September Stock Market Update

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In past posts I had discussed the dramatic effect that record setting corporate buybacks had in helping to lift stock prices. I knew this couldn’t last forever but it was difficult to determine when the tapering would begin. A colleague pointed out an interesting article written by Aswath Damodaran, a professor of finance at New York University that supports the notion that buybacks and financial engineering has to gradually slow in the next couple months.

While the article talks about the short comings of the CAPE ratio, that’s not what really interested me. What interested me was the discussion on the sustainability of cash flows. In 2015, companies that comprised the S&P 500 returned 105.59% of their earnings as cash flows. During the first two quarters of 2016 the percent of cash returned has risen to 112.18%. The last time the percent of earnings returned was over 100% occurred in 2007 and 2008 after the previous period of torrid stock buybacks. We all know what happened next.

While it can be difficult for investors to let the market play out, it eventually does. I still believe now is the time for investors to raise cash for better buying opportunities down the road. I’m not alone. According to a recent regulatory filing, Warren Buffett’s Berkshire Hathaway Inc. cash position is now at a record high of $72.7 billion. Warren is raising cash, waiting for a better business opportunity.

Consider this – Central banks are adding $200 billion of stimulus a month in an attempt to keep assets from falling and consumers confident. Companies are paying out more in cash than they’re making. Goldman Sachs’ David Kostin pointed out that the current median forward P/E for an S&P 500 stock is in the 98th percentile of its range dating back to 1976.

So let me ask you this – how willing are to bet your future funds that valuations for stocks will become the highest in history (on virtually all levels)? Stocks cannot, nor have they ever continued to drastically outperform their underlying business valuations for a long period of time.

The dominoes are starting to tilt and eventually will start to fall.

George Soros

George Soros is an investing legend that has made billions by placing large bets when he believes the market is very much out of kilter and the odds are in his favor.

Soros is often referred to as “the man who broke the Bank of England”. This moniker came from his bet vs the pound in 1992 which earned his Quantum Fund more than $1 billion and cost U.K. taxpayers more than $3 billion. He also has had similar success in 1997 in trading the Thai baht and in 2013 with the Japanese Yen.

George Soros had been enjoying retirement until recently, when the temptation became too great to simply watch the market from the sidelines. Soros has once again made a large wager. This time it’s against the market as he bought 4 million shares of put options over time on the SPDR S&P 500 ETF (SPY). It’s now his fund’s biggest holding.

When George Soros comes out of retirement to place a very large wager, I pay attention.

FOMC

Investors have been squarely focused on searching for yield and the “there is no other alternative” mantra during this ultra-low interest rate period. As I’ve pointed out, that mantra and lack of action by the FOMC has led to excessive valuations and low volatility in the market.

If/when interest rates do face the possibility of starting to raise, uncertainty will creep back into the markets and they will adjust accordingly. This is what we saw on Friday. The 2% drop in the markets came on rumors that the FOMC may tighten rates in September fearing that the window of opportunity is closing for them to do so.

Many investors became complacent, forgetting that two of FEDs key metrics, core inflation (CPI) and hourly wages are increasing to the 2% level they’re looking for to raise rates. The FED realizes that the window to raise rates is once again closing and they don’t want to make the same mistakes they’ve previously made.

Next week’s reports on retail sales, consumer sentiment and industrial production are among the last major economic releases that will help determine rather or not there will be a rate increase before the central bank meets Sept. 20-21. The market will more than likely face weakness until that time.

If the FOMC states that rates will stay low through the end of the year we should see a nice relief rally. If they announce a rate increase we will more than likely see continued weakness.

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