During the Great Recession, annual operating earnings of the Standard and Poor’s 500 Index (“the Index”) fell 56% from a high of 91 to a low of 40. As the current recession unfolds, the consensus is that it will be worse in depth than the Great Recession, although highly likely less in duration. If you take 44% of the Index’s operating earnings of 157 during 2019, earnings for 2020 would be 69. So far few strategists have come close to forecasting that low a number.
Here’s how one could envision 2020 earnings dropping to 69. The lockdown of the U.S. economy began just three weeks from the first quarter’s end. Now with 88% of companies having reported, first quarter’s earnings are expected to be 20.23, down 47% from 37.99 last year. We are almost midway into the second quarter, and the lockdown is just beginning to end. And if, during the economy’s reopening, the populace isn’t disciplined about social distancing, many states will be forced back into some semblance of a lockdown. It is not a stretch to envision an Index LOSS of 10 in the second quarter, down from last year’s earnings of 40! In that case, Index earnings for the first half would be 10. Furthermore, most Wall Street strategists now no longer foresee a “V” recovery in the last half of 2020. During the second half last year, earnings were 79. To reach 69 for this year, earnings during the last half would have to decline 25%, to 59. To me, that is not an outrageous assumption.
Wall Street’s Bullish Bias — An Asymmetry
Wall Street in aggregate makes more money in bull markets than bear markets. Strategists’ forward earnings estimates tend to be significantly higher than actual earnings turn out to be. There is a tendency to apply average P/E multiples to peak earnings, which can lead to “buying at the high.” On the other hand, strategists don’t apply average P/E multiples to bottom earnings. For example, before the pandemic, strategists were estimating earnings to be 170 for 2020. At the Index high of 3394, the P/E multiple was 20 — not that high, strategists claimed, with interest rates so low. However, 20 times assumed earnings of 69 would suggest an Index price of 1380! I can count on one hand the number of well-known strategists that suggest that low an ultimate Index price.
I don’t expect the Index to fall to 1380 because: 1)the Fed is doing everything in its power to keep the economy from lapsing into a depression; and 2) the probability is high that a viable vaccine will be available in quantity during late 2020 or early 2021. However, a retest of the March 23 low of roughly 2200 is probable once more reasonable 2020 earnings estimates become the narrative.
Tuesday, May 12, 2020
Wednesday, April 29, 2020
Today The Standard and Poor's 500 Index reached 2950. I Lowered My Equity Exposure From 30% To 25% Of My Financial Assets.
In my last post I expressed concern that President Trump, due to his overriding interest in being reelected, would urge reopening of the economy prematurely--before sufficient testing would allow the scientists to recommend loosening the restrictions that had closed down the economy. Unfortunately, premature opening is happening.
As a result, a resurgence in infections and a reimposing of restrictions seem probable near term. And another wave of virus cases late in 2020 is expected by the scientists. I continue to expect a slow economic recovery--a prolonged "U," if you will.
I do realize that summer's heat may moderate the rise of cases resulting from prematurely reopening the economy And there is talk that a vaccine may be available during 2020 for hospital workers and others most vulnerable to the virus, such as the elderly and infirm.
With the Standard and Poor's 500 Index ("the Index") at 2950, my calculation of the Index's future risk/reward favors taking some profits. Today I lowered my equity exposure to 25% from 30% of my financial assets. The proceeds of the sale again are placed in short-term U.S. government securities as I continue to consider long-duration government fixed income to be grossly overpriced for those investors with a ten-year horizon.
How I Calculate Index Fair Value
Those readers of my previous posts are well aware that I use Shiller's CAPE ratio to determine the extent that the Index is overvalued, at fair value, or undervalued. Shiller's mean CAPE ratio is 17; my modified mean CAPE ratio is 20--the average ratio over the last 50 years rather than Shiller's last 138 years. Fair value to me is when mean reversion to a CAPE ratio of 20 occurs.
Shiller takes actual annual Index earnings for the last 10 years, adjusts for inflation using the consumer price index ("CPI"), totals the ten results, and divides by 10. I consider this to be "trend line earnings."
