Timing for investing cash into equity markets

Friday, September 02 2011

Given the recent volatility in the markets, we thought it would be a good time to revisit timing to deploy cash into equity markets.   Investors should develop an investment “battle plan” and stick to it.  A very good article titled “Reinvesting when terrified” by Jeremy Grantham, (GMO) is located at the end of this report.

Whilst no one can predict the bottom of equity markets, a discipline approach should yield good returns in the longer run.

Three indicators we feel dictate good times to deploy cash are valuation indications, news flows and sentiment.

Valuation Indications Dividend yields verse cash and or bonds a
Price to earnings ratio verse history a
Company health a
Sustainability of dividends a
Earnings growth x 
News flow Global economic growth x 
Company M&A and good reporting season a
Sentiment VIX a
Cash levels are high a
Technical indicators x 

Valuation Indications

Valuations are very attractive.  Dividends of the major banks are well above the market and well above TD’s.  Dividends look maintainable and interest rates are likely moving down.

The dividend yield of the market is well above the 90 day bank bill rate.

The PE of the market is below historical averages.

Company Health

Australian companies leading into the GFC had relatively high levels of debt on their balance sheet.  Shareholders wore the pain of dilutive capital raisings during the GFC to pay down debt levels.  This has lead to many Australian companies becoming arguably under geared.

Increasing dividends and payout ratios represent a low risk and easy path for many companies and boards. We are seeing increases in dividends given a more supportive balance sheets.  We note pre GFC a number of companies were paying dividends out of debt (infrastructure, property trusts).  This is no longer the case.

Earnings Growth

The Australian market is forecasting 12% earnings growth in 2012.  This looks at risk given the softer economic conditions.  We note that the weakness will be offset by (presumably) a lack of floods, Tsunamis and interest rate rises.

The downgrade cycle has continued this reporting season overall with a downgrade of 2%.  The market is pricing in a fall in earnings of around 20% to get back to a PE of 13.5 which seems excessive.

News flow

News flow outlook is negative driven by likely economic data from the US and the lack of a decent policy response from Europe.

The two main pieces of better news that could emerge include potential policy reponses such as interest rate rises and M&A pick up given the strength of balance sheets.

US Economic Outlook –

Consumer Sentiment has fallen which is driving a deterioration of economic data.

We can expect further falls in the ISM (Manufacturing indicators).  The market remains worried about this data point.  As can be seen below when the ISM falls below 50 it can sometimes indicate a recession (but not always). Once the market becomes comfortable regarding the extent of the US slowdown then we can expect a rebound.

Most companies discussing their results highlight that they are not seeing signs of a significant deterioration in activity (at this point). Furthermore we highlight a couple of factors which will offset the expected slowdown:

  • US housing market is very soft, inventories have reduced and it is unlikely to fall from such a low level and create a drag on the economy like it did in 2008.
  • Likewise inventories have been run down and do not have far to fall as they did in 2008.
  • Car manufacturers supply chain will bounce back from the Tsunami.
  • Lower oil prices.
  • Most corporates are in excellent health from a debt perspective. Corporates and consumers have been de-gearing.

Sentiment

Volatility Index

The VIX is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30 day period.

The chart of the VIX can be seen below.

Historically, when the VIX Index trades above 48.5, this generally has proven a good time to invest into equities.

How the S&P traded after the VIX traded over 48.5

Cash levels are high

Post the global financial crisis flows into term deposits have increased dramatically.  Over the past 2 years, nothing has flowed into equity funds whilst term deposits grew by $230 billion. US equity funds have recorded $43 bn of outflows in August – third largest monthly outflow on record.

The Australian household balance sheet is underweight shares compared to cash.

Technical indicators

One technical indicator is the move of the moving average of shares.  The chart below highlights the move in the 10 week moving average and the 50 week for the S&P500.    This can be a useful measure for looking at turning points in the market.   We have produced the chart back to 1986 below.  The short term 10 week moving average has crossed the 50 week moving average on 7 occasions.  It was a very useful measure of the turning point in 2001 and 2007 but not so much on the other occasions.

