Mark Twain's wonderful comment resonates on Wall Street. We who attempt to predict the future course of equity prices are always searching for the perfect indicator. That indicator would embody the concept of "all and only." That is, ALL sought after outcomes are preceded by the indicator and ONLY sought after outcomes are preceded by it. In other words, there are no false negatives and no false positives. Alas, there are no perfect indicators, only those that "rhyme."
Those who have read my previous posts know that I am a contrarian investor. I tend to sell when there is an extreme of bullishness and buy when there is an extreme of bearishness. During my career, I have found the most reliable sentiment indicator to be the Investors Intelligence Sentiment Index Survey published by Investors Intelligence ("II").
For fifty years the people at II have scrutinized weekly more than a hundred independent financial market newsletters and categorized each writer's outlook for the stock market into three groups--bullish, bearish, and expecting a correction. Each category's percentage of the total is published. Rarely do these weekly numbers have predictive value -- they're just noise. At extreme levels, however, they do have significance. Since we are in a bull market and want to know when to cut back our risk exposure to equities, we should be looking for an extreme high percentage of bulls and an extreme low percentage of bears. To me, the combination of 60% or more bulls and 20% or less bears defines "extreme".
During the last 25 years, there have been only five previous occasions when this extreme occurred. The percentage change in the Standard and Poor's 500 Index ("the Index") one year afterward (excluding dividends) was plus 4.3% from January 22, 1992, plus 12.4 % from June 18, 2003, plus 5.9% from February 25, 2004, plus 3.4% from December 29, 2004, and MINUS 39.0% from October 17, 2007. Overall, the average change was MINUS 2.6%, which is much lower than the 6% to 7% average annual appreciation (excluding dividends) during this period.
Another way of describing these results is that there were four false positives, of which three were of minor significance, and one, plus 12.4%, a glaring error. Overall the predictive value was good because this indicator nailed the bull market peak in 2007. A cynic might grouse that "this sentiment indicator has forecast five of the last one bear market." I should also mention that there was one glaring false negative. This indicator failed to detect the bull market top in March 27, 2000, from which the Index fell 25.3% in one year!
This reminds me of an incident that occurred during a tour to China. Every time our group left our bus, we were besieged by vendors. Once, a fellow traveller boarded our bus with an ear-to-ear grin. She exclaimed with glee, "I just bought a Gucci bag for a dollar!" As she walked by me, I noticed that the brand name on the bag was spelled "G-u-c-c-e". When I called that to her attention, she responded without missing a beat, "CLOSE ENOUGH!"
While this sentiment indicator is far from perfect, it is "close enough." The latest reading is 59.6 % bulls, 14.1% bears. While not quite my threshold point of 60% or more bulls and 20% or fewer bears, it is unique over the last 25 years. I back-tested how often more than 59% bulls and fewer than 15% bears has occurred during that lengthy time period. NEVER!! Furthermore, the last time there were only 14.1% bears was in March, 1987! I have brought my equity risk exposure down from 42% of my financial assets to my core level of 30%.
A reminder: for reasons I have explained in earlier posts, I have determined that a core equity holding of 30% is appropriate for me, given my other asset holdings and age. Among investment advisors, the standard core holding for equities has been roughly 60%, with around 40% in bonds, and little, if any, cash. With bond returns negative during 2013 and the Index up 30%, the stock/ bond relationship is seriously out of whack. If unadjusted, the stock portion of the portfolio has grown to 67% of financial assets.
Following this great equity surge, you might say "Let me get this straight! After such a year, you are asking me to sell my equities down to my core of 60% and put the money in cash equivalents, returning nothing? The Fed is tapering, so they think the economy has achieved escape velocity. Earnings are growing. Things couldn't get much better! Are you crazy?" Here's why I recommend lightening up.
The Current Situation
Let's look at the three most important forward-looking variables: sentiment, the Federal Reserve's future action, and valuation.
Sentiment
As noted above, sentiment has reached a level of extreme bullishness. That doesn't happen UNLESS things are great.
