WAITING FOR GODOT

Professor Robert Shiller’s CAPE ratio reached 28 recently. During the prior 135 years (i.e., 1620 monthly observations) there have been only 68 monthly readings at or above that level: 4 in 1929 with a CAPE high of 32.5, and 64 during the 1997 through April 1, 2002 period with a CAPE high of 44 in March 2000—the same month that Professor Shiller published his famous book “Irrational Exuberance”. 

Why can’t the CAPE ratio approach 44 again?  Here’s why: 1) the bull market in bonds, which began more than three decades ago, is over; and 2) the negative effect of demographics on P/E ratios, overwhelmed for years by the powerful positive effect of the Fed’s zero interest rate policy ("ZIRP"), will resurface now that the Fed is raising rates. 

The More Than Three Decade Bull Market In Bonds Is OVER.  

In a post dated July 10, 2014 entitled "Shiller's CAPE Versus the 10 year U. S. Treasury Note Yield--an Important Negative Correlation", I demonstrated that the CAPE ratio is negatively correlated with the ten year note yield.  As interest rates rise, the CAPE ratio declines, and vice versa.  That is mathematically how a dividend discount valuation model should work. In a number of posts I have suggested that the note yield bottomed around 1.35% in 2012 after more than three decades in decline; and that a secular uptrend in rates had started. After moving to a 3.0% yield in late 2013, the yield bottomed again around 1.35% this year--thus a double bottom has been formed.

Since the Trump victory, a little over three weeks ago, the note yield has jumped more than 50 basis points  to 2.44% -- a rare event. Confirmation that a secular uptrend in the note yield has begun would require a break to the upside through the previous 3% high. If Trump's intended fiscal spending increases and tax reductions materialize, and average hourly wages continue to accelerate, then the 3% yield level should be penetrated. If that occurs, the yield could reach the 4.5% to 5.00% range within a year or so afterward -- completing interest rate levels reverting to their mean.  In my opinion, mean reversion in the CAPE ratio would soon follow. 

On the other hand, this move up in yields may prove to be a head fake like the one in 2013 -- a mere blip in the "new normal" slow growth, low inflation economy. Even better, perhaps the Trump effect would be to increase real growth significantly without much increase in inflation -- the desirable "goldilocks scenario." Were that to occur, then this bull market in stocks could continue -- albeit at a slower than normal pace. Hard to assign probabilities to these outcomes due to the political risk. 

Demographics

On August 22, 2011  the Federal Reserve Board of San Francisco published a letter entitled “Boomer Retirement: Headwinds for U. S. Equity Markets?” written by Liu and Spiegel.  

They showed how the movement of the Baby Boomers through their life cycles would impact the P/E ratio of the Standard and Poor's 500 Index ("the Index").   They measured the relationship  over time between two population groups:  the middle-aged 40-49 year olds  (“M”) and the old-aged 60-69 year olds (“O”).  Their hypothesis was that, as the boomers phased out of their work lives into retirement, equity values  would be negatively affected—that as the M/O ratio declined, so would the P/E ratio of the Index. 

Their study  spanned from 1954 to 2010.   The results were significant.  As they put it, “In our model, we obtain a statistically and economically significant estimate of the relationship between the P/E and M/O ratios. We estimate that the M/O ratio explains about 61% of the movements in the P/E ratio during the sample period.  In other words, the M/O ratio predicts long-run trends in the P/E ratio well.”

During the  period from 1997 to early 2000, when the CAPE ratio rose to its all time high of 44, the M/O ratio was rising sharply as well.  From 2000 to 2021, the M/O is expected to fall, then flatten out.  So demographics will not provide a tailwind this time; but rather a significant headwind. 

It is interesting to note that from 2010 (the end of the study) to the present, the relationship between the M/O and the P/E faltered.  M/O continued to decline; P/E rose to its current level.  The explanation—ZIRP.  The positive effect on the P/E from  the Fed’s seven year zero interest rate policy  overwhelmed the negative demographic effect.  Remember the M/O paper was published by the Fed.  It occurs to me that not only was the Fed worried about an echo recession after the Great Recession, but also the Liu and Siegel paper may have influenced the Fed into prolonging ZIRP. 

ZIRP has ended. Rising interest rates and a falling M/O ratio will be with us  for the next five years.  Together both should put serious downward pressure on the P/E ratio of the Index. That is why the euphoria of 1997 to March, 2000 will  likely not be replicated over the next five years.  

What To Do Now

As you know, I embrace the notion that financial assets revert to mean valuations.   The question is when?  I use 4.50 %  to 5.50 % as the mean yield on the  10 year note; and a 19.6 mean CAPE ratio— the average over the last 50 years.  (Professor Shiller’s mean CAPE ratio is 16.7, the average over the full 135 years.) 

