When we first featured this a while back, it was about the economy — and we’ll refer back to this outline as we build out our Market Barometers (Extended Version) today…

Economy at Stall Speed?

I finished Bailout Nation this weekend (7/11/2012). As most of you know, I’ve followed the work of author Barry Ritholtz for some time. The following are his thoughts from 35,000 feet about the state of the current economy. We’ll take a closer look at his barometers and see if we can build some findings that have some bearing on prudent asset allocation.

Source: http://www.ritholtz.com/blog/2012/07/7-factors-to-watch-in-a-slowing-economy/

The data continues to come in showing the global economy is slowing. The key question is whether this slowdown is to full on recession or merely a sloppy-muddle-through-barely-above-stall-speed economy.

With all of the cross currents out of Europe and the US, its easy to get distracted with less important nonsense. We watch all of the usual macro signs, but to find clarity, watch this earnings season. I want to especially pay attention to the following 7 factors:

• Transports have been very soft and confirm slowing global trade. Pay attention to UPS, Fed Ex, and Rails.

• A corollary is energy prices and the shifting revenues of the major oil companies.

• Retailers often feel the bite first. Middle market retailers, than luxe goods. Watch for signs of improvement amongst the discounters like WalMart, Target and the dollar stores as consumers feel stressed.

• Defensive issues such as Utilities and Consumer Staples attract buyers (but should not see big changes in revenues)

• Pay attention to visibility and revenue expectations from companies. I expect the uncertainty trope t0 be in full flower;

• More important than that, watch S&P500 Quarterly earnings growth; Is the rate of growth (2nd derivative) slowing?

• Valuations remain reasonable but not cheap; See where the SPX ends after earnings season is over.

These earnings are where the rubber meets the road, and I expect them to be telling.

We recently shared a graphic that we feels captures the importance (we’d dare say urgency) of balancing portfolios with a blend of blue chip stalwarts, medium-sized work horses and promising faster-growing smaller companies. Not the one on the right, the graphic here:

Advantage of Growth (Size) Diversification

“What about the other side? —@InvestEdInc

The ‘Too Big Of A Market Cap Stock’ Theory

Highlights:

• I don’t know about you, but have you noticed how big-cap stocks are being priced by the market? If you haven’t noticed, they are cheap.

Cheap? There’s more to “cheap” than P/E ratios. We know that P/E is just one piece of the puzzle and can be misleading or uninformative in the absence of more information. Here’s a look at our collection equally-weighted S&P 1500 components using three exchanged-traded funds from Guggenheim:

As you can see, none of the three — not even the S&P 500 — stands out with a dramatically high return forecast, even after a lost decade. The fact that all three groups have similar average growth forecasts also suggests a whole bunch of “cross pollination” these days.

• And if [lost decades are] the new norm in the large cap space — where stocks can go nowhere for years and years — why would someone want to be invested in a large cap stock over the long term, except of course for a good dividend? Also, is long-term stock appreciation not a possibility anymore with large cap stocks?

The problem was P/E compression. As Julie Werner has pointed out, Nardelli faced a lot of challenges at Home Depot (HD), but one of the bigger obstacles (from the perspective of generating superior shareholder returns as CEO) was the 40x current P/E at the time he plopped down in the CEO chair for the first time.

I don’t think lost decades are the ‘new norm’ in any stock category.

In fact, merely tendering the thought probably means that collective P/E expansion for the S&P 500 is around the corner.

Some people think it would be nice if we could just focus on the dividends. But we can’t — they’re just one piece of the puzzle too.

There’s price appreciation potential in stocks with lower growth rates. Hunt patiently.

• Assuming this totally out of the box theory of mine makes any sense, reach for smaller cap stocks and let stocks over $50 billion in market cap (or even less) for large institutional investors.

To some extent, it does. The challenge of cash deployment at Apple could very well mirror the attrition of serial M&A ten years ago at Cisco Systems (CSCO). The concepts of saturation probably apply — somewhat.

Our advice from a few months ago to hunt down faster-growing stocks can probably be tempered to shift back to an evenly distributed emphasis on smaller and larger companies. See: The Difference Between Tricks & Treats

But we stand by our time-honored recipe. All of the categories take turns leading at the dance. No one can tell you when or which partner is going to lead (and it’s certainly not obvious in those Guggenheim ETFs — at least not right now.)

In fact, we think the Guggenheim suggestion right now is shop amongst all three growth/size ranges. The return forecast stratification is as high as we’ve seen it in a while in all three classifications. Seek the highest quality companies and wait for their return forecasts to justify purchase. Hold them for as long as it makes sense to do so.

Mark Hulbert and I have compared notes on the Value Line Median Appreciation Projection (VLMAP) over the years. Yesterday we spent some time collaborating on our relatively new emphasis on the Value Line Low Total Return (VLLTR) forecast as another guiding resource for long-term investors.

Hulbert’s article for WSJ MarketWatch: Where Will Stock Market Be in January 2017?

Some thoughts after co-pondering this subject with Mark Hulbert for a few moments yesterday:

1. We know better than to believe in crystal balls. That said, I think successful investors need to remind themselves often about patience and discipline. And in this case — one of our greater gifts is the discipline (and I’d argue, freedom) delivered by an emphasis on returns, return forecasts and the oasis from chaos that shelters us from the noise of obsessing over prices and short-term noise.

2. Mark and I continue to find it intriguing and certainly counter-intuitive that forecast error for 4-year time horizons is apparently lower than 1-year versions (individual stocks and markets.) Quarterly forecast error is even higher. Dreman was right about that. But our emphasis on long-term trends and longer time horizons is actually another counter-intuitive oasis. We think we understand why people like Jeremy Grantham and GMO are comfortable with 7-year forecast horizons. Grantham merely smiles when “average investors” wail about GMO’s track record and philosophy of 7-year forecast time horizons.

3. As we said when comparing the actual vs. forecast for VLLTR, it’s the shape that matters. (In fact, Hulbert urged us to be more comfortable with the implications of that 2003-2007 “flat spot” … noting that a vulnerable stock market was finally whacked.) Investors who sought refuge in high-quality stocks (we did) or who ratcheted up cash equivalent allocations would have been served well during and after the Great Recession.

4. And of course, the flip side is that our back-up-the-truck moment in early to mid-2009 is vindicated as these quarters go into the long term track record “can” as noted in the article and previous post.

5. At MANIFEST, we like VLLTR better than VLMAP. VLLTR includes dividends (is not just annualized price appreciation). Yes, the shape is what matters … and VLMAP provides guidance on a relative basis. But actual results more closely resemble historical VLLTR and we the prefer the absolute over the relative wherever we can pursue it.