In an excellent book by Anthony Boeckh (Chairman BCA Research) called the Great Deflation he argues that using the moving averages in addition to other tools can enhance their usefulness.  The other tools he describes include valuation and psychology or sentiment (which we have noted above).  We think there are some key differences on these indicators compared to 2001 and 2007.  Specifically :

  1. Markets were very excessive in 2001 and 2007 with substantial froth.  Valuations were stretched, balance sheets were poor.
  2. There were a lot of companies going broke – Enron, Worldcom, Centro, Lehmans etc

The main similarities include concerns have emerged regarding global growth rates which also occurred in 2001 and 2007 and subsequently led to ugly recessions in the US.

Conclusion

Long term indicators are very supportive of equities – valuation, cash levels, sentiment.  Short term indicators remain mixed – newsflow, technical.   The short term could turn on the back of a change in policy settings or as the market gets a sense of the depth of the downturn.

We thought we would include an interesting article by Jeremy Grantham which was written in March 2009 about investing when terrified.

Reinvesting When Terrified

Jeremy Grantham

GMO article March 2009

It was psychologically painful in 1999 to give up making money on the way up and to expose yourself to the career risk that comes with looking like an old fuddy duddy.

Similarly today, it is both painful and career risky to part with your increasingly beloved cash, particularly since cash has been so hard to raise in this market of unprecedented illiquidity. As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution. Every decline will enhance the beauty of cash until, as some of us experienced in 1974, ‘terminal paralysis’ sets in. Those who were over invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brilliance. So almost  everyone is watching and waiting with their inertia beginning to set like concrete. Typically, those with a lot of cash will miss a very large chunk of the market recovery.

There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer. This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines. It is particularly important to have a clear definition of what it will take for you to be fully invested. Without a similar program, be prepared for your committee’s enthusiasm to invest (and your own for that matter) to fall with the market. You must get them to agree now – quickly before rigor mortis sets in – for we are entering that zone  as I write. Remember that you will never catch the low.

Sensible value-based investors will always sell too early in bubbles and buy too early in busts. But in return, you may make some important extra money on the roundtrip as well as lowering the average risk exposure. For the record, we now believe the S&P is worth 900 at fair value or 30% above today’s price. Global equities are even cheaper. (Our estimates of current value are based on the assumption of normal P/Es being applied to normal profit margins.) Our 7-year estimated returns for the various equity categories are in the +10 to +13% range after inflation based on an assumption of a 7-year move from today’s environment back to normal conditions.

This compares to a year ago when they were all negative!  Unfortunately it also compares to a +15% forecast at the 1974 low, and because of that our guess is that there is still a 50/50 chance of crossing 600 on the S&P 500.  Life is simple: if you invest too much too soon you will regret it; “How could you have done this with the economy so bad, the market in free fall, and the history books screaming about overruns?” On the other hand, if you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot. We have tried to model these competing costs and regrets. You should try to do the same. If you can’t, a simple clear battle plan – even if it comes directly from your stomach – will be far better in a meltdown than none at all. Perversely, seeking for optimality is a snare and delusion; it will merely serve to increase your paralysis.  Investors must respond to rapidly falling prices for events can change fast. In June 1933, long before all the banks had failed or unemployment had peaked, the S&P rallied 105% in 6 months. Similarly, in 1974 it rallied 148% in 5 months in the UK! How would you have felt then with your large and beloved cash reserves? Finally, be aware that the market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but just a subtle shade less black than the day before.

Battle plan for investing cash

We feel the above indicators are in the favour for deploying cash albeit with some caution.  The market is currently trading at attractive valuations but momentum is weak.  As GMO article stated a battle plan is needed to begin investing.

  • One must firstly determine how much to invest in equities from a long term perspective.
  •  Accept valuations are attractive and look to invest a proportion say 50% at current levels.
  • Invest a further 25% if the market falls by 8%; or in two months, if markets are at current levels or below.
  • Invest the remaining 25% if markets fall by a further 8% or if markets are below where they are now in 4 months.

Battle plan for investing cash

 

We feel the above indicators are in the favour for deploying cash albeit with some caution.  The market is currently trading at attractive valuations but momentum is weak.  As GMO article stated a battle plan is needed to begin investing.

  • One must firstly determine how much to invest in equities from a long term perspective.
  •  Accept valuations are attractive and look to invest a proportion say 50% at current levels.
  •  Invest a further 25% if the market falls by 8%; or in two months, if markets are at current levels or below.
  • Invest the remaining 25% if markets fall by a further 8% or if markets are below where they are now in 4 months.

 

 

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