The  Index is at 2200.  At 28, the CAPE ratio is 42% overvalued using my mean CAPE ratio (67% overvalued using Professor Shiller’s ).  An immediate mean reversion would result in  a 30% drop in the Index  using my mean CAPE (40% with Professor Shiller’s).  Even after the recent sharp rise in yield, the ten year note yield is still  far  from its  mean, so mean reversion in the CAPE ratio is unlikely to  occur immediately.  

I have not rebalanced my financial assets in more than two years.  As you may remember, I decided to rebalance not periodically such as once a year, but rather  as the CAPE ratio indicates that the Index has become more overvalued.  I had set as my next trigger point an overvaluation of 70%.  However, I find the above analysis persuasive and have rebalanced my equity exposure back to my core 30% of financial assets.  The  sales proceeds remain in cash equivalents  until mean reversions occur.  Were this "Trump rally" to continue, I am prepared to rebalance again whenever: 1) the CAPE ratio becomes 80% overvalued based on Professor Shiller's  mean CAPE of 16.7; or 2) whenever my sentiment indicator shows an extreme in bullishness. 

  

The Trump Effect--Return of the Bond Vigilantes?

I  haven't written a post since "BREXIT--A Sign Of Our Times" (June 25, 2016).  Given the Trump victory and a Republican majority in both houses of  Congress,  I thought it appropriate to express my current thoughts.

Trump ran on a platform of lower taxes, fiscal stimulus, trade protectionism, and immigration control.  If everything he promised were enacted, the results would be: 1) some movement higher in domestic  real growth from the 2% a year that has prevailed in this economic up cycle, but not nearly to the 4% he promised; 2) much larger budget deficits; 3) significant domestic inflationary pressure associated with protectionism; 4) higher U.S. interest rates due to numbers 2) and 3); and 5) slower global growth.

The markets' initial reactions to Trump's election have been: 1) a "look out below" waterfall decline in the overnight Standard and Poor's 500 Index futures followed by a recovery and sharp rise, bringing today's level  to  a record high  for  the DJIA and within a percent or so of a record high for the Standard and Poor's 500 Index ("500 Index"); and 2) a rare 30 basis points move upward in the yields of long-dated U.S. Treasury securities within one day, followed by another increase today of a few more basis points.

Too soon to say how much of  Trump's platform will be enacted, despite the Republican control of Congress. While President Elect Trump acted "presidential" in his victory speech, my understanding is that "personality transplants" have not been perfected yet.  A lot of his future success is a function of the Cabinet he chooses--whether this egoist can tolerate pushback from presumably more able and stable minds. And even with a friendly Congress, will he have the patience to deal with the give and take that goes on there?

Where We Were Before the Election

In my last post around mid year, the average hourly wages, which are reported monthly, had started to increase at a faster pace.  Subsequent reports have been confirming--the annual increase is now up to 2.8%.  Usually, that means downward pressure on aggregate corporate profit margins and higher product prices. As a result of this inflationary pressure, the Fed most likely will increase interest rates at its December meeting.

After eleven consecutive down quarterly earnings comparisons, due primarily to the strong dollar and the serious slide in oil and gas industry profits, earnings for the 500 Index rose in the third quarter.

Since midyear, both the 500 Index and the U.S. Treasury 10 year note have been trading in narrow ranges--probably due to election uncertainty.

The Future Outlook

Trump's platform is more inflationary than Clinton's; so it is no surprise that interest rates shot up after the election--the extent of that rise, however, was eye popping!  Since higher inflation and more rapid real growth normally lead to higher earnings, the stock market should have a near-term upward bias, particularly the DJIA, which has a greater tilt toward economically-sensitive stocks than the 500 Index. The markets' immediate reactions following the election are reflective of portfolio managers selling long duration fixed income and buying stocks.

Taking a longer term perspective, I rely on Shiller's CAPE Index to determine over or under  valuations.  In his approach, a couple of years of accelerated earnings have less impact than Wall Street might give them because he averages earnings over a ten year period.  My approach takes his Cape Index and adjusts for the level and trend in interest rates. The faster the interest rate on the 10 year U.S. Treasury note reverts to its mean, the faster the 500 Index reverts to its mean.

