The Matrix Revisited

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule.

Friedrich Nietzsche

In my last blog post I laid out a fairly simple system we use to evaluate opportunity in the market and help guide our investment process for our clients. If you did not see it, I would encourage you to review it at

Today I want to focus on where we find ourselves at this point in time within this paradigm and make a prediction as to where we might go next.

First, with respect to valuation – we find ourselves in the most expensive decile observed over time. Just to highlight some of the metrics we look at to evaluate this:

Price to Earnings Ratio:  The last complete quarter for which we have reported earnings on the S&P 500 is 2Q2017, and the final calculation came in at $104.02. As I write this, approximately one-quarter of the S&P 500 companies have reported for 3Q2017 and the official estimate from S&P Dow Jones is $106.96. There is obviously a little uncertainty around what the final number will be when reporting season wraps up, but let’s agree that at present the S&P earnings are around $107 per share. As an aside, this will finally get us back to and slightly surpass the previous high in per-share earnings of $105.96 observed in 3Q2014 (3 years ago!).

Today, October 24, 2017, the S&P 500 closed at 2569.13. When you divide the index value into the earnings figure (2569.13/107), you get a price-to-earnings multiple of 24x. To put this into context, you are paying $24 for every dollar of earnings this basket of companies, weighted by market value, is generating at present. Is this a good deal?

Well, 1/24 equals an earnings yield of 4.17%. Does that sound reasonable? Maybe it does against a 10-year treasury yield of 2.4%, but historically it lands in the most expensive decile.

Price to Sales Ratio: These two charts speak for themselves. The first is the price-to-sales ratio for the index overall, weighted by index components (market capitalization) (Source:


The second looks at the median price-to-sales ratio among the 500 components of the index. In other words, if we were to look at all 500 companies and rank them on this one statistic, where would we find the middle observation, where half of the companies are more expensive on this one measure of value and the other half are less?:


Gets your attention, doesn’t it?

Any time you observe a statistic such as this one at an extreme reading, in this case easily an all-time-high, you have to stand up and take notice. This is especially true given that this particular statistic has a long history of reverting back to its long-term average observation of approximately 1.5x.

So, we know that within The Matrix, we currently find ourselves in the furthest column to the right, which implies disappointing returns over the next 10-12 years for buy-and-hold investors in strategies which closely mimic the S&P 500 index.

What about the y-axis? Well, that is the good news. On all ten of our questions surveying technical strength in the S&P 500 index, the answer is “yes.” Visually, this puts us here:


So, for the time being, we are moderately aggressive in holding equities for our clients. Despite the fact that the market looks very expensive on a historical basis, virtually every segment of it appears to be firmly in an uptrend. “Party on, Garth!”

I suspect that the next destination in the Matrix will be the dreaded Southeast quadrant, where both long-term and short-term prospects will look disappointing. It seems very unlikely that we will witness enough improvement in the fundamentals (growth in both sales and profits among the S&P 500 companies) to correct the overvalued observations without having a bear market in the process. The only way this would be possible would be for the collective top and bottom lines to grow faster than the index over the next several years, without experiencing any technical weakness over the intervening period. Anything is possible, but such an outcome seems like a very remote possibility to me.

In summary, I have a lot of respect for the current strength of the market, especially given the broad-based nature of it, and fully recognize that it may continue for a while longer and extend these valuation metrics even further than one would think possible.

Keep in mind that Nietzsche quote. We remain vigilant for signs of changing trends.

All investing involves risk and you may incur a profit or a loss. There is no assurance that any investment strategy will be successful. Keep in mind that individuals cannot invest directly in any index. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of David McKee and not necessarily those of Raymond James.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. U.S. government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Treasury bills are certificates reflecting short-term (less than one year) obligations of the U.S. government.

The Matrix

Over time, investors have developed hundreds if not thousands of systems to use as guides in trying to answer the two most basic questions of portfolio construction – what to own, and when to own it. Some of these are rather complex or downright arcane, while others are so simple they can almost seem silly. In 23 years in this business, I have come across many systems which seem like they have worked at various times, and may even be worthwhile to try and implement, but more often than not, it is easy to come up with reasons to pass because the case is either not compelling enough or there are practical limitations to implementation, such as trading costs or scalability.

There are two basic principles, however, which for me have cut through the clutter and have left an enduring impression on me. And I would argue that both are fairly uncontroversial in the world of investing.

The first is that you want to try and buy things when they are cheap and avoid them when they are not. Pretty obvious in principle, but deceptively hard to follow in practice for many investors.