Federal Reserve
On December 18, the Federal Reserve announced its initial tapering. They softened the announcement by saying that they intend to keep their Federal Funds rate at zero for a long time. While the Fed has far more input on how the economy is faring than I, their forecasting record has been far from stellar. If the expectation of future inflation picks up and the long end of the bond market experiences a ratcheting up in yields, then the Fed may be forced to raise the Fed Funds rate. In other words, the Fed will be "behind the curve". This has happened often in the past and has given rise to the phrase "bond vigilantes." No matter how the Fed has couched its action last week, it is still a tightening.
The Fed's target for inflation is 2% or slightly more. While the nominal yield on the U.S. Treasury 10 year note is currently 2.9%, the real yield, adjusted for the current 1.1% inflation, is closer to 1.8%. For many years, the real yield on that security averaged 3 percentage points. Add that to the Fed's inflation target of 2.0 %, one would expect that the yield on the 10 year note would ultimately reach 5%+. How long that will take is crucial! For purposes of discussion, let's assume the absurd case that the yield adjusts immediately. Then, in my opinion, the result of the yield's breaking convincingly through 3.0% would mean a 10% correction in the Index; through 4%, a 20% bear market; and through 5.0% as much as a 30% decline. However, this will be spread over time. The longer it takes, the less downward impact on the Index, because the effect will be mitigated by annual normalized earnings growth of 6% to 7%.
Valuation
At 1833 the Index is 40% overvalued. At the peak of the bull market that ended in March, 2000, the Index was 100% overvalued; at the peak of the next bull market in October, 2007, the Index was 80% overvalued. So there could be a lot further room to run, particularly since individual investors seem to adjust their equity exposure while looking in the rear view mirror. As bond yields rise and investors continue to lose money, the inclination is to sell bonds and buy stocks. That rotation may only be in the early innings. However, if bond yields rise quickly, the institutional investor, at some level, will sell overvalued stocks to take advantage of good yields. This downward pressure on the Index will cause the individual investor to halt his rotation into stocks.
If the last bull market's peak 80% overvaluation were to repeat, then there is 30% more upside in this bull market. My rebalancing now will have, in hindsight, been a mistake. However, I will still have my core equity position working on the upside.
Thursday, December 26, 2013
Friday, November 1, 2013
Rebalance Now?
I have taken no action in my account since my last post in March, 2013. Due to equity appreciation and some reduction in cash to pay living expenses, equity mutual funds are now 40% of my total financial assets, with the remaining 60% in cash equivalents. My core, or target, equity position is roughly 30%. Should I rebalance now by reducing equity mutual funds by 25%?
Argument For Rebalancing (1)
Based on my assumptions of 1) normalized earnings of roughly 87 for the S&P 500 Index; 2) a normalized P/E ratio of 15; and 3) a normalized 5% yield to maturity for the U.S. Treasury 10 year note, fair value for the Index is 1300. The Index is currently selling at 1760; thus, based on these metrics, it is 35% overvalued.
Counterargument
Fair value, though relevant, is a blunt instrument. In 2000, at the top, according to this model, the S&P 500 was 100% overvalued. So there is further upside to go.
Furthermore, this model of theoretical fair value assumes a 5% yield on the ten year Treasury note. That note is now yielding 2.6%. If you inserted a 2.6% yield into this model, the Index is vastly undervalued.
Argument For Rebalancing (2)
During more than two centuries of U.S. history, economic cycles have occurred roughly once every four to five years. This up cycle has already lasted more than four years from the last trough, and close to six years from the last peak. Thus, based on history, it is long in the tooth.
Also, five years from the trough in the 1930s Depression, there was an "echo" recession in 1938. This last recession was the worst since that Depression. Perhaps there is an echo recession in the near future.
Counterargument
There is symmetry in economic cycles. That is, short, shallow recessions lead to short, shallow recoveries. The last recession was called "The Great Recession" for good reason; it was both long and deep. So the recovery will be longer than usual, and may have years to go.
Also, Fed Chairman Bernanke, a scholar of The Depression, has been vigilant in keeping monetary policy extremely easy; and his replacement, Janet Yellen, is considered even more of a "dove." While there is a possibility of monetary policy's being ineffective in preventing another recession ("pushing on a string"), remember the Wall Street admonition, "Don't fight the Fed!" The Fed will continue its monthly purchases of $85 billion of long-dated Treasuries and mortgages until there are clear signs of the economy's achieving escape velocity.