Shiller's CAPE ratio is available intra-day free of charge. If one divides the Shiller CAPE ratio into the Index price, you arrive at Shiller's earnings. Right now they are roughly 107. During the Great Recession actual earnings declined 56%. Last year's actual earnings were 157; so, if the actual earnings decline during this recession equaled that of the Great Recession, the low in annual actual earnings would be 69. The 2010 Index earnings adjusted for inflation are much higher than 69. According to the way Shiller's model works, those 2010 adjusted earnings will be dropped and the 2020 earnings added. Furthermore, this year I expect the CPI to be negative--deflation rather than inflation. So at the end of 2020, Shiller's earnings may fall from 107 to roughly 100. Fair value at the end of 2020 would then be 20 times 100, or an Index at 2000. From 2950, mean reversion then would imply a depreciation of 32%.
How I Calculate Future Returns
To calculate the Index's nominal compound annual total return for the next ten years, I assume that mean reversion to my adjusted CAPE ratio of 20 occurs at the end of the tenth year. For example, assume the current CAPE earnings of 107. I compound 107 at a 5.8% annual earnings increase to arrive at earnings in a decade of 188. Multiply that by 20 to arrive at an Index fair price of 3760 in 2030. From 2950, that would be a compound annual appreciation of 2.5%. Add two percentage points for dividends to reach a compound annual total return of 4.5%. At fair value the compound annual total return would be 5.8% annual appreciation plus the two percentage points for dividends, or 7.8%.
As a result, a resurgence in infections and a reimposing of restrictions seem probable near term. And another wave of virus cases late in 2020 is expected by the scientists. I continue to expect a slow economic recovery--a prolonged "U," if you will.
I do realize that summer's heat may moderate the rise of cases resulting from prematurely reopening the economy And there is talk that a vaccine may be available during 2020 for hospital workers and others most vulnerable to the virus, such as the elderly and infirm.
With the Standard and Poor's 500 Index ("the Index") at 2950, my calculation of the Index's future risk/reward favors taking some profits. Today I lowered my equity exposure to 25% from 30% of my financial assets. The proceeds of the sale again are placed in short-term U.S. government securities as I continue to consider long-duration government fixed income to be grossly overpriced for those investors with a ten-year horizon.
How I Calculate Index Fair Value
Those readers of my previous posts are well aware that I use Shiller's CAPE ratio to determine the extent that the Index is overvalued, at fair value, or undervalued. Shiller's mean CAPE ratio is 17; my modified mean CAPE ratio is 20--the average ratio over the last 50 years rather than Shiller's last 138 years. Fair value to me is when mean reversion to a CAPE ratio of 20 occurs.
Shiller takes actual annual Index earnings for the last 10 years, adjusts for inflation using the consumer price index ("CPI"), totals the ten results, and divides by 10. I consider this to be "trend line earnings."
Shiller's CAPE ratio is available intra-day free of charge. If one divides the Shiller CAPE ratio into the Index price, you arrive at Shiller's earnings. Right now they are roughly 107. During the Great Recession actual earnings declined 56%. Last year's actual earnings were 157; so, if the actual earnings decline during this recession equaled that of the Great Recession, the low in annual actual earnings would be 69. The 2010 Index earnings adjusted for inflation are much higher than 69. According to the way Shiller's model works, those 2010 adjusted earnings will be dropped and the 2020 earnings added. Furthermore, this year I expect the CPI to be negative--deflation rather than inflation. So at the end of 2020, Shiller's earnings may fall from 107 to roughly 100. Fair value at the end of 2020 would then be 20 times 100, or an Index at 2000. From 2950, mean reversion then would imply a depreciation of 32%.
