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Why Investor Sentiment May Not Be A Contrarian Indicator Anymore

Investor sentiment indices such as the AAII have been extremely bearish since this summer, before the August downturn. Many analysts have pointed to this bearish sentiment as a contrarian, and therefore bullish, indicator. However, the bearish investors this summer were proven right in August, and they may well be proven right again in October. Sentiment surveys may no longer reflect the opinion of as substantial a portion of the market as they used to. Also, the spreading knowledge of technical analysis in recent years may have made average investors — lo and behold — smarter than they were in 2007-2008. Since this summer, well before the August downturn, a variety of measures of investor sentiment have given extremely bearish readings. Headlines appeared in July that investors are the most bearish that they’ve been in 15 years, and similar headlines still appear in September. And it is now typical for the articles about these bearish sentiment measures to point out that historically such sentiment readings have been a contrarian indicator: Extreme bullish sentiment has tended to indicate that a bull market has peaked and is about to decline, while extreme bearish sentiment has tended to indicate that a bear market has bottomed and is about to rally. Strangely, though, this year bearish sentiment exploded before the bull market even entered a correction. Some analysts still point to the sentiment now and use it as an argument that we are only in a correction, not a bear market, and that the bull market will soon resume its march higher. I doubt this very much. Rather, I argue, this year — for once — investor sentiment was and is on the money about the direction of the market. Investors were and are right to be bearish. So why is investor sentiment no longer a contrarian indicator in 2015? This is a very good question, so allow me to offer a couple plausible explanations. First, the individual investors whose sentiment is being measured in the surveys may not represent as substantial a portion of the market as they used to. Large institutional investors make up an even more dominant share of the market than they did 7 years ago or 15 years ago. Trading driven by computer algorithms is certainly a much bigger factor in the market than it ever was before. This summer, individual investors felt the fear before the technical indicators alerted the computer algorithms that something was wrong. Another factor in recent years is the flood of money from overseas that has been seeking out relative safety in the U.S. stock markets. Most of the sentiment indicators probably do not incorporate the opinions of overseas investors as much as those of American investors, so the surveys are likely overlooking relatively more bullish sentiment from overseas investors, who have been happy to buy U.S. stocks rather than Asian, European, or other stocks. Second, the spread of technical analysis itself may be a factor in the sentiment readings since August (most technical indicators turned negative slightly before the market downturn). Individual investors have far more access to the basic principles of technical analysis than they did 15 years ago or even 7 years ago. The technicals were flashing danger signs almost an entire year before the 2008 crash, but most investors were not aware of them or ignored them. Today there is far less ignorance or lack of awareness of such information among investors. Many more people now know how to read a simple chart of the price, the 50-day moving indicator, and the 200-day moving indicator of a stock or index. And even such simple charts give an accurate enough indication to tell individual investors to be bearish before the market has bottomed, rather than waiting until after the market has bottomed to suddenly panic. Moreover, the type of knowledgeable investor who understands technical analysis is precisely the type of investor who is also likely to be a member of the American Association of Individual Investors and reply to their sentiment survey. The investment newsletter advisors whose sentiments are measured in the Investors Intelligence survey are also more likely to follow the technical charts. I strongly suspect that newsletter advisors too have increased their knowledge of basic technical analysis a great deal in the past 7 years. On the other hand, the more passive “buy and hold” investors, and the people who simply put part of their 401k money in an S&P 500 index fund and never make any adjustments to it, are less likely to pay enough attention to turn bearish before the market completely crashes and they panic. Their sentiments are also less likely to be captured in investor sentiment surveys. In summary: The type of active investors whose opinions tend to be measured in sentiment surveys may well have gotten a lot smarter now than they were 7 years ago or 15 years ago! I dare say websites such as Seeking Alpha may have contributed to this increase in investor education. There is still a lot of dumb money out there, but at least there’s hopefully less of it, especially among investors such as those who read Seeking Alpha.