To me, the key to the future of both stock and bond markets is how fast and to what level inflation accelerates during this up cycle.   The Fed's preferred measure of inflation is the core personal consumption expenditures price index -- now at 1.7%.  Until recently, the Fed had established 2% as the inflation threshold that would lead to further interest rate increases.  Before the election,  Fed Chairman Yellen had commented that she is considering letting the economy "run hot" above an inflation rate of 2% before additional increases in the Fed funds rate (presumably beyond December's expected rise). Given the inflationary bent of Trump's platform,  Chairman Yellen may abandon this "run hot" tactic; if not, she runs the risk of falling behind the inflationary curve.

Years ago, when the Fed was lagging inflation, the fixed income market, ignoring the Fed, adjusted interest rates upward on long duration notes and bonds. This behavior led to the phrase "bond vigilantes"; in essence bond traders wrested control over interest rates.  If the Fed were to fall behind the inflationary curve again, history suggests that the vigilantes will return during the next several years to force the yield on the 10 year note to its mean level of 4% to 5%.  (Its present yield is 2.1%.)

The 500 Index, currently at 2173, is 65% overvalued based on Shiller's mean CAPE ratio.  My adjusted mean CAPE ratio* indicates the 500 Index is 40% overvalued.  If, as I expect,  reversion to my adjusted mean CAPE ratio occurs during the next five years, the total return, including dividends, of the 500 Index will be just 2% to 3% annually--a meager return at best.

 I would rebalance my equity position if Shiller's CAPE ratio reaches 70% overvalued or if the Investors Intelligence  sentiment indicator reaches a level of more than  60% bulls and fewer than 20% bears.  (It is now at 42% bulls and 24% bears.)  As mentioned in previous posts, on the downside, I would begin buying a SPDR Standard and Poor's 500  ETF ("SPY") at a 500 Index level of  1600--which is only likely to occur during or in anticipation of  a recession.


*See my post dated July 10, 2014 entitled "Shiller's CAPE Versus the 10 year U.S. Treasury Note   Yield--an Important Negative Correlation". There I mention that  Shiller's  CAPE ratio was averaged over 143 years; and that, instead, I prefer averaging over the last 50 years.  As a result of these different time frames, Shiller's mean CAPE ratio is 16.7; mine is 19.6--a huge difference.

BREXIT--A Sign Of Our Times

The pendulum is swinging toward nationalism and isolationism, not just in Great Britain, but in other  countries as well--Austria, where the Rightist party narrowly lost an election; France, where Marine Le Pen's Rightist party is gaining strength; and in the United States where the "Trump phenomenon" has achieved significant traction.

While few have predicted what's happening,  we really shouldn't be surprised.  For whatever the reasons, free markets and free borders don't seem to be working.  The anger represented by Trump is palpable.

During the latter part of this meager U.S. economic recovery, fiscal stimulus has been thwarted by a deadlocked Congress; thus the reliance on monetary policy alone  to jump start the economy.  Theoretically, the Federal Reserve would keep short-term interest rates at zero (ZIRP), which should inflate assets (equities, fixed income, real estate, art, etc.) resulting in a "trickle down," stimulative  wealth  effect on economic growth.   After seven years of this, those assets have, indeed, inflated; but with limited trickle down effect on the real wages of most employees.  The one percenters are smiling; most everyone else is angry.  "Throw the rascals out!" seems to be the mantra.

As always, there is the counterfactual.  Without ZIRP, it could have been worse, possibly a depression.  It reminds me of the reluctant eulogizer at a funeral who has been asked to say something about the deceased whom he disliked.  His eulogy: "I'll be brief. His brother was worse!"

There is an irony in this.  Recently, average hourly wages have been rising at a higher rate than inflation; so real wages have begun to increase.  In fact, profit margins have begun to shrink--another sign that wages are getting a larger share of the corporate pie.   Perhaps the above-mentioned monetary strategy is working after all; it just took longer.

If business and consumer confidence doesn't wane significantly due to this trend toward nationalism and isolationism, then the  negative impact of Brexit on the Standard and Poor's 500 Index ("the 500"), now at 2037, should be limited, at most, to the technical double bottom at 1810.

If, however,  the current toxic international political climate leads to serious tariffs resulting in restricted global trade, then a recession in the U.S.  would probably occur, resulting in  a bear stock market.  We are in unfamiliar territory, so it is hard to assign a probability to the event of recession.

According to Shiller's CAPE ratio, the 500 Index is currently 52% overvalued.  I continue to hold  30% of my financial assets in no-load equity mutual funds, with the remaining 70% in cash equivalents.  Were a bear market to ensue, I would raise my equity exposure to 70% in two tranches, the first around 1600.  On the upside,  I would rebalance my equity position if the CAPE ratio reached 70% overvalued.

During the next five years, normalization to fair value would result in, at most,  a mid-single digit annual return, inclusive of dividends, for the 500 Index.