How I Calculate Future Returns
To calculate the Index's nominal compound annual total return for the next ten years, I assume that mean reversion to my adjusted CAPE ratio of 20 occurs at the end of the tenth year. For example, assume the current CAPE earnings of 107. I compound 107 at a 5.8% annual earnings increase to arrive at earnings in a decade of 188. Multiply that by 20 to arrive at an Index fair price of 3760 in 2030. From 2950, that would be a compound annual appreciation of 2.5%. Add two percentage points for dividends to reach a compound annual total return of 4.5%. At fair value the compound annual total return would be 5.8% annual appreciation plus the two percentage points for dividends, or 7.8%.
Monday, April 13, 2020
IS THE U. S. ECONOMY AT THE EDGE OF A PRECIPICE?
Federal Reserve Behavior--A Tell
During 2020 so far, the Federal Reserve on two occasions has lowered the Fed Funds rate between scheduled meetings--once is rare! Last week, the Fed announced that it may be purchasing BB-rated corporate bonds--that has never been done before! Usually the Fed considers the "moral hazard"* implications before acting. With this decision it has suspended that consideration. Desperate times call for desperate measures!I have mentioned in previous blog posts that the "search for yield" would end badly. As interest rates have declined, financial managers have gone farther out on the risk spectrum to reap higher yields there. The problem is that during a bear market the fixed income market for these riskier bonds has little liquidity. Recently with bond prices up and stock prices down, financial managers want to rebalance their portfolios by selling bonds to buy stocks. A financial manager whose fixed income portfolio is in high risk securities has trouble selling because there isn't a viable market. The Fed's action will unclog that market.
The Fed's behavior signals its expectation of very bad news ahead! It is trying to counter the negative wealth effect that a deep recession causes. If both home values and stock prices decline significantly, owners will likely save more and pull back on consumption, the main driver of the U.S.economy.
Right now, the Fed's ultimate concern is prolonged deflation, a condition few of us have ever encountered. Were that to occur, a vicious cycle might result. To illustrate: a consumer interested in buying a house or car realizes that prices for those items are declining. Why not wait for the lower price before buying? The seller then lowers the price even more, which may encourage the consumer to wait even longer! Given that the Fed had been unable to raise inflation to its desired 2% prior to the pandemic, its worry about deflation after the pandemic shock seems rational. The Fed is fighting the tail risk of deflation. I applaud their action.
The Bad Scenario
1) The recession is very deep and lasts longer than expected. Recent weekly claims for unemployment compensation suggest that the unemployment rate, recently at 50-year lows, may swell to a level only exceeded during the Great Depression! That suggests a recession even deeper than the 2008-2009 Great Recession. The shock from the pandemic causes the consumer to save more and spend less. As a result, the recovery from the recession will be much slower than expected--more like a prolonged "U" than a "V."
2) President Trump's decisions are primarily motivated by one goal--to be reelected. This introduces the risk that he will encourage a premature lifting of the sheltering-at-home and social-distancing restrictions now in place in most of the country. In the best of all possible worlds, the scientific data, not political ambition, would dictate when to reopen the economy. That data involves extensive testing beforehand, which seems unlikely. So the recent plateauing of the virus may continue longer than expected before tapering off. The current price of the Standard and Poor's 500 Index (the "Index") suggests that Wall Street is expecting a V-shaped recovery after a dismal second quarter.
3) With few exceptions, Wall Street strategists have not yet built into their earnings estimates the reality of a prolonged U-shaped recovery. During the last two recessions, Index operating earnings fell 32% and 56% respectively. In 2019 earnings were 157. With those declines in mind, 2020 earnings should range between 107 and 69. I expect that actual earnings will be in the lower half of that range.
4) There is a second wave of the virus in the last quarter of 2020.
5) Due to the factors mentioned above, the Index retests the low on March 23; and the low fails to hold.
The Good Scenario
1) A bona fide VACCINE is discovered soon and is fast-tracked for approval by the FDA--the GAME CHANGER!
2) President Trump listens to the scientists and doesn't urge lifting of the restrictions until adequate testing indicates the go-ahead signal.
3) The Fed's massive support program and fiscal stimulus approved by Congress eliminate the tail risk of deflation.
3) The Fed's massive support program and fiscal stimulus approved by Congress eliminate the tail risk of deflation.