Argument For Rebalancing (3)
When the economy achieves escape velocity, and the Fed starts to reduce its $85 billion of monthly purchases, or what is now known as "tapering", interest rates at the long end of the yield curve will rise sharply due to this withdrawal of demand. This will stifle the housing recovery, cause the stock market to drop precipitously, and essentially end the positive wealth effect that has been the backbone of the paltry economic recovery during the last four years.
Counterargument
Taken alone, rising interest rates should have a negative effect on stock prices. However, there will be an offset. Due to more rapid real economic growth and inflation, earnings growth will pick up, so while the P/E ratio will be lower, earnings will be higher.
Argument For Rebalancing (4)
Between the end of World War II and 2000, real economic growth in the U.S. averaged 3.5% a year; and that included recession years. Since 2000, real average economic growth has been below that, bringing the post -War average economic growth down to 3.2%. Since the bottom of the Great Recession, economic growth has been a meager 2% and inflation under 2%. With top line revenue growth of around 4%, how can American companies generate a 7% earnings growth in the future, particularly with profit margins at all time highs?
Counterargument
The multinational companies based in America are investing in more rapidly growing areas of the world, such as Southeast Asia. That has had a meaningful effect on overall top line growth.
Furthermore, many of these companies are engaging in financial engineering. They are sitting on large amounts of nonessential cash. These companies are buying back their stock in quantities that exceed the amount needed for stock options. This has had the impact recently of raising annualized earnings per share by 1 1/2 to 2 percentage points. Unfortunately, companies tend to buy back their shares when their stocks are overvalued. Better that they reserve the cash when things are going well, and repurchase the shares when their stock is undervalued. How much this repurchasing will impact future earnings per share is tough to predict. Excess cash may not be replenished, so there will be a finite life to this.
Given these pros and cons, how do I come out on this?
Some key issues:
1) Tapering will inevitably take place. When and how rapidly is important. And even more important is how rapidly and to what extent long-term interest rates rise as a result. The bond market, like the stock market, anticipates the future. Once tapering begins, then future increases in the federal funds rate, now at close to zero percent, appear on the radar screen. An increase in the yield of the Treasury 10 year note from 2.6% to 3.0% would cause some downside in the stock market, perhaps 10 percent. A rapid increase to 4.0% would, in my opinion, result in a bear stock market (down 20%) because bonds would then become competitive with stocks and mortgage rates would rise to a level that may choke off the housing recovery.
2) An unlikely event, but if an "echo" recession cannot be prevented by the Fed, then the S&P 500 Index could easily drop 30%. And that decline could happen very fast. (See October, 1987, when the market was down more than 20% in one day.)
3) Most important in my view of reality, the sentiment indicator that I watch most carefully is not yet at the extreme in bullishness that I would consider a red flag. Most, but not all, bull markets end when greed becomes extreme. (Again, October, 1987 was a rare exception.)
4) Money invested in the bond market is in the process of being transferred into equities due to the fact that bonds have already lost money recently even before tapering has begun. This trend should
continue for awhile.
While I may regret this suspension of discipline, I have chosen not to rebalance at this time. If the sentiment indicator flashes red, I shall immediately rebalance and perhaps take my equity risk exposure below my core level.
Argument For Rebalancing (1)
Based on my assumptions of 1) normalized earnings of roughly 87 for the S&P 500 Index; 2) a normalized P/E ratio of 15; and 3) a normalized 5% yield to maturity for the U.S. Treasury 10 year note, fair value for the Index is 1300. The Index is currently selling at 1760; thus, based on these metrics, it is 35% overvalued.
Counterargument
Fair value, though relevant, is a blunt instrument. In 2000, at the top, according to this model, the S&P 500 was 100% overvalued. So there is further upside to go.
Furthermore, this model of theoretical fair value assumes a 5% yield on the ten year Treasury note. That note is now yielding 2.6%. If you inserted a 2.6% yield into this model, the Index is vastly undervalued.
Argument For Rebalancing (2)
During more than two centuries of U.S. history, economic cycles have occurred roughly once every four to five years. This up cycle has already lasted more than four years from the last trough, and close to six years from the last peak. Thus, based on history, it is long in the tooth.
