William Smead
Chief Executive Officer
Chief Investment Office
Dear Fellow Investors:
Our long-time readers are aware that we are stingy when it comes to trading and big believers of keeping trading costs low at Smead Capital Management. Despite these natural inclinations, we do try to keep the pulse of sentiment in the US stock market. The old adage used to be that in the short run your stock movements were 70 percent market-related (beta), 20 percent industry-related (sector attribution) and 10 percent company-related (stock picking). In the long run (3-5 years), we assume the numbers were exactly the opposite, 70 percent company- related, 20 percent industry-related and 10 percent market-related. Therefore, long-duration investors like us focused almost exclusively on company selection (which we do), since it affected our long-term track record and wealth creation the most.
Despite these disciplines, we do follow sentiment indicators and try to conclude what the masses are up to in the marketplace. In our view, these sentiment indicators are useful at extremes and can even be helpful to long-duration owners and buyers of common stock. Since the bear market low of March 2009, we have observed a huge new factor in sentiment indicator usefulness.
We wrote a missive a couple of years ago and we talked about how people are participating with one foot out the door. Our theory has been that heavy use of indexing and ETF investing, coupled with wide-asset allocation and tactical work in those arenas, has altered what the traditional sentiment indicators mean. Our belief in the bull market in US stocks has been positively affected by the near total lack of belief the largest pools of money have in the US stock market. They might get somewhat invested in it from time to time, but they have over-emphasized the most pessimistic S & P 500 sectors like energy, basic materials, heavy industrials and consumer staples, all the sectors which would benefit from the world economy outperforming the US. In other words, long US stocks and bearish on the US economy and future.
Here are a few examples that might be helpful. First, at the high in the S&P 500 index in 2010, 2011 and 2012, bullish sentiment reached a level of around three bulls for each bear in the Investor’s Intelligence weekly survey. Each reading led to a painful mid-year correction. Neither time did bullish sentiment reach 60 percent, which we view as a historically meaningful signal for declines of 20 percent or greater. Since institutional and individual investors appear to have a very small part of their overall portfolio in long-only US large cap stocks and are instead heavily committed to wide-asset allocation, do these sentiment numbers mean as much as they used to? Should you reduce exposure to US common stocks as a long-duration investor in an era of loneliness and US equity de-emphasis because of historically effective sentiment indicators?
Second, the American Association of Individual Investors (AAII) weekly poll is another useful sentiment indicator. We were astounded recently when the S&P 500 was up nearly 10 percent for the year and the AAII voters were bearish by a ratio of two to one! We haven’t given you the worst part of the story. We spoke at a regional meeting of the National Association of Investment Clubs, which is affiliated with the American Association of Individual Investors. They told us the membership is down over 40% in the last four years. You almost have to add those folks to the bearish category. Throw in 38 consecutive months of Lipper analysis indicating net liquidation of US equity mutual funds and you wonder if the sentiment polls can accurately compare today with years gone by.
Third, the CFTC reported over the weekend that money managers have more net long bets on oil in the week ended September 4th as they did the week ended May 1st of this year. In our opinion, this should especially scare oil investors. The net long exposure in early May was at over $106 per barrel and September 4th was at $96 per barrel. Any technician gets very nervous at lower peaks on worse sentiment. We believe very few institutions, almost no registered investment advisors and very few financial advisors had any participation in commodity futures contracts 10-12 years ago. With more participants than ever in history and more capital committed than ever, we believe these sentiment stats from the CFTC should scare every oil optimist to death. It is the dead opposite of the AAII polling circumstance in our view.
Lastly, one anecdotal piece of sentiment was provided over the weekend. China appears to us at SCM to be six months into a four-year recession/depression. We believe they badly need it to clean their economy of severe imbalances, fraud and bad loans in the banking system. We view where they are today to where the US was in the 1870?s when the four-year depression in our economy was triggered by over-building the western railroad system on money borrowed from Europe. Numerous US companies like FedEx (FDX), Cummins (CM) and Intel (INTC) have warned of the affects a hard landing in China could have on their business. All it took last week was the announcement of new government controlled-fixed asset investment stimulus on the part of Chinese government to trigger a four-percent rally in the Shanghai Composite. It also caused the President of Caterpillar (CAT) to declare over the weekend that the new stimulus from China would cause business to pick up for CAT in China in early 2013.
Why is this so important? Caterpillar is one of the companies we use as an example of representing the risk associated with “suckling on China’s economic boom”. They bought Bucyrus International near the top in investor enthusiasm for coal, gold and just about everything pulled out of the ground. When you helped people dig up the ground, we think you should get nervous when things have never gone better in the history of your company and industry. Our point is this; so many people are twisted up in the BRIC trade that bullish sentiment is effectively on steroids. More people are interested and participating in emerging markets and commodity-related stocks, bonds and commodities than ever before and we believe any smart contrarian should be doubly skeptical.
In conclusion, we at SCM are assuming low overall interest in US large cap stocks should be included when thinking about sentiment indicators. Our belief is that historically foolish enthusiasm and participation in all things BRIC-trade related should be avoided based on sentiment alone.
Best Wishes,
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