4) Trump's politically-motivated decision to open prematurely proves prescient--whether due to warmer weather and/or a natural tapering off of the coronavirus's cases. No extended first wave and no second wave occur. A "V" recovery!
5) The Index never retests the low on March 23; that low proves to be THE BOTTOM!
Was the Index low on March 23 the capitulation phase? In many respects this reminds me of October 10, 2008. At that time TARP was just announced. The volume of trading on that day was twice the recent volume, and 86% of NYSE listed stocks reached new lows. At that time I wrote that a breadth climax had occurred. I was in the process of building an equity position, and I completed it soon thereafter. As it turned out, most stocks did bottom on October 10, but the Index dropped another 26% before bottoming at 666 in March 2009. The average cost of my equity position in 2008 was at an Index level of 1080. Compared with the previous bull market high above 1500, that seemed like a good price, and the position did well in the ensuing bull market, However, compared to the Index low of 666, I should have done better!
Now a much larger Fed and Treasury effort than TARP and huge stimulus approved by Congress have been announced and will be implemented much faster. Trading volume during the two weeks prior to March 23 was more than twice recent volume; and the percentage of new lows was 86%. A breadth climax has occurred! But was that the Index low?
Bear market bottoms occur when there is an extreme of fear. Sentiment indicators measure the level of fear among investors. At extreme levels they are contrarian in that the higher their level the more bullish one should become. There are two sentiment indicators that are primarily relevant for traders: 1) On March 23 bearish sentiment at AAII was at levels last seen at the bottom of the last bear market in March 2009; and 2) the volatility index,VIX, was at new highs. As an investor with a five to ten year horizon, I pay more attention to the percentage bears at Investors Intelligence’s weekly Survey of Advisors’ Sentiment. For the week ending March 20, that percentage reached 41.7%, not near the October 10, 2008 level of 53% and below the levels at each of the last five bear market bottoms. However, it is at the highest level in eight years! So the “fear gauges” were flashing a trading “Buy!” but not quite yet an investor “Buy!” As it turned out, a vigorous rally has ensued.
Catching a Falling Knife
Stock markets discount the future. During a bear market resulting from a recession, the stock market will bottom before the recession is over. Bear market bottoms form when fear reaches a crescendo. when investors tell their brokers “Get me out of stocks! I don’t care what the price!” That is known as the “capitulation phase.”
Now a much larger Fed and Treasury effort than TARP and huge stimulus approved by Congress have been announced and will be implemented much faster. Trading volume during the two weeks prior to March 23 was more than twice recent volume; and the percentage of new lows was 86%. A breadth climax has occurred! But was that the Index low?
Bear market bottoms occur when there is an extreme of fear. Sentiment indicators measure the level of fear among investors. At extreme levels they are contrarian in that the higher their level the more bullish one should become. There are two sentiment indicators that are primarily relevant for traders: 1) On March 23 bearish sentiment at AAII was at levels last seen at the bottom of the last bear market in March 2009; and 2) the volatility index,VIX, was at new highs. As an investor with a five to ten year horizon, I pay more attention to the percentage bears at Investors Intelligence’s weekly Survey of Advisors’ Sentiment. For the week ending March 20, that percentage reached 41.7%, not near the October 10, 2008 level of 53% and below the levels at each of the last five bear market bottoms. However, it is at the highest level in eight years! So the “fear gauges” were flashing a trading “Buy!” but not quite yet an investor “Buy!” As it turned out, a vigorous rally has ensued.
What to do now?
With the great uncertainty that the pandemic has caused, it is difficult to determine which scenario is more probable. I am risk averse. My inclination is to go with the bad scenario.
In my Medium post entitled "A Case for Cash,"** published January 1, 2020, I suggested that both the Index and bonds were so overvalued that they would produce subpar returns over the next ten years. So a large cash position was warranted until prices reverted to the mean. At that point, the Index was at 3230. In that post, I assumed compound annual Index earnings growth of 6.3% over the next decade. I assumed stock buybacks would continue to contribute one to two percentage points. The Democratic party has been quite vocal against these buybacks, and that has become part of the current narrative. Therefore I have reduced my expected annual Index earnings growth to 5.8%. Were this rally to continue into the 2900-3000 range, I would reduce my equity exposure from 30% to 25%. At 2950 the Index would generate a paltry 4.4% compound annual total return (including dividends) over the next decade.