Also, five years from the trough in the 1930s Depression, there was an "echo" recession in 1938. This last recession was the worst since that Depression. Perhaps there is an echo recession in the near future.
Counterargument
There is symmetry in economic cycles. That is, short, shallow recessions lead to short, shallow recoveries. The last recession was called "The Great Recession" for good reason; it was both long and deep. So the recovery will be longer than usual, and may have years to go.
Also, Fed Chairman Bernanke, a scholar of The Depression, has been vigilant in keeping monetary policy extremely easy; and his replacement, Janet Yellen, is considered even more of a "dove." While there is a possibility of monetary policy's being ineffective in preventing another recession ("pushing on a string"), remember the Wall Street admonition, "Don't fight the Fed!" The Fed will continue its monthly purchases of $85 billion of long-dated Treasuries and mortgages until there are clear signs of the economy's achieving escape velocity.
Argument For Rebalancing (3)
When the economy achieves escape velocity, and the Fed starts to reduce its $85 billion of monthly purchases, or what is now known as "tapering", interest rates at the long end of the yield curve will rise sharply due to this withdrawal of demand. This will stifle the housing recovery, cause the stock market to drop precipitously, and essentially end the positive wealth effect that has been the backbone of the paltry economic recovery during the last four years.
Counterargument
Taken alone, rising interest rates should have a negative effect on stock prices. However, there will be an offset. Due to more rapid real economic growth and inflation, earnings growth will pick up, so while the P/E ratio will be lower, earnings will be higher.
Argument For Rebalancing (4)
Between the end of World War II and 2000, real economic growth in the U.S. averaged 3.5% a year; and that included recession years. Since 2000, real average economic growth has been below that, bringing the post -War average economic growth down to 3.2%. Since the bottom of the Great Recession, economic growth has been a meager 2% and inflation under 2%. With top line revenue growth of around 4%, how can American companies generate a 7% earnings growth in the future, particularly with profit margins at all time highs?
Counterargument
The multinational companies based in America are investing in more rapidly growing areas of the world, such as Southeast Asia. That has had a meaningful effect on overall top line growth.
Furthermore, many of these companies are engaging in financial engineering. They are sitting on large amounts of nonessential cash. These companies are buying back their stock in quantities that exceed the amount needed for stock options. This has had the impact recently of raising annualized earnings per share by 1 1/2 to 2 percentage points. Unfortunately, companies tend to buy back their shares when their stocks are overvalued. Better that they reserve the cash when things are going well, and repurchase the shares when their stock is undervalued. How much this repurchasing will impact future earnings per share is tough to predict. Excess cash may not be replenished, so there will be a finite life to this.
Given these pros and cons, how do I come out on this?
Some key issues:
1) Tapering will inevitably take place. When and how rapidly is important. And even more important is how rapidly and to what extent long-term interest rates rise as a result. The bond market, like the stock market, anticipates the future. Once tapering begins, then future increases in the federal funds rate, now at close to zero percent, appear on the radar screen. An increase in the yield of the Treasury 10 year note from 2.6% to 3.0% would cause some downside in the stock market, perhaps 10 percent. A rapid increase to 4.0% would, in my opinion, result in a bear stock market (down 20%) because bonds would then become competitive with stocks and mortgage rates would rise to a level that may choke off the housing recovery.
2) An unlikely event, but if an "echo" recession cannot be prevented by the Fed, then the S&P 500 Index could easily drop 30%. And that decline could happen very fast. (See October, 1987, when the market was down more than 20% in one day.)
3) Most important in my view of reality, the sentiment indicator that I watch most carefully is not yet at the extreme in bullishness that I would consider a red flag. Most, but not all, bull markets end when greed becomes extreme. (Again, October, 1987 was a rare exception.)
4) Money invested in the bond market is in the process of being transferred into equities due to the fact that bonds have already lost money recently even before tapering has begun. This trend should
continue for awhile.
While I may regret this suspension of discipline, I have chosen not to rebalance at this time. If the sentiment indicator flashes red, I shall immediately rebalance and perhaps take my equity risk exposure below my core level.
