Wall Street and its unnecessary complexity

March 19, 2012, 9:28 PM UTC

Keep it simple – it sounds so easy and yet very few people on Wall Street are capable of it.

Complexity negatively infiltrates the investment process in a number of ways. One way is analysis paralysis. Undoubtedly, we’ve all worked with analysts that are guilty of this crime. The guilty analyst will have a 75-page spreadsheet analyzing a company down to the return on capital of the administrative assistant to the head janitor, but won’t be able to make a call on whether the stock is going up or down. The analyst knows so much, he or she is in fact paralyzed and unable to make a decision.

The other crime of investing complexity is when an analyst complicates simple things, like say valuation. A friend of mine from home says that when it is – 40 degrees Celsius out, you don’t need to ask how cold it is, you just know it is *expletive* cold. The same could be said for valuation. If a stock or asset is cheap, you shouldn’t have to argue it’s cheap, or justify that it is cheap. The valuation will be plainly obvious.

Late last week I wrote a research note on the valuation of the S&P 500 index. Many stock market pundits are making the case that the SP500 is cheap based on future consensus earnings. Unfortunately, that analysis is not really all that simple, for the basic reason that consensus estimates are usually wrong. In fact, according to a McKinsey study from 1985 to 2009, S&P 500 earnings estimates were higher than the actual reported number 92% of the time.

MORE: Stocks only look cheap

So, obviously when making the simple valuation call, it depends on the complexity of the underlying estimates. When looking at the valuation of the S&P 500, we prefer to use CAPE, or cyclically adjusted price to earnings. CAPE is a metric popularized by Yale Professor Robert Shiller that looks at a market P/E that is adjusted for inflation and normalized for cycles. Currently, CAPE is showing that the S&P 500 is trading 21.9 times earnings, which is the highest level since July 2011 and in the top quintile of market valuations going back to 1880 (before even I was born).

CAPE hit a 35-year low in March of 2009 at 13.4x. This also coincided with a low in other stock market valuation metrics and the bottoming of the market. Stocks were, simply, and obviously, cheap. As for now, it is neither simple, nor obvious.

As of late, we’ve been flagging and harping on another simple indicator of the equity markets peaking, which is the VIX. The chart below goes back exactly three years to the bottom in March 2009 and compares the S&P 500 to the VIX over that period. As the chart shows, a VIX level of 15-ish has coincided consistently with a short-term top. To the simpletons at Hedgeye, that is a red flag worth emphasizing. More simply, the VIX at this level signals that complacency is setting in.

Last week, we made a couple of simple moves in the Virtual Portfolio that should inform you on our current positioning:

1. Shorted Greece via the ETF GREK – With “positive” catalyst of the Greek debt restructuring in the rear view mirror, Greek equities now have to deal with austerity headwinds and a population that is leaving Greece en masse.

2. Shorted SP500 via the ETF SPY – Selling the SP500 at our overbought line has a high historical batting average and at 1,401, the SP500 is overbought. Yes, it can be that simple.

3. Shorted consumer discretionary via the ETF XLY – With oil prices and inflation accelerating, this isn’t good for growth or discretionary spending. Historically, growth slows when oil reaches 5.5% of GDP. Simplistically, a Brent oil price of $116 equates to 5.5% GDP and Brent is currently at $123.

Henry Wadsworth Longfellow also had a great quote about simplicity, which was: “In character, in manner, in style, in all things, the supreme excellence is simplicity.” Indeed.

Follow Daryl Jones on Twitter @HedgeyeDJ

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