Given my experience during 2008 and the lack of extreme bearishness, I believe there will be a retest of the March 23 low; and if the bad scenario becomes the narrative then, a further downdraft might happen. If the Index gets low enough, I would raise my equity exposure to 70% in two tranches: the first 40% of my open-to-buy at 2,000-2200; and the remaining 60% if the Index breaks through 2000, thus signaling another leg down.
*In the long run, this Fed action encourages bad behavior. Financial managers will expect the Fed to bail them out again, so why not buy the riskier bonds? And perhaps the Fed will buy stocks as well, so why not buy the Index no matter what the P/E multiple? (Japan's Central Bank has tried this.)
**The URL is https://medium.com/@walterweil39/a-case-for-cash-e2819905137c
Tuesday, February 25, 2020
A Reason To Rebalance My Equity Exposure Now
It has been several years since I rebalanced my equity exposure back to my core position. I had been waiting until Shiller's CAPE ratio had reached the January, 2018 high of more than 34; and the Investors Intelligence percentage bulls had reached 60%. Neither has happened yet.
That notwithstanding, to me, a possible exogenous event, a pandemic, if it were to occur, would wreak havoc on the worldwide economy and stock markets. I have no way of assigning a probability to that event. Due to this uncertainty, I have rebalanced my equity exposure back to my core level.
That notwithstanding, to me, a possible exogenous event, a pandemic, if it were to occur, would wreak havoc on the worldwide economy and stock markets. I have no way of assigning a probability to that event. Due to this uncertainty, I have rebalanced my equity exposure back to my core level.
Monday, January 29, 2018
How Shiller's CAPE Ratio Is Important In Managing My Grandchildren's Section 529 Accounts.
When my two grandchildren were born, I established a Section 529 College Plan for each. As you probably know, these are attractive because the capital appreciation in the account is tax-free, as are the distributions out of the account if they go toward financing the beneficiary's college education.
To illustrate how I use Shiller's CAPE ratio to help me manage these accounts, let's consider the account for my grandson. It was just dumb luck that he was born in November, 2008--right after most stocks bottomed in October that year. I began investing right away, and ultimately put in a total of $154,000.
The New York State 529 College Plan is managed by Vanguard, which allows the money to be invested in a number of their no-load mutual funds. Unfortunately, Vanguard's Standard and Poor's 500 Index Fund wasn't one of the choices. I asked Vanguard to determine a mix of available funds that would correlate highly with the performance of that Index. I invested in those funds. As of last Friday, the account now totals $396,000.
I called my alma mater to find out what tuition, room, and board costs a freshman this year, which is
$70,000. And one could expect that number to compound at an annual rate of between 3% and 7%, he said. (At my fiftieth reunion, the compound annual growth during that half a century was 6.3%.)
So for planning purposes, I assume the worst--that college costs compound at 7% a year.
Now you might think that I would relax since my grandson's account already has almost $100,000 a year in it, and there are almost ten years left before he enters college. Wrong!
As you know, I have adjusted Shiller's mean CAPE ratio to take into account only his last fifty years of data. My adjusted mean P/E ratio is 19.8, well above his 16.8. As of Friday, Shiller's CAPE ratio was 34.8, which means the Index is 75% overvalued using my adjusted mean P/E. So, if mean reversion were to occur immediately, the Index could fall 42%. In that case, rather than $100,000 a year available, my grandson would only now have $58,000 a year--well below the actual cost of $70,000. So rather than being well ahead, the account is really "behind the eight ball!"
Furthermore, the compound annual total return for the Index (inclusive of dividends reinvested) during the next 10 years until he enters college is likely to be, at best, little more than 3%. Meanwhile, annual tuition, room, and board could be $140,000 ten years from now.