Wednesday, March 13, 2013
What's With China?
Back in the Fall of 2008, I initiated a large position in T. Rowe Price's New Asia Fund which ultimately accounted for 25% of my equity portfolio (with the remaining 75% in T. Rowe Price's Standard and Poor's Equity Index 500 Fund). My total equity position then was double what I considered to be my personal core equity exposure given my age and investment in East Hampton real estate, whose value correlates highly with how Wall Street fares. The reason I had such an outsized exposure to equities was that the Standard and Poor's 500 Index ("the 500 Index") was significantly undervalued then due to the "great recession's" having wreaked havoc on earnings. I am a contrarian by nature -- prefer to invest when there is a maximum of fear and disinvest when there is a maximum of greed.
At that time China's economy was growing at a double digit rate, due primarily to its relative low wage rate and its rapid population migration from rural to urban areas. Its products cost far less to manufacture than here, and thus China's export growth was explosive. Our economy, on the other hand, was mired in recession. In fact, many developing countries in Asia (ex Japan) were similarly growing far faster than the world's developed countries. Given the disproportionate growth rates of the region's economies relative to ours, and the relative cheapness of its stock markets, I wanted to have exposure there despite the political risks, currency risks, and the fact that China's was not a free enterprise economy but rather a centralized one managed by the Communist Party. Most economists warned that the China model wouldn't work. Despite these misgivings, I felt that investing in the New Asia Fund was a good risk/reward pairing, like an attractive "high risk/high return" growth stock.
Prior to this week, my position in the New Asia Fund had been cut back by 60%, yet it still accounted for 25% of my total equity portfolio. The cutbacks were the result of the fund's initial dramatic out-performance relative to that of the 500 Index which led to a rebalancing of the overall portfolio; and the reduction of the overall equity portfolio to its core level because equities in general went from undervalued to overvalued as central bankers throughout the world flooded economies with money, the so-called "quantitative easings". (The 500 Index is now roughly 25% overvalued.)
The comparative labor cost advantage that was responsible for China's export explosion has narrowed somewhat. Several U.S.-based companies have decided to build plants here rather than in China due to this narrowing and the potential for lower fuel costs here as our natural gas becomes a larger contributor to domestic fuel supplies during the next decade. China's growth has slowed from double digits to 7-9%, still high relative to ours, but the gap has narrowed.
As China's comparative labor cost advantage closes, its growth must become more dependent on internal consumption than on exports. China's recent prosperity has created a vast middle class whose rising income should potentially stimulate consumption. The key to the New Asia Fund's future performance will be how easily China's transition from an export-driven economy to a consumption-driven economy will unfold. (While only 30% of the fund's portfolio is directly invested in China's equities, the fund's investments in other Asian countries are significantly affected by exports to China; so as China goes, so goes the New Asia Fund.)
The risk of a speed bump in this transition has grown. Two weeks ago "Sixty Minutes" exposed what the skeptical economists have been warning about all along. (They may not have been wrong, merely early!) China's centralized managers have been encouraging construction of whole cities to accommodate continued population migration from rural areas. This construction has provided work for fifty million people. (With China's population of 1.4 billion that isn't such a large number but still significant.) Many of these newly constructed cities remain empty. What happens when such construction slows down and construction workers must find employment elsewhere or return to the rural areas? Civil unrest may ensue.
Furthermore, the savings of many wealthy Chinese have been invested in second and third homes because prices of such real estate have been growing rapidly. Sound familiar? China may be experiencing now what the U.S. economy dealt with in 2005-2007--a real estate bubble. If so, eventual bursting of that bubble would probably have a similar negative impact on China's consumption as it did on ours.
For months now, the New Asia Fund has underperformed the 500 Index. So far this year, it is up 1% versus 9% for the 500 Index. Being a risk-averse individual, believing that there are times when "discretion is the better part of valor," I have reduced my New Asia Fund position from 25% to roughly 15% of my total equity portfolio. Thus, from its original peak, that exposure has been cut by 75%.
