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.

Challenge Club

We’ll hold the January 2013 (online) session of the Challenge Club on Thursday, January 17 at 8:30 PM ET.

Think of it as an open house — guests welcome to lurk, browse and participate as we make decisions intended to improve the model portfolio.

Registration: http://www.manifestinvesting.com/events/106-challenge-club-january-17-2013

The Challenge Club is an investment club emulation — launched back in 1999. The central theme is (1) the maintenance of a model portfolio and (2) sharing of ideas in a learning environment. The tools and resources deployed are based on the lessons and methods of the modern investment club movement.

Since 1999, the annualized total return is 6.5%. Since the Wilshire 5000 (Total Stock Market, VTSMX) has gained 3.3%/year over the same time frame — the Challenge Club has a annualized relative return of +3.2% (i.e. an “alpha” of 320 basis pts).

During 2012, the internal rate of return for the portfolio was 14.3% for a relative return of +1.4%.

Portfolio Discussion and Analysis

The following images provide an overview of the holdings, current dashboard and diversification graphics.

• Overall Portfolio Return Forecast: 12.7% vs. 7.7% for market median — will get a boost when cash position is deployed.

• Overall Quality: Check. (81.6) Maintain relatively high levels of quality and financial strength (90% = A+) when the median return forecast is below long-term averages.

• Overall Growth Forecast: Check. 11.0% — the target range is 11-13%, so a blend of faster-growing companies should receive some emphasis while shopping for either accumulation candidates or screening for new additions to the portfolio.

• Sector Diversification: Solid.

One Big Picture

As 2011 came to a disappointing close, we shared an image from www.onebigphoto.com that featured a group of people huddled and looking out over a vista.

As 2012 comes to an encouraging and successful close — continuing to reinforce a solid long-term track record, our advice is the same. Seek refuge from the noise and chaos. Focus on what’s important — the patience and discipline encouraged by the founders of the modern investment club movement. Carefully consider growth, profitability and valuation during diligent studies and continuous vigilance. Challenge assumptions. (Most participants are probably happy with our partial sale of Apple last month, “20% ago”, even if you voted against it.)

No one promised you a straight line from “A” to “B”. If they did, they should occupy the cell next to Bernie Madoff. No, the road ahead will have curves, inclines and troughs … and yes, a few weeds along the way.

But reaching that crest to enjoy a good sunset with a bunch of friends is really what long-term investing can be all about.

Why do we pay attention to the Value Line low total return forecast?

Well, another quarter is in the can. With the quarter ended 12/31/2012, we’re able to compare the 4-year (3-5 years) forecast from 12/31/2008 (17.9%) versus the 4-year actual annualized total return in the Value Line Arithmetic Index (22.5%).

• This is a bottom-up forecast based on the continuous analysis of 1700 companies in the Value Line Investment Survey.

• It’s the shape that matters. We like what we see.

• We’re also comfortable that our median forecast (MIPAR, based on 2500 stocks) tends to track pretty well with the Value Line low total return forecast.

Following a recent day-long session on successful long-term investing that we presented in Chicago, a friend of mine walked up and asked, “Do you realize how HUGE this is?” I smiled, nodded and responded “Yes, I think so.”

When a successful long-term investor sees validation, confirmation and potential — we’re grateful and doubling down on the principles that generate these types of returns for legions of individual investors and investment clubs that we work with.

Core Diem vs. Balanced Budget: Update
January 15, 2013

We started this comparison demonstration a mere three months ago and the two portfolios are still running pretty much neck-and-neck, but they’re quite different — so it’ll be most interesting to see what happens with the next disruptive correction.

The relative return since inception for the Core Diem portfolio is +3.1% with an outperformance accuracy of 80%. Both portfolios have outperformed the Wilshire 5000 so far.

Core Diem: As a reminder, we invest an amount each day based on MIPAR into the three top of the top percentile stocks at Manifest Investing (MANIFEST Rank > 99.9). The amount depends on MIPAR. Yesterday, with MIPAR at 7.8%, we invested $7.80 into Coach (COH), Knight Transportation (KNX) and Qualcomm (QCOM). We’re still amazed at the accumulation into a fairly small group of stocks.

We make the same infusion ($7.80 times 3) into the Balanced Budget portfolio, in this case parking it in cash while we deploy between Gundlach’s bond fund and our Value Line Arithmetic Average proxy of three equally-weighted ETFs. The cash equivalents (bonds + cash) level roughly tracks the asset allocation recommendation from the Value Line Selection & Opinion — currently at approximately 45% cash.