nobody’s fault, the government has been more willing to spend money helping those who have been economically damaged than they otherwise would have. It’s probably unlikely that the next recession will see such a generous response. Additionally, while I expect lots of stimulus in the coming 6 months, we might not get a whole lot after that, and we may see higher corporate tax rates at the same time as the stimulus. Longer term, this will have a drag on earnings growth and eventually I expect prices will come down for most of the stocks in this series. There will be a few, as we saw with Home Depot and Texas Instruments, whose earnings actually support (at least to some degree) a rising stock price. But there are many more, like Nike, who posted their worst earning in 5 years and are trading at P/Es over 60, whose prices will eventually come down as time goes on unless they find a way to dramatically grow earnings in a way they haven’t been able to do the past 3-4 years.
Time will tell, and I am prepared to keep tracking these ideas on a quarterly basis, so we can see what happens over the long-term and learn from it. Perhaps the biggest lesson so far is that federal stimulus can indeed help the economy and lift asset prices when the stimulus is big enough. Now, the question is, how long that stimulus boost will last?
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Disclosure: I am/we are long SYK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.