Middlesex Water Is A Dividend Aristocrat

Middlesex Water Company has a remarkably safe, growing dividend, with a current yield of over 3%. Using a constant dividend growth model, investors will find that the current stock price is slightly below the fair value. Investors looking for a safe utility company with a steady dividend should take a look at Middlesex Water Company. Middlesex Water Company (NASDAQ: MSEX ) could be one of the safest dividend stocks in the market. This is a water utility company operating in central and southern New Jersey, as well as Delaware and northeastern Pennsylvania, which include some of the highest-income areas in the nation. As a water utility company and a company whose customers are overwhelmingly wealthy, Middlesex Water Company is able to provide a remarkably safe dividend, with the current 3%+ yield representing a payout ratio of under 70%. Furthermore, recent developments in New Jersey (where Middlesex Water Company operates most of its business) should allow the company to grow earnings and maintain its healthy dividend. Governor Chris Christie recently signed into law the Water Infrastructure Protection Act , which allows municipalities to sell their water systems to water companies. So while utility companies have typically been seen as safe investments, in New Jersey they can be considered safe and also have the potential for growth. These developments show that the Middlesex Water Company’s dividend should be safe, and that earnings growth opportunities in the future could potentially provide an additional incentive to invest. If the under 70% payout ratio is not impressive as it is, the company has made a cash dividend payment every year for 102 years, even in the midst of the financial crises. Furthermore, Middlesex Water Company has raised its dividend every year for 42 years. (click to enlarge) This is a perfect case of a dividend stock, and a stock that many investors will only purchase for the safety of its dividend. Thus, we can safely use the dividend growth model to find its value. Excluding that one quarter blip, Middlesex Water Company has raised its dividend every four quarters by .25 cents, for an annual increase in its dividend of 1 cent. While this nominal growth rate is constant, in order to use the dividend growth model, we must come up with a percentage rate. The percentage rate will be declining year after year, even as the dividend growth remains at a steady 1 cent increase. For next year, the dividend growth rate is represented by .01/.77 = 1.3%. In about 25 years, we know this rate will decline to just under 1%, so we can split the different and use a rate of 1.15%. This assumes the investor will be holding the stock for a period of 25 years. For our required return rate, we will use the Weighted Average Cost of Capital for Middlesex Water Company. This can be calculated by finding the weighted average cost of equity, which we will find using the Capital Asset Pricing Model (CAPM), and the cost of debt multiplied by 1 minus the tax rate). The weights will be 71% equity and 29% debt, using market cap of equity and the book value of debt. The Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market – Risk-Free Rate of Return). The risk-free rate we will use is the 10-year Treasury, currently yielding about 2.05%. The beta we will use is .62, as calculated by YCharts, which uses data from BATS Exchange. The expected return of the market – the risk-free rate, otherwise known as market premium – is left up to much more interpretation. I will use a rate of 5%, which is slightly less than the average S&P performance minus the current risk free 10-year Treasury rate. I am using a slightly less-than-average S&P average because evidence suggests the market will not do as well as it has done the past few years, as news is coming out that people are pulling money out of the market and into other investments. For example, the return on cash now exceeds returns on stocks and bonds for the first time in 25 years . This model will assume that investors putting money in the market will receive a historically lower return than average. Plugging all these values in, we get a cost of equity of 5.15%. The cost of debt can be easily calculated as interest expense divided by book value of debt. In this case, using year-end data from 2014, we get $5.067 million divided by $162.2915, which equals 3.45%. Middlesex Water Company’s average tax rate for the past two years has been 34.57%, so we will multiply 3.45%*(1-.3457) to get 2.26%. Now, to weight them, it will come out to (.71)*(.0515) + (.29)*(.0226) = 4.31% Using the next annual dividend payout of $0.78 as well as all these values, we can use the dividend growth model to estimate the stock is worth approximately $24.69. At a current price of $23.75, it appears MSEX is undervalued by approximately 4%. For investors looking for a safe, growing dividend, Middlesex Water Company is worth a look.