So what's a grandfather to do? I could take my chances and keep the account fully invested in equities. Or I could reduce the equity exposure and bet that I can buy back at significantly lower prices. Last Friday, I reduced the equity exposure to 50%.
This outlook is daunting for other long-duration accounts as well. Most notable are the government pension funds who can't meet their future obligations without assuming an annual return of 7% over the next ten years. They will be lucky to achieve 3%. The difference must be made up by a combination of increasing taxes, borrowing more, or cutting entitlements. Not a pretty picture!
To illustrate how I use Shiller's CAPE ratio to help me manage these accounts, let's consider the account for my grandson. It was just dumb luck that he was born in November, 2008--right after most stocks bottomed in October that year. I began investing right away, and ultimately put in a total of $154,000.
The New York State 529 College Plan is managed by Vanguard, which allows the money to be invested in a number of their no-load mutual funds. Unfortunately, Vanguard's Standard and Poor's 500 Index Fund wasn't one of the choices. I asked Vanguard to determine a mix of available funds that would correlate highly with the performance of that Index. I invested in those funds. As of last Friday, the account now totals $396,000.
I called my alma mater to find out what tuition, room, and board costs a freshman this year, which is
$70,000. And one could expect that number to compound at an annual rate of between 3% and 7%, he said. (At my fiftieth reunion, the compound annual growth during that half a century was 6.3%.)
So for planning purposes, I assume the worst--that college costs compound at 7% a year.
Now you might think that I would relax since my grandson's account already has almost $100,000 a year in it, and there are almost ten years left before he enters college. Wrong!
As you know, I have adjusted Shiller's mean CAPE ratio to take into account only his last fifty years of data. My adjusted mean P/E ratio is 19.8, well above his 16.8. As of Friday, Shiller's CAPE ratio was 34.8, which means the Index is 75% overvalued using my adjusted mean P/E. So, if mean reversion were to occur immediately, the Index could fall 42%. In that case, rather than $100,000 a year available, my grandson would only now have $58,000 a year--well below the actual cost of $70,000. So rather than being well ahead, the account is really "behind the eight ball!"
Furthermore, the compound annual total return for the Index (inclusive of dividends reinvested) during the next 10 years until he enters college is likely to be, at best, little more than 3%. Meanwhile, annual tuition, room, and board could be $140,000 ten years from now.
So what's a grandfather to do? I could take my chances and keep the account fully invested in equities. Or I could reduce the equity exposure and bet that I can buy back at significantly lower prices. Last Friday, I reduced the equity exposure to 50%.
This outlook is daunting for other long-duration accounts as well. Most notable are the government pension funds who can't meet their future obligations without assuming an annual return of 7% over the next ten years. They will be lucky to achieve 3%. The difference must be made up by a combination of increasing taxes, borrowing more, or cutting entitlements. Not a pretty picture!
Wednesday, January 10, 2018
I REMAIN A CAPE CRUSADER!
As you know, I rely on Professor Shiller's CAPE ratio to determine when I rebalance my family's financial assets. Yesterday it reached 33.5--roughly the high of the bull market that ended in 1929, before the stock market crash in October of that year. The only other time the CAPE was above this level was during the bull market that ended in March, 2000, when the CAPE reached 44. (In a post called "WAITING FOR GODOT" written December 2, 2016, I explained why I think the CAPE won't reach that lofty level this time.)
CAPE detractors are numerous and tend to become vehement at major market tops. Why? Professor Shiller recognized that business cycles exist, resulting in profit margin cycles. Wall Street practitioners in general have a bullish bias. They tend to apply mean P/E ratios to peak earnings to determine fair value, rather than the more reasonable approach -- applying them to mean earnings. Thus, to them the market appears still cheap at market tops. Shiller's CAPE concept "curbs the enthusiasm" of the bulls.
Recently CAPE logic seems even more under siege.
