Thursday, December 17, 2015
Federal Funds Rate Increase
Yesterday the Fed raised its federal funds rate 25 basis points from 0% to 0.25%. Its zero rate posture had been in effect for more than seven years. Furthermore, the Fed suggested that normalization of this rate would proceed along a gradual glide path to exceed 3% over three years.
The Fed took this action before the economy had achieved one of its two objectives--an annual inflation rate of 2%. (The other objective, an unemployment rate down to 5%, had already been reached.) The Fed's preferred measure of inflation, the core personal consumption expenditures price index, (or "core PCE"), had only risen to 1.6%. Apparently, they felt that recent rising wages would lead to a higher inflation rate, so opted to act sooner.
Seven years of zero interest rates is unprecedented during the last 75 years, so whether the Fed's action is timely or not is difficult to determine. I have written that a RAPID normalization of long-term interest rates would result in a bear market due to the negative impact of rising interest rates on the stock market's price to earnings ratio.* (A rapid jump in the yield-to-maturity of the 10 year U.S, Treasury note, now at 2.25%, to more normal levels of 4% to 5%, would bring about such a downward stock market trend.)
If the gradual glide path were to happen, then a bear market might be avoided, because the normal annual 6% to 7% earnings growth over three years would mitigate somewhat the price-to-earnings ratio compression. If so, the total annual return of the S&P's 500 Index would be, at best, little more than the dividend yield, or slightly more than 2%.
Recessions have traditionally resulted from the bond market's response to virulent inflation. In what seemed to be an off-hand comment yesterday, Fed Chairwoman Yellen said there was no more than a 10% percent probability of the economy's entering into a recession in the near term. I believe her low probability assessment results from her feeling she can anticipate a recession and reverse her current path before it is too late. However, the Fed's forecasting record is spotty at best. And keep in mind that her ability to reduce interest rates significantly from here is unusually limited, and also that the economy's growth going into this rising interest rate environment has been subpar. As I discussed in my last post**, today's environment is so unusual that a recession might result just from the negative wealth effect of declining stock and bond markets. I would assign a much higher probability than 10% to a recession within the next twelve months.
In addition to my 30% equity position, I have maintained a 70% cash position in order to take advantage of the next bear markets in both stocks and bonds. If I am wrong and the Fed's glide path case is correct, even then I should be able to add to my equity position at or near current prices sometime during the next three years.
*See my post, dated July 10, 2014, entitled "Shiller's CAPE Versus the 10 year U.S. Treasury Note Yield--an Important Negative Correlation."
**See my post, dated August 24, 2015, entitled "Will the Tail Wag the Dog?"
Monday, August 24, 2015
WILL THE TAIL WAG THE DOG?
The traditional money management approach assumes that the stock market discounts the future economy--the stock market is the dependent variable and the economic outlook is the independent variable.
However, since the Great Recession, the opposite may have occurred. The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP), has sought to inflate asset prices. Higher asset prices would result in a " wealth effect", which, the Fed believed, would stimulate consumption, and would kick start the economy into escape velocity, when the economy could resume growth at historical rates without ZIRP. In other words, the stock market would determine the economy, rather than vice versa.
The Federal Reserve has been successful in inflating assets. After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years. I have argued that the Index is now vastly overvalued.
However, the economy has so far failed to respond as expected. Growth has been sub-par since 2009. Only recently has the economy shown signs of a pickup in real growth. There has been talk of the Fed's soon raising the federal funds rate for the first time in many years. Unfortunately, events in China may thwart this virtuous cycle.
I have discussed that China is trying to morph from an export-driven economy into one relying more on internal consumption. That transition has proven to be difficult. The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there. However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.
The ramifications of a much slower growth in the Chinese economy are significant. For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and stock markets of the raw material supplying countries.
If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?" In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.
As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure? The answer is 1600. (The Index closed Friday at 1971, down from the bull market high of 2130.)
Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement of the bull market from the 2009 low. That is an important Fibonacci number. Because many traders believe in such numbers, I pay attention to them.
However, since the Great Recession, the opposite may have occurred. The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP), has sought to inflate asset prices. Higher asset prices would result in a " wealth effect", which, the Fed believed, would stimulate consumption, and would kick start the economy into escape velocity, when the economy could resume growth at historical rates without ZIRP. In other words, the stock market would determine the economy, rather than vice versa.
The Federal Reserve has been successful in inflating assets. After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years. I have argued that the Index is now vastly overvalued.
However, the economy has so far failed to respond as expected. Growth has been sub-par since 2009. Only recently has the economy shown signs of a pickup in real growth. There has been talk of the Fed's soon raising the federal funds rate for the first time in many years. Unfortunately, events in China may thwart this virtuous cycle.
I have discussed that China is trying to morph from an export-driven economy into one relying more on internal consumption. That transition has proven to be difficult. The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there. However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.
The ramifications of a much slower growth in the Chinese economy are significant. For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and stock markets of the raw material supplying countries.
If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?" In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.
As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure? The answer is 1600. (The Index closed Friday at 1971, down from the bull market high of 2130.)
Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement of the bull market from the 2009 low. That is an important Fibonacci number. Because many traders believe in such numbers, I pay attention to them.
Monday, March 23, 2015
TINA--The Greater Fool Theory In Disguise
As you who have been reading my posts know ad nausea, I believe that fair value for the stock market (the Standard and Poor's 500 Index) is the discounted cash flow of future dividends. The discount rate is a function of the ten-year U.S. Treasury note. I believe that both the stock and bond markets ultimately revert to historical norms. The key factors--discount rate, earnings, and earnings growth rate--each undergo this mean reversion.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
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