The second is captured in the saying “the trend is your friend.” Specifically, for whatever reasons it may be in place, once a trend is established, it is more likely to continue into the near future than not. Of course that will not always be true, but in this business it is about stacking the odds in your favor, and logic would dictate that you want to own things while they are in an uptrend, price-wise, and avoid then when they are not. Again, kind of a no-brainer. If there are many (a majority of) components and sectors of a market in uptrends, we can call this “technically strong.”

We can look at these two simple principles in conjunction with one another to provide us with a sensible way to evaluate risk and make portfolio management decisions in a logical and dispassionate manner.

The Matrix is a tool I use to visually evaluate the present risk and reward relationship in the US stock market. It is presented below:


It is a simple 10-by-10 grid, where the horizontal or x-axis is valuation, and the vertical or y-axis is technical strength. I will describe how we evaluate the market along these two variables and apply the observation to our approach to investing in stocks.

The Standard and Poor’s 500 Index (S&P 500) generally consists of the 500 largest publicly-traded companies in the US. The actual number of components will vary slightly around this number on account of mergers and reorganizations but will always be pretty close to 500 – and while there are actually 7x that number of publicly-traded companies in America, the top 500 typically comprise more than 80 percent of the total value of US stocks at any point in time. As such, looking at what is going on with these 500 stocks is a good place to start.

It is also important to understand that the S&P 500 (and the Russell and MSCI indices for that matter) are all market-cap weighted. The practical consequence of this is that large companies, based on market value, have an outsized influence on the index. For example, as I write this, Apple Inc. comprises 3.66% of the S&P 500 Index. If all of the stocks in the index were weighted equally, that would be 0.20% each. At 3.66%, Apple has more than 18x the influence on the index that Micron Technology, which at #120, does carry a 0.20% weight. This implies that approximately 380 companies in the index each have even less influence than that. The point here is that these cap-weighted indices tend to be more than a little “top-heavy” and it can be very helpful to look beyond the changes in the index value itself to try and figure out what is really going on.

Although the S&P 500 has origins back to the 1920’s, it was expanded to 500 holdings in 1957, so we have data on this measure of US equities going back 60 years we can look at.

In terms of valuation, we look at four measures, and compare them to past observations. By developing a composite of these four numbers we make sure that we are not placing too much emphasis on any one of them:

  • Price-to-Earnings Ratio for the Index, as weighted by market-cap
  • Median Price-to-Earnings Ratio of the index components
  • Price-to-Sales Ratio for the Index, as weighted by market-cap
  • Median Price-to-Sales Ratio of the index components

After evaluating all four and comparing them to their histories, we can place the market into “decile” along the cheap/expensive axis. If the market is “cheap”, meaning that a composite of these statistics produced lower than average values, historically-speaking, then it would be in a lower decile and placed somewhere on the left hand side of The Matrix. If it is “expensive” (higher than average values) then it would land in a high decile on the right-hand side.

It should be said at this juncture that merely determining the market is cheap compared to its own history is a very poor timing tool. Just because something is cheap, that doesn’t mean that it can’t, or won’t become a lot cheaper before the overall trend reverses. Likewise, an expensive market can get a whole lot more expensive. As John Maynard Keynes once quipped, “The markets can remain irrational a lot longer than you can remain solvent.” In fact, the frustration which this tries to express has been a hallmark of human nature for centuries. Isaac Newton lost a whole lot of money in the South Sea Bubble of 1720. In the wake of this, he famously said “I can calculate the motion of heavenly bodies but not the madness of people.”

That is the bad news. In the short run, markets can do just about anything, no matter how disconnected from reality or what a prudent investor might consider reasonable in term of providing a fair trade-off between risks and anticipated returns informed by economic principles and history.

The good news is that, in fact, these valuation metrics have a long history of reverting to their respective means, and as such, are very valuable in terms of evaluating prospective returns over a longer time frame, such as 10 years or longer. I have seen valuation models using various measures of these two metrics (price-to-sales and price-to-earnings) which have better than a 90% coefficient of correlation to future 12-year returns. If we are trying to invest for something a decade or more into the future (virtually everyone), then failing to take full account of this data and the predictive value of it is extremely foolish. This is why the horizontal axis of The Matrix is labeled “Cheap (Good Long-Term)” and “Expensive (Bad Long-Term)” By “Long-Term” we are talking 10-12 years or more.

So, how does the vertical axis (Technical Strength) fit into this? It informs us as to what we should anticipate, or at least the most likely outcome, over the shorter run.

The methodology here is similar, except that here we are simply asking 10 yes-or-no questions about the S&P 500 Index and its components:

  • Six questions about what has happened to the index value itself over the previous 50, 125 and 200 days
  • Four questions which survey the 500 components and give them equal weight in the answer

The number of “yes” answers we get determines which decile the market is in from a technical perspective and where to place the market into The Matrix along the vertical axis.

