Economy and Markets

The stock market continues to inch upward, fueled by a flow of predominantly strong earnings reports. Tensions continue to tighten on the geopolitical front, but stocks aren't showing much concern in that respect or regarding the stymied progress on policy change.

Year-to-date (as of September 19th), the S&P 500 has gained 12.01% to 2,507. The big winners by sector are: information technology (+25.58%), healthcare (+19.90%), materials (+13.23%) and utilities (+11.48%), with energy and telecommunications continuing to lose ground by 11.65% and 11.40%, respectively. The Dow Jones Industrial Average rose to 22,372, gaining 13.24% year-to-date, while the tech-heavy Nasdaq reflects that sector's enduring strength with a gain of 20.01% so far this year to its current level of 6,460.

For the first time since February, core CPI did not come in below expectations, hitting the consensus with a modest 0.2 percent gain. Overall prices rose slightly more than expectations at 0.4 percent. Components of the growth included housing and transportation, both up 0.4%. Including fuel, transportation costs rose sharply (by 1.4%)--energy costs rose by 2.8% (in part reflecting month-end pressure from Hurricane Harvey) and gasoline increased by 6.3%.

U.S. import prices rose by 0.6%, well above consensus and the biggest gain in 7 months. Housing starts for July totaled 1.18 million, above the expected 1.175 million. Mortgage application traffic rose by a seasonally adjusted 11% in the first week of this month.

Last week's report of new jobless claims came in at 298,000, below the consensus estimate of 302,000. Volatility in these numbers is expected in the coming weeks as the effects of Hurricane Harvey and Irma manifest, however (and Maria continues to bear down on Puerto Rico). Data for the week of September 2^nd shows the unemployment rate holding at 1.4%.

Retail sales fell 0.2% in August versus an expected dip of 0.1%. The Commerce Department did not isolate the impact of Hurricane Harvey's late month hit on Houston but weakness in auto sales, which fell 1.6 percent, and strength at gasoline stations, up 2.5 percent on higher prices, might indicate a link. Within the sector, restaurants sales were up 0.3%, furniture rose by 0.4%, offset by dips in apparel sales (-1.0%) and non-store retailers (-1.1%).

The consumer sentiment index for September fell to 95.3 from 96.8 in August, with both 1-year and 5-year inflation expectations up 1 tenth to 2.7% and 2.6%, respectively.

The market P/E is 24.11, about on par with a year ago.

Recommended Reading

Many subscribers are familiar with Validea's Guru Investor blog (launched in 2008), in which we offer highlights of interesting articles and investment commentary that is helpful to investors and that we believe stands out from the daily market noise. In case you missed our recent posts, here's a short list:

• Byron Wien's Market Insights from Annual Lunch Series: Barron's article summarizes takeaways from Byron Wien's annual summer luncheons series. Read full post
• Market Forecasting Difficult: The Economist discusses the difficulty analysts face in forecasting returns given the current market's stretched valuations. Read full post

• Podcasts of the Week: Dalio, Bass, Gardner & Egan: Our Jack Forehand shares his weekly list of favorite podcasts. Read full post
• Buffett Converts BofA Warrants: Bloomberg reports that Buffett recently exercised warrants to purchase 700 million shares of Bank of America common stock. Read full post
• Market Forecasting Difficult: The Economist discusses the difficulty analysts face in forecasting returns given the current market's stretched valuations. Read full post
• REIT Outperforms Through Active Management: Institutional Investor article on competition faced by active stock managers from low-cost index funds. Read full post
• Poor Market Breadth is Sign of Pullback, But No Bubble Envisioned: The Wall Street Journal outlines "worrisome signals" that could be pointing to weakening market momentum and a possible pullback. Read full post
• Dalio and Gundlach Say Emerging Markets are Risky:A host of concerns across the globe are raising red flags for heavy-hitting investors such as Ray Dalio and Jeffrey Gundlach, says a recent Bloomberg article. Read full post
• Preserve and Grow Your Wealth with Good Habits & Discipline: Our John Reese shares insights on getting rich versus staying rich. Read full post
• GMO Paper Says Indexing the S&P 500 is Risky: A recent MarketWatch article offers a synopsis of a GMO white paper that argues against a predominantly index-focused investing strategy. Read full post

Latest Changes

David Dreman and Investor Psychology

It seems that nearly every day investors are faced with emotion-triggering events. The news media is churning out a steady stream of presidential tweets, North Korean saber rattling, and what seem like weekly natural disaster-related tragedies.