Preparing For A Market Collapse, Part III

Summary U.S. equities are down but not cheap. They could fall further. It is time to prepare…. … In fact, it is always a good time to be prepared. This is the third in a series. You can read Part I and Part II for background. Since the series began, the S&P 500 (NYSEARCA: SPY ) is down over 10%; it could have much further to fall. What current shorts have the most asymmetric exposure? How can average investors see the need to short? Here are three specific short ideas followed by three ways for investors, including retail investors, to weigh when to short. China In terms of country exposure, China is among my favorite shorts. Artificial central bank stimulus drove the Chinese equity mania in early 2015. New equity buyers flooded into the market. These new investors purchased stocks using a record amount of margin debt. They had weak hands once the market direction turned around. The supply of new capital was finite. Eager new investors pushed up prices, but quickly pulled out of the market once prices declined. How do you short China? One way is to short Direxion Daily China Bull 3X Shares (NYSEARCA: YINN ). It is down over 70% since I first disclosed this idea, but it could drop much further over time. That being said, not all Chinese equities are expensive. While China is a big short idea overall, there are some small long ideas worth considering, such as Taomee (NYSE: TAOM ). Biotech Turning to sector exposure, biotech is another favorite short opportunity. This has been a hot sector, but one with market prices that are high, unstable, and precarious . It is down over 20% but remains overpriced. In the long term, it will probably decline substantially further. While biotech is a major short opportunity, one can find bargains in the wreckage. Depomed (NASDAQ: DEPO ) is one worth considering. Due to its drug prices, it is far less sensitive to political pressure than Horizon (NASDAQ: HZNP ) or Valeant (NYSE: VRX ). High Yield In the current credit environment, “high yield” is a bit of a misnomer. In fact, it borders on false advertising. This is one of my favorite types of securities to short because high yield is expensive enough that it does not cost too much if it maintains these rarified prices, and investors long this exposure will probably not hang in there if it begins to decline substantially. Retail investors (including not just a few on Seeking Alpha) who seek yield at any price have driven securities with the appearance of stable yield to zany prices. One security to consider is PIMCO High Income Fund (NYSE: PHK ). As of today, it trades at a 13% premium to its NAV. Down over 25%, it is still overpriced. Its price should continue to converge upon its value in the years ahead. If credit spreads widen from here, it could decline substantially. Should you own any broad-based bond exposure? At today’s prices, no. “HPHs [high priced helpers] frequently think of risk as a function of asset class along the lines of “cash is safe, stock is risky, and bonds are in the middle”. In reality, risk is never a function of asset class; it is a function of price. Thinking proxies such as asset class-based risk models are designed only to excuse HPHs from doing any fundamental analysis to determine value. They can’t make you safe because they can’t even define, let alone quantify, risk. If you are a 65-year-old retiree, a smart-sounding HPH might say that you should be 65% in bonds, with others arguing importantly that the right number is 70% or 60%. The right number is 0%. Alternatively, come up with an explanation of how the credit market is currently undervalued. I could, of course, be completely wrong, but the current credit market looks like an epic bubble. It is conventional to own a lot of bonds, but when the bubble bursts, you will conventionally lose a lot of money.” – Where Can I Find Safe Income For Retirement? Shiller P/E When to short? At the level of individual securities, the fundamental analysis and event analysis takes more time than most investors have to short stocks. In terms of shorting country markets, sectors, or parts of the capital structure, there are some readily-available resources that might be helpful in knowing when to short. For a quick heuristic on the market’s price, you might consider the Shiller P/E. This ratio is more indicative of value across business cycles because it is less impacted by fluctuating profit margins. The U.S. equity market’s Shiller P/E is currently over 43% above its historical mean of about 17. Market prices have rarely maintained such high multiples for long. For further reading on topics, including the Shiller P/E, you might like Rock Breaks Scissors: A Practical Guide to Outguessing and Outwitting Almost Everybody . U.S. equities are the fourth most expensive in the world according to this