Ideally, you want to see a situation where you end up in the Northwest quadrant (potentially good for both short and long-term), and if the overall market doesn’t get you there, then try to find markets that do (a sector, or overseas?). Alternatively, you clearly want to avoid markets when this exercise puts you into the Southeast quadrant (technically weak and expensive).

Where are we today? I will leave that for a future post in the near future – stay tuned!

All investing involves risk and you may incur a profit or a loss. There is no assurance that any investment strategy will be successful. Keep in mind that individuals cannot invest directly in any index. Sector investments are companies engaged in business related to a specific sector. They are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of David McKee and not necessarily those of Raymond James. Raymond James Financial Services and its employees may own options, rights or warrants to purchase any of the securities mentioned.

A Consolidation of Power

Andrew Adams, CFA, CMT, Senior Research Associate discusses public company consolidation and its impact on investors.

October 10, 2017

Is the stock market experiencing a consolidation of power among a few of the largest companies, and if so, why?

The stock market is shrinking in terms of the number of publicly-traded companies, a fact that is both a result of, and contributing factor to, the increasing importance of a select few, large companies. Since 1996, the total number of listed stocks in the U.S. has been cut in half – from 7,322 to about 3,600 – as annual mergers and acquisitions have doubled and the average number of initial public offerings per year has dropped considerably. Meanwhile, the share of gross domestic product (GDP) generated by America’s 100 biggest companies rose from about 33% in 1994 to 46% in 2013 according to The Economist, meaning not only are there fewer firms in total these days, but a small number of them are taking a greater piece of the pie.

The concentration at the top is, of course, primarily weighted toward the big technology companies, all of which have seen their products and services become increasingly integrated into the lives of their loyal cus­tomers. Through innovation, acquisition and the power of so-called ‘network effects,’ these modern-day conglomer­ates have built dominant, industry-controlling brands that continue to gain value as their huge user bases expand. The digital age has witnessed data evolve into the most important commodity in the world, and much of the suc­cess of these large tech companies is due to the ever-widening ‘data moat’ that exists between them and up-and-comers lacking that established network of bil­lions of existing customers.

Should investors and consumers be worried about the growing importance of mega-cap companies?

Despite the growing importance of these technology com­panies, the impact of the ten largest stocks in the S&P 500 has not really changed much over the last 40 years, even if the specific names on that list have changed. The ten big­gest stocks currently make up a shade over 20% of the index’s market capitalization, which is right around the average since 1980 when the more cyclical energy sector helped the ten largest companies represent a dominating 25% of the S&P 500. Today’s large tech companies also happen to be some of the most profitable, with Apple, Google, Facebook and Microsoft alone accounting for about 10% of the S&P 500’s total profits. As such, technology’s place at the top of the market is not unwarranted. Moreover, the roughly 23% of the S&P 500 that technology represents today is nothing compared to the 34% it comprised back in March 2000 at the peak of the dot-com bubble. Considering American corporate profits (as a percentage of GDP) are higher than they have been any time since 1929, elevated valuations in the stock market are warranted and investors don’t appear overly concerned.

Consumers have also benefited in a big way, with techno­logical innovation throughout history helping to bring down costs and prices, while making lives more convenient and requiring less manual labor. Per The Economist, tech com­panies provide Americans and Europeans with an estimated $280 billion-worth of “free” services per year, such as search results or directions. Even the stuff cus­tomers purchase provides tremendous bang for each respective buck. In their book Abundance, authors Peter Diamandis and Steven Kotler estimate that modern smart­phones contain roughly $900,000 worth of applications based on each piece of technology’s original manufactur­er’s suggested retail price in 2011 dollars (video conferencing, GPS, video camera, etc.), which illustrates the value being created by tech’s game-changing compa­nies. It’s no wonder these disrupting forces are raking in the profits and the cash.


How are the big companies using all that cash?

The success of the mega-cap stocks has not only pro­duced extraordinary profits, but it has also left the big tech companies with unprecedented levels of cash. As of June 2017, Apple, Alphabet, Microsoft, Amazon and Facebook together held $330 billion in cash (net of debt), and the S&P 500’s corporate cash as a percentage of current assets has basically doubled since 2000. Naturally, companies have had to find effective ways to use this cash; there has been a clear uptick in dividends, share buybacks, merger & acquisi­tions activity, and capital expenditures over the last several years. The share buyback policies have come under some criticism since they can help artificially boost earnings and sales per share numbers. However, buying back stock has been shown to help shareholders, and that is not the only way companies have been able to grow their businesses. The five aforementioned tech firms alone spent $100 billion last year on research and development (three times more than half a decade ago). These firms are definitely investing in the future. Finally, there is an estimated $2.4 trillion in cash held by U.S. companies overseas that is just sitting there not contributing much. Should tax reform occur next year and overseas cash comes home, Raymond James esti­mates share buybacks and the repatriated cash could improve S&P 500 earnings by an additional 1% – 2.5%.