Powerful emotions are nothing new to the markets, however. In the late 1990s, the rise of the Internet sent stocks -- particularly tech stocks -- soaring, and many investors were swept up in the euphoria. But the bursting of that bubble in 2000 turned visions of endless profits into the reality of devastated portfolios. Then the real estate bubble began to inflate, and buyers across the country were consumed with visions of homeownership, and/or quick, easy profits. But, of course, those dreams turned to nightmares when the housing bubble burst. Panic set in in the fall of 2008, with unemployment spiking, lending seizing up, and the "D"-word -- Depression -- swirling.

Today, as the gray-haired bull market pushes forward, many fear the "other shoe" is about to drop, even though there doesn't seem to be any clear-and-present danger. There are as many theories as there are "expert" prognosticators, but the fact remains that none of them can possibly know for sure what will ensue. Still, the market are prone to quickly react to the latest soundbite.

Investor behavior is firmly rooted in psychology, a notion that's evident in all the guru-inspired stock screening models I created for Validea. One of these gurus, however, dug into this field of study more than most others--David Dreman, author of several books, the most recent being Contrarian Investment Strategies: The Psychological Edge. Dreman (who founded his own investment company) is also on the board of directors of the Institute of Behavioral Finance, publisher of the esteemed Journal of Behavioral Finance.

In his books, Dreman presents an implementable, proven strategy for investing while also addressing the psychological reasons that many investors fail. He argues that investors can't follow simple strategies to beat the market because they are prone to overreaction. Under certain, well-defined circumstances, in fact, Dreman argues that investors overreact predictably and systematically. In the latest work, Dreman shares a number of very interesting and relevant pieces of data and research and addresses the notion of "Affect" and its impact on investors.

Affect and Decision-Making

Dreman writes that psychologists have begun to recognize and understand the critical role Affect plays in people's decision-making and the manner in which our minds tag representations of objects or events with positive or negative feelings. "A rabid sports fan, for example, will have positive representations for a favored sports team and negative ones for an archrival team," Dreman writes.

Although this may seem obvious, it's important to understand how it works within the "dual-process" dynamic our minds use to make decisions. One part of that process is the "rational-analytic system", which is deliberative and analytical and evidence-based, Dreman notes. The other part of the process is where Affect comes into play -- the "experiential system", which draws on "information derived from experience and emotional recall and encodes reality into images, metaphors, and narratives to which affective feelings have been attached," Dreman writes.

The emotion-based experiential system, therefore, functions much faster than the rational analytic system -- though it often is a far worse investment decision-maker than its rational counterpart. "In periods of great anxiety and uncertainty," writes Dreman, "it is quite natural for the experiential system, often dominated by Affect, to take over." During such times, fundamentals and facts fall by the wayside and a herd mentality often takes over - which can lead to disastrous results for the investor.

In order to combat the impact Affect has on your decision-making processes, of course, you have to recognize it. According to Dreman, the four earmarks of Affect are:

• Insensitivity to probability: Dreman cites several studies showing that once people attach a positive Affect to something, they don't care how expensive it is -- they become convinced it will only continue to gain in value.
• Negative correlation between risk and benefit-- When we view something as "good", i.e., with positive Affect, we tend to think it entails less risk. When we view something as "bad", i.e., with negative Affect, we tend to think it involves more risk -- regardless of the facts and data. So, for example, when the tech stock bubble formed, the positive emotional response people had when they thought of tech stocks actually caused their brain to underestimate the amount of risk associated with those stocks, which was of course quite substantial.
• The Durability Bias: Investors overestimate how long a positive or negative event will impact a company, its stock, its industry, or the market itself, Dreman says.
• Temporal Construal: Studies also show that when people look at a company's short-term prospects, they are more detail- and fact-oriented. But when the look at the longer term, they let vague feelings drive their decisions.