metric, behind only Japan, Ireland, and Denmark. Market Cap/GDP Market capitalization / GDP in the U.S. is another key metric. When it is high, it is a particularly important time to focus on short opportunities. Today, the U.S. market cap is about 112% of the U.S. GDP. Historically, from such lofty levels, subsequent total returns are typically less than 2% per year. The U.S. equity market is pricey on both metrics. Real returns are probably negative or too low to justify the risk. Incidentally, on both metrics, Russia is a bargain. Its Shiller P/E is about 5 and its market cap/GDP is about 18%, close to its historical minimum of 17% over the past 15 years. The inverse, leveraged Russian ETF (NYSEARCA: RUSS ) is down over 25% since our previous article on that opportunity. However, despite the move in price, it remains an attractive short. 7-Year Real Return Forecast GMO publishes a monthly chart comparing the estimated prospective annual real return over the subsequent seven years of various asset classes from current market prices. The comparison between the 6.5% long-term historical U.S. equity return and the returns from today’s levels is not favorable for today’s equity investors. Average returns will probably be around zero, with somewhat negative returns overall and only marginally positive returns for equities that GMO considers to be high quality. At least we have plenty of timber in Maine, so we have that one covered. Conclusion Part I covered the virtues of maintaining both sizing discipline and a cash balance. “Ordinary opportunity sets should lead to only ordinary position sizing, leaving extraordinarily large positions for only the rarest of opportunities. At a one percent position, one could conceivably find subsequent risk:reward opportunities to double down three times and still have a statistically diversified portfolio. Hyper-diversification accomplishes very little, but having a dozen truly uncorrelated positions accomplishes much of what correlation can offer. However, if one starts with a 5% position and doubles it three times on apparently better subsequent entry points, one is left with an over-concentrated or overleveraged portfolio.” “When everything is going horribly wrong, the comparative advantage of being more liquid than your marginal counterparty becomes extreme. So, while I do not know what the right amount of cash is, I am certain that it is better to have more. You should have more than whomever you are trading against when nothing is working in the markets. How much is that? I currently have 25% of my assets in easily accessible cash and am glad that I do. My percentage might be too low but I am virtually certain that it is not too high. Whatever opportunity cost that I pay in terms of diminished return can be quickly recouped during the next market collapse.” Part II covered some of my favorite company-specific short ideas. The ten disclosed short ideas declined from 2 to 35% since publication; none have yet to fully converge upon their intrinsic values. The average decline of 16% is over three times the S&P 500 ( SPY ) decline over the same period. The larger point is that a flexible mandate that allows one to go long or short creates an optimal environment for analytical rigor. “When someone is able to buy or short investment opportunities, he can first be analytical – gathering relevant facts, measuring value, and examining events that are likely to unlock or reveal that value. One need not be a fan, only an analyst. Regardless of whether or not you like what you are looking at, there is something to do either way. One can buy, one can short, one can ignore. One does not need to prejudge before reaching a conclusion informed by the relevant premises.” You can protect your capital by shorting expensive (and therefore risky) securities with exposures to China, biotech, and high yield credit as described above in Part III. Additionally, you can monitor the Shiller P/E ratio, the market cap/GDP, and the 7-year return forecast for a quick look at the market’s price. These tools are valuable additions to the toolkit of the prepared investor. Regardless of the specifics on how you choose to prepare for the possibility of a market crash, it is unlikely that the next half-century will look anything like the past. It is (barely) conceivable that it continues at the current pace and the S&P 500 races through 48,000. But even if it is possible, it is not a safe bet. When it comes to investing, I do not hope for or expect any single outcome. I do not hope or expect that my home will burn down either, but I still have fire extinguishers and plenty of insurance. None of this is a call to panic; it is a modest call to prepare. I would be perfectly happy to be wrong in my view that such preparation is both wise and timely. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.