As I mentioned in my last post of October 23, 2016, the denominator of the CAPE ratio is the ten-year average annual earnings of the Standard and Poor's 500 Index ("the Index") adjusted for inflation. Because of this moving average construct, during the next two years the depressed earnings of the Great Recession will be dropped, and earnings during 2018 and 2019 will be added. Hypothetically, even if actual earnings during the next two years were flat, the CAPE ratio,with the Index still at 2751, will have declined to the high twenties just because the ten-year average earnings would have increased. This argument is valid, but it relies on a vagary in how the CAPE is calculated. Once the U.S. economy experiences the next recession, this effect will be reversed!
Also recently, one of the money managers I most respect hinted that recent elevated profit margins may be the "new normal" -- or at least that these profit margins will be extended many years going forward. He might be right. But to me he has uttered the most dangerous phrase in a money manager's lexicon, "This time it's different!".
Yesterday, the CAPE ratio reached 100% overvaluation. As a CAPE crusader, I rebalanced. The sale proceeds remain in cash equivalents.
So long as the yield on the ten-year U.S. Treasury note remains under 3% (it is now at 2.58%) and earnings increase, the Index will have an upward bias. Once 3% is breached, a bear market should quickly ensue. As the Index becomes more overvalued, I shall continue to rebalance--next stop 110%.
CAPE detractors are numerous and tend to become vehement at major market tops. Why? Professor Shiller recognized that business cycles exist, resulting in profit margin cycles. Wall Street practitioners in general have a bullish bias. They tend to apply mean P/E ratios to peak earnings to determine fair value, rather than the more reasonable approach -- applying them to mean earnings. Thus, to them the market appears still cheap at market tops. Shiller's CAPE concept "curbs the enthusiasm" of the bulls.
Recently CAPE logic seems even more under siege.
As I mentioned in my last post of October 23, 2016, the denominator of the CAPE ratio is the ten-year average annual earnings of the Standard and Poor's 500 Index ("the Index") adjusted for inflation. Because of this moving average construct, during the next two years the depressed earnings of the Great Recession will be dropped, and earnings during 2018 and 2019 will be added. Hypothetically, even if actual earnings during the next two years were flat, the CAPE ratio,with the Index still at 2751, will have declined to the high twenties just because the ten-year average earnings would have increased. This argument is valid, but it relies on a vagary in how the CAPE is calculated. Once the U.S. economy experiences the next recession, this effect will be reversed!
Also recently, one of the money managers I most respect hinted that recent elevated profit margins may be the "new normal" -- or at least that these profit margins will be extended many years going forward. He might be right. But to me he has uttered the most dangerous phrase in a money manager's lexicon, "This time it's different!".
Yesterday, the CAPE ratio reached 100% overvaluation. As a CAPE crusader, I rebalanced. The sale proceeds remain in cash equivalents.
So long as the yield on the ten-year U.S. Treasury note remains under 3% (it is now at 2.58%) and earnings increase, the Index will have an upward bias. Once 3% is breached, a bear market should quickly ensue. As the Index becomes more overvalued, I shall continue to rebalance--next stop 110%.
Monday, October 23, 2017
"BULL MARKETS GO UP LIKE ESCALATORS; BEAR MARKETS GO DOWN LIKE ELEVATORS!"
Another man's vivid image of markets which resonates with me. Bull markets die hard! It takes time for one to form a top. Bear markets, on the other hand, generally end with what I have called a waterfall decline, a "puking" phase, or a selling climax. (See my posts during 2008 and 2009.) This asymmetry of stock market phases has dictated my asymmetric money management approach. During the bull phase, I rebalance my equity exposure back to my core 30% position as the Standard and Poor's 500 Index (the "Index") becomes more and more overvalued according to Shiller's CAPE ratio*. On the other hand, during the bear phase, I rely only on technicals --trading volume, market breadth, and price -- to confirm a market bottom. At that point, time is of the essence; and my adjusted CAPE ratio determines how much I add to my equity risk exposure.
At 2578 today, the Index became close to 89% overvalued according to Shiller. In previous posts, I have mentioned that 90% would be a call to action. To me, the tax decreases likely to be passed have already been discounted by the market. And any meaningful tax code overhaul will be a long slog. Today I rebalanced my equity exposure back to my core 30% of financial assets. Next stop: Shiller's 100% overvaluation.