Portfolio Applications

The notion of Affect and the latest research into the concept supports something Dreman's argument that investors allow emotions to make them overvalue stocks that are considered "good" -- those flashy stocks with exciting growth stories behind them -- and undervalue stocks that are considered bad -- those that are getting bad press because of short-term problems, industry concerns, or some other factor. Because of that, buying unloved stocks -- those trading at low prices compared to their book value, earnings, cash flow, or dividend payout -- has been a very profitable strategy over many decades. Investors overreact in the short term, pushing the prices of these stocks down too low; then, once rationality returns to the market, those stocks tend to bounce back strongly.

The Dreman Investment Strategy

In order to find stocks that are undervalued based on their fundamentals, Dreman compared a stock's price to four different financial variables that measured the strength of the company's underlying business operations; earnings, cash flow, book value and dividend yield. He looked for ratios falling among the bottom 20% of the overall market, which is how I also structured my Dreman-based screening model (in order to pass my screen, at least two of the four ratios must fall within that range):

1. Price-Earnings Ratio: Global investment firm KKR & CO. L.P. (KKR) meets this requirement.
2. Price-Cash Flow Ratio: If a company's share price is low relative to its operating cash flow, Dreman viewed this as a good indication that the stock is undervalued (he defined cash flow as after-tax earnings plus depreciation and other noncash charges). Communications company AT&T Inc. (T) fits the bill.
3. Price-Book Ratio: Book value is defined as the value of common stock less all liabilities and preferred shares. Investment management firm Oaktree Capital Group, LLC (OAK) gets a thumb's up according to my Dreman-based screen.
4. Price-Dividend Ratio: Our model (as did Dreman) treats this as a criterion to be used in conjunction with the other three as using it alone would be appropriate primarily for income-seeking investors.

In addition to the four ratio tests, Dreman focused on a company's size and earnings power, believing an investor is less exposed to the risk of accounting gimmickry when investing in larger firms. He also felt that since larger companies are more in the public eye, then tend to have more staying power. Our model, therefore, focuses on medium- to large-sized companies by requiring that a stock is among the 1,500 largest publicly-traded stocks.

Regarding earnings, our model requires the most recent quarter to exceed the previous quarter and, for non-cyclical companies only, for earnings to have grown more than those of the S&P 500 for the prior six months (expected growth for the current year has to exceed that figure as well). Chile-based electricity company Enel Generacion Chile SA (EOCC) meets this requirement.

Finally, the Dreman-based model looks for as many healthy financial ratios as possible to ascertain a company's financial strength. Dreman wanted to be sure he was investing in strong firms whose stocks were being beaten down because of irrational fear or negative hype - not firms whose stocks were struggling because of long-term financial problems. The following criteria, therefore, form part of our Dreman based model:

• Current Ratio must be greater than or equal to 2;
• Payout Ratio (the percent of a company's earnings paid out in dividends) must be less than the stock's 5 to 10-year historical average, indicating leeway to increase dividends going forward;
• Return-on-Equity must be in the top-third of the 1,500 largest-cap stocks. The best case would be an ROE exceeding 27%;
• Pre-Tax Profit Margin of at least 8% with a best case being anything over 22%;
• Yield of at least 1 percentage point higher than that of the Dow;
• Debt-Equity Ratio less than or equal to 20%, with a best case being a debt-free balance sheet.

After a tough couple years the Dreman strategy has been bouncing back recently. Year-to-date, our Dreman-based,10-stock portfolio has returned 18.3%, versus 9.8% for the S&P 500. In 2016, our portfolio returned more than three times that of the S&P 500 (30.5% versus 9.5% for the index).

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