Largest Companies

Savvy Steps to Stay Cyber-Safe

Defend yourself with simple, everyday practices that can help protect your identity, your accounts and your devices.

October 3, 2017
Americans lose tens of billions of dollars each year to financial fraud. In the digital frontier, many crimes – including identity theft, tax fraud and elder abuse – are committed by online outlaws, making cybersecurity all the more important. As cybercrime becomes more prevalent, learn how to defend yourself with simple, everyday practices that can help protect your identity, your accounts and your devices.

Fighting Fraud

Familiarize yourself with common scams to help protect your assets and your identity. Often, identity thieves pretend to be someone they’re not, whether they’re claiming to be from a legitimate organization, acting as though they are in love or purporting to be someone you trust. The effort is an attempt to induce you to reveal personal information, such as passwords or credit card numbers. Crimes such as these fall under the umbrella of phishing, a popular fraudulent activity.

Never click on the unknown. If you receive an email from a reputable company, go directly to their website. If you receive an unexpected email from someone you know, call them before opening it. Additionally, never reveal your passwords and only use credit card numbers on sites you’re confident are secure. If you have any doubt, refrain from revealing personal information.

Tax season is a notable time to take extra precaution as email compromise and mail theft tend to crop up each year and more than 237,750 tax fraud victims are reported to the IRS annually. Remember that the IRS will never request personal or financial information by email, phone, text message or social media, nor will they threaten you with lawsuits, imprisonment or other enforcement action if you have done nothing wrong. Elect to receive your tax forms online rather than in your mailbox, where they may be at risk of physical theft, and file as soon as possible to decrease the likelihood that someone will maliciously file on your behalf.

Prudent Prevention

By taking small steps toward a safer online presence, you and your loved ones will be less likely to experience a loss of personal information and privacy. There are a number of everyday practices everyone should follow.

  • Improve your passwords: Use complex and unique passwords that are different for each account. Include numbers, capital and lowercase letters, and symbols.
  • Take it one step further: Turn on two-step authentication for your accounts – a security process in which the user provides two means of identification rather than one.
  • Opt for biometric identification: On top of your standard password, consider adding a photo of your face, the sound of your voice or an image of your fingerprint to your protective arsenal.
  • Keep an eye on apps: Before you download an app, review the privacy policy and what data (such as location) the app can access.
  • Clean up your mess: Keep your electronics free from malware and viruses. Apply updates and patches on computers and mobile devices as soon as possible, and wipe computers and mobile devices of data before selling or disposing of them.
  • Use public wireless networks with caution: Avoid visiting sensitive websites or conducting financial transactions on an unsecure network.
  • Post prudently: Be mindful of what you’re posting to social media platforms, and avoid sharing personally identifiable information. Check privacy settings to ensure that you are not sharing your profile with people you don’t know.
  • Be alert to risks online: Never open attachments or links in suspicious emails or from senders you don’t recognize.
  • Secure your information: Keep software up to date and install an antivirus product. Shred sensitive material or store securely in a digital or physical vault.

Post-Theft Protection

The Federal Trade Commission reports that 11.7 million people are victims of identity theft each year. Should your information be compromised, these are the actions you should take.

  • Contact the Federal Trade Commission: Call to report the issue or access the online complaint form. Visit the FTC’s identity theft website for more information.
  • Report the incident: File a police report, and retain a copy as proof.
  • Contact creditors’ fraud departments: Close affected accounts and speak with someone in the security or fraud department. Notify credit card companies and banks in writing. Follow up with a letter for affidavit as well as copies of any supporting documents. Order new debit and credit cards.
  • Alert credit bureaus: Report the breach to one of the three major credit bureaus and ask for credit monitoring, fraud alerts, credit freezes and copies of your credit reports.
  • Keep good records: Notify businesses and agencies by phone and in writing. Log dates, times and the names of people you spoke with as well as what they tell you. Keep copies of any correspondence, and use certified mail, return receipt requested.
  • Reset your passwords: Consider using password manager software if needed. Experts blame weak or stolen usernames and passwords for 76% of data breaches.
  • Check for additional fraudulent activity: Watch your monthly statements, emails and regular mail, sign into Investor Access, and call your advisor to report suspicious activity.
  • Other steps: Contact the Social Security Administration, the Postal Inspection Service or your issuing driver’s license office if your Social Security card, mail or driver’s license has been stolen.

Talk to your advisor about these and other ways you can protect yourself and your accounts. Together, you can explore options like secure file sharing, fraud and consumer preference text alerts, and two-factor authentication.