US Stocks-ETF Account Strategy Changes

US Stocks-ETF Account Strategy Changes
May 14, 2011
David R. Kotok


There were big changes in portfolios last week.

We downgraded materials and energy. Those accounts have moved to underweight from overweight. Healthcare was upgraded again and is now the most overweight. Consumer staples are also overweight. So is telecom. In addition, there is a cash reserve.

For the moment, we are not fully invested. When we apply our allocation methods to the sectors of the S&P 500 and modify the weights for the relative size of a sector, we cannot find enough sectors to invest 100% of a portfolio. That is a warning sign to raise some cash.

Another warning sign is an indicator named for the late Yale professor James Tobin. Tobin’s Q is an estimate of the value of the stock market vs. the value of the replacement of the assets that are represented by those underlying stocks. One can do this estimation for the market as a whole or for sectors and industries within the market. For example, when manufacturing stocks are cheap it is more economical to buy capacity on the stock exchange than to go and build a plant. When stocks are richly priced, the opposite is true.

Harvard Professor Greg Mankiw estimates Q on his blog. See: He compares data derived from the Federal Reserve with the total stock market, using a Vanguard ETF. The chart on his website tells the story. Bottom line: stocks are not cheap. They were two years ago. They are getting expensive now.

Note that Q does not tell you when to trade. It is not a short-term trading guide. It does tell you when valuing levels are cheap or richly priced. Today Q is sending a very clear message that the US stock market is vulnerable to a correction, because it is pricing assets higher than their replacement cost.

A third warning sign is found in the ratio of total stock market value to GDP. We use several methods to calculate this one. GDP is estimated by US statisticians and is readily available to anyone who seeks the information and its revisions. Stock market capitalizations are another matter. One has to beware of double counting from ETFs and from exaggeration of totals from debt-like instruments and preferred stocks. These also trade on the exchanges and distort the actual total equity numbers.

We use World Federation of Exchanges aggregates and we use the exchange estimates from each exchange. We also use Ned Davis’ extensive database. Ned tries to exclude the influence of preferred stocks. In the current environment, all three methods are giving us warnings signs that US stock market value is very high relative to GDP.

One sector that is currently underweighted in our portfolios is the financials. They have underperformed for some time. They were over 23% of total market valuation at their peak before the financial crisis. They accounted for over 40% of the reported earnings of all US stocks. They included firms like Fannie Mae and Lehman Brothers and AIG. Now Financials remain under 16% of the S&P 500 index. Only the technology sector is larger, at almost 18%. For reference, healthcare is 11.4%.

We discussed these sector weights in our May 9 interview with Mark Haines and Melissa Lee on CNBC Squawk on the Street. See: The key point is getting these weights “right.” Readers may find the interview on sectors worthwhile. It is only a few minutes.

While the macro stock market indicators have been warning investors, the market has favored commodity-oriented sectors like materials and energy. Those have done quite well and have been the leaders until last week. Now the CME has imposed margin requirements that shocked the markets. That is an additional warning sign; it piled on the valuation level indicators. It was enough for us to make an immediate change. It started with silver and had it been limited to silver we would have stayed the course. However, it expanded and now includes oil and other commodities. It adds to the risk premium on all commodities because the future actions of the CME have now become unpredictable. That news was the catalyst for an immediate change in our strategy.

The news actually broke on Monday night while we were doing a joint interview with John Kilduff and Sri Jegarajah on Squawk Box Asia with Martin Soong and Karen Tso joining in. John Kilduff actually read the summary of the CME release on the air. Such is the world that breaking news in the financial arena comes on air from a Singapore-based studio connected live to New York via satellite and one of the parties is reading the release from a Blackberry. In the US, it was almost 7 PM.

Readers may not know that Sri compiles an oil price sentiment survey on a regular basis and publishes it on CNBC-Asia. John Kilduff and I are both participants.

Anyway, as soon as we exited the TV studio, we immediately started to put the energy sector profits in the bank and went from overweight to underweight. That was initiated and completed last week in all US stock ETF accounts. Increases in margin requirements have a history of triggering selling. That is a trading indicator. In the CNBC interview on Squawk Box Asia, I call it a “game-changing” event.

The change realigned many weights for us and raised some cash. We have not finished realigning weights on the buy side and clients come ahead of readers, so this is all we can say now.

It has turned out that “Sell in May and go away!” may yet be applicable in 2011. Time will tell.

David R. Kotok, Chairman and Chief Investment Officer

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