The "Search For Yield" Trap
As you know, I believe in mean reversion in both stock P/Es and bond yields. I also feel that Shiller's CAPE ratio is helpful in determining how far stock P/Es have strayed from their mean. As stocks and bonds both become more overvalued, I reduce risk in both of these asset classes. In certain circumstances, like now, cash becomes a legitimate asset class.
A good example of this is how I have managed my two daughters' financial assets. Their core equity exposure over the last several decades has been an aggressive 100% of their financial assets. Originally, the money was invested equally in four no-load equity mutual funds--a Standard and Poor's 500 Index fund, and three T. Rowe Price funds with a higher risk: New Horizons, Small Cap Value, and New Asia. So 75% of the accounts were then in funds with a higher risk than in the Index.
As the Index became more overvalued, I have been reducing the equity risk exposure in these accounts, with the proceeds invested in cash equivalents because bonds are overvalued as well. Now the equity exposure is 55% of financial assets, with 45% in cash. Furthermore, the composition of the equity exposure has changed. Now 50% of the accounts are in the Index fund, with only 50% in the higher risk funds.
As stocks and bonds become more overvalued, many money managers are compelled to do the opposite: they are increasing risk in their clients' accounts. This is due to managers' abhorrence of
cash. In fixed income, their search for higher yield takes them from U.S. government bonds to investment-grade U.S. corporates to high-yield U.S. corporates to emerging market corporates. In equities, as the Index becomes more overvalued, they go farther out on the risk spectrum by investing in, for example, emerging market funds.
This makes no sense to me; for their clients, this will end badly!
* An arcane point--in calculating his CAPE ratio, Shiller uses the average earnings (adjusted for inflation) over the last ten years. During the Great Recession which began in late 2007, Index annual operating earnings fell from 91 to 40 in eight quarters. During the next eight quarters these depressed earnings (adjusted for inflation) will be dropped and the expected strong current earnings will replace them. Absent a recession during this period, the result will be an additional significant temporary jump in Shiller's earnings in each of the next two years -- thus putting downward pressure on the CAPE ratio. However, during the next recession, this positive impact on Shiller's earnings will ultimately be reversed. Nevertheless, short term, this will be grist for the bulls' mill.
At 2578 today, the Index became close to 89% overvalued according to Shiller. In previous posts, I have mentioned that 90% would be a call to action. To me, the tax decreases likely to be passed have already been discounted by the market. And any meaningful tax code overhaul will be a long slog. Today I rebalanced my equity exposure back to my core 30% of financial assets. Next stop: Shiller's 100% overvaluation.
The "Search For Yield" Trap
As you know, I believe in mean reversion in both stock P/Es and bond yields. I also feel that Shiller's CAPE ratio is helpful in determining how far stock P/Es have strayed from their mean. As stocks and bonds both become more overvalued, I reduce risk in both of these asset classes. In certain circumstances, like now, cash becomes a legitimate asset class.
A good example of this is how I have managed my two daughters' financial assets. Their core equity exposure over the last several decades has been an aggressive 100% of their financial assets. Originally, the money was invested equally in four no-load equity mutual funds--a Standard and Poor's 500 Index fund, and three T. Rowe Price funds with a higher risk: New Horizons, Small Cap Value, and New Asia. So 75% of the accounts were then in funds with a higher risk than in the Index.
As the Index became more overvalued, I have been reducing the equity risk exposure in these accounts, with the proceeds invested in cash equivalents because bonds are overvalued as well. Now the equity exposure is 55% of financial assets, with 45% in cash. Furthermore, the composition of the equity exposure has changed. Now 50% of the accounts are in the Index fund, with only 50% in the higher risk funds.
As stocks and bonds become more overvalued, many money managers are compelled to do the opposite: they are increasing risk in their clients' accounts. This is due to managers' abhorrence of
cash. In fixed income, their search