At that time China's economy was growing at a double digit rate, due primarily to its relative low wage rate and its rapid population migration from rural to urban areas. Its products cost far less to manufacture than here, and thus China's export growth was explosive. Our economy, on the other hand, was mired in recession. In fact, many developing countries in Asia (ex Japan) were similarly growing far faster than the world's developed countries. Given the disproportionate growth rates of the region's economies relative to ours, and the relative cheapness of its stock markets, I wanted to have exposure there despite the political risks, currency risks, and the fact that China's was not a free enterprise economy but rather a centralized one managed by the Communist Party. Most economists warned that the China model wouldn't work. Despite these misgivings, I felt that investing in the New Asia Fund was a good risk/reward pairing, like an attractive "high risk/high return" growth stock.
Prior to this week, my position in the New Asia Fund had been cut back by 60%, yet it still accounted for 25% of my total equity portfolio. The cutbacks were the result of the fund's initial dramatic out-performance relative to that of the 500 Index which led to a rebalancing of the overall portfolio; and the reduction of the overall equity portfolio to its core level because equities in general went from undervalued to overvalued as central bankers throughout the world flooded economies with money, the so-called "quantitative easings". (The 500 Index is now roughly 25% overvalued.)
The comparative labor cost advantage that was responsible for China's export explosion has narrowed somewhat. Several U.S.-based companies have decided to build plants here rather than in China due to this narrowing and the potential for lower fuel costs here as our natural gas becomes a larger contributor to domestic fuel supplies during the next decade. China's growth has slowed from double digits to 7-9%, still high relative to ours, but the gap has narrowed.
As China's comparative labor cost advantage closes, its growth must become more dependent on internal consumption than on exports. China's recent prosperity has created a vast middle class whose rising income should potentially stimulate consumption. The key to the New Asia Fund's future performance will be how easily China's transition from an export-driven economy to a consumption-driven economy will unfold. (While only 30% of the fund's portfolio is directly invested in China's equities, the fund's investments in other Asian countries are significantly affected by exports to China; so as China goes, so goes the New Asia Fund.)
The risk of a speed bump in this transition has grown. Two weeks ago "Sixty Minutes" exposed what the skeptical economists have been warning about all along. (They may not have been wrong, merely early!) China's centralized managers have been encouraging construction of whole cities to accommodate continued population migration from rural areas. This construction has provided work for fifty million people. (With China's population of 1.4 billion that isn't such a large number but still significant.) Many of these newly constructed cities remain empty. What happens when such construction slows down and construction workers must find employment elsewhere or return to the rural areas? Civil unrest may ensue.
Furthermore, the savings of many wealthy Chinese have been invested in second and third homes because prices of such real estate have been growing rapidly. Sound familiar? China may be experiencing now what the U.S. economy dealt with in 2005-2007--a real estate bubble. If so, eventual bursting of that bubble would probably have a similar negative impact on China's consumption as it did on ours.
For months now, the New Asia Fund has underperformed the 500 Index. So far this year, it is up 1% versus 9% for the 500 Index. Being a risk-averse individual, believing that there are times when "discretion is the better part of valor," I have reduced my New Asia Fund position from 25% to roughly 15% of my total equity portfolio. Thus, from its original peak, that exposure has been cut by 75%.
Wednesday, January 9, 2013
Significant Austerity Without A Crisis--Unlikely
Avoidance of the "fiscal cliff" brought clarification of several important tax rate issues. This should boost business and consumer confidence over the near term. However, these changes are only the "low hanging fruit" in the herculean effort to bring the nation's debt burden to manageable levels. (This tax increase on the richest Americans is acceptable to most of the voting public.) Over the next ten years, these changes only amount to 15% of what will have to be done merely to keep federal debt as a percentage of GDP constant. The tough austerity lies ahead.
What needs to be done involves spending cuts, tax reform, and entitlement reform. The problem is that most everyone will have to give up something.
On CNBC recently, Larry Summers interviewed the chairman of Caterpillar, one of this nation's premier capital goods companies. The Caterpillar executive agreed that all tax preference items should be eliminated and the discussion as to which ones, if any, should be reinstated should then begin. Examples of some tax preference items are the deductibility of mortgage interest, charitable contributions, state and local taxes, and accelerated depreciation of capital equipment. When Summers then pressed the executive whether he would approve elimination of the accelerated depreciation provision, he answered that that provision stimulates capital spending and improves the country's productivity and should therefore be kept intact.
The real estate industry feels the same way about mortgage interest. And the charities about contributions. It reminds me of a town's needing to build a new garbage dump and each citizen says
"Yes, we do need one, but NOT in my backyard!"
And consider entitlement reform. Extending the social security eligibility age from 65 to 67 enrages those heading into retirement. AARP has an ad campaign warning Congress that its members are a huge voting block, so don't mess with us!
And unfortunately we have interim elections in less than two years. While the voting public has a vague understanding that we have a debt problem, there is no catalyst to force strong action. At some point, holders of the U.S. government's debt will demand much higher interest rates in anticipation of rapidly increasing inflation. But that hasn't occurred yet. In fact, investors still buy Treasuries as a hedge against uncertainty when fear of a European country's default resurfaces. In my opinion. the financial markets will ultimately have to be in disarray to force meaningful change. We experienced such disarray in late 2008 when a bear market forced Congress to enact TARP. (At that time,
I wrote about this in a post entitled "Scared Straight!") When this will occur is difficult to predict. It could be years from now.
Meanwhile, the thirty year fixed income bull market has probably ended. The ten year U.S. government note reached a low yield of 1.33% and is now trading at 1.87%. At these low interest rates, it doesn't take much of an increase in rates to cause a loss on these investments. In aggregate, investors have been withdrawing money from equity mutual funds and putting funds into fixed income mutual funds since the brutal bear market of 2007-2009. Also, as the baby boomers reach retirement age, they are more inclined to move money out of equities and into fixed income to "reduce risk." On the other hand, if a period of losses on bonds were to occur, there should be some movement out of fixed income back into equities. This would result in an increase in price to earnings multiples, thus rendering an overpriced equity market even more overpriced.
I remain with my core equity position.
What needs to be done involves spending cuts, tax reform, and entitlement reform. The problem is that most everyone will have to give up something.
On CNBC recently, Larry Summers interviewed the chairman of Caterpillar, one of this nation's premier capital goods companies. The Caterpillar executive agreed that all tax preference items should be eliminated and the discussion as to which ones, if any, should be reinstated should then begin. Examples of some tax preference items are the deductibility of mortgage interest, charitable contributions, state and local taxes, and accelerated depreciation of capital equipment. When Summers then pressed the executive whether he would approve elimination of the accelerated depreciation provision, he answered that that provision stimulates capital spending and improves the country's productivity and should therefore be kept intact.
The real estate industry feels the same way about mortgage interest. And the charities about contributions. It reminds me of a town's needing to build a new garbage dump and each citizen says
"Yes, we do need one, but NOT in my backyard!"
And consider entitlement reform. Extending the social security eligibility age from 65 to 67 enrages those heading into retirement. AARP has an ad campaign warning Congress that its members are a huge voting block, so don't mess with us!
And unfortunately we have interim elections in less than two years. While the voting public has a vague understanding that we have a debt problem, there is no catalyst to force strong action. At some point, holders of the U.S. government's debt will demand much higher interest rates in anticipation of rapidly increasing inflation. But that hasn't occurred yet. In fact, investors still buy Treasuries as a hedge against uncertainty when fear of a European country's default resurfaces. In my opinion. the financial markets will ultimately have to be in disarray to force meaningful change. We experienced such disarray in late 2008 when a bear market forced Congress to enact TARP. (At that time,
I wrote about this in a post entitled "Scared Straight!") When this will occur is difficult to predict. It could be years from now.
Meanwhile, the thirty year fixed income bull market has probably ended. The ten year U.S. government note reached a low yield of 1.33% and is now trading at 1.87%. At these low interest rates, it doesn't take much of an increase in rates to cause a loss on these investments. In aggregate, investors have been withdrawing money from equity mutual funds and putting funds into fixed income mutual funds since the brutal bear market of 2007-2009. Also, as the baby boomers reach retirement age, they are more inclined to move money out of equities and into fixed income to "reduce risk." On the other hand, if a period of losses on bonds were to occur, there should be some movement out of fixed income back into equities. This would result in an increase in price to earnings multiples, thus rendering an overpriced equity market even more overpriced.
I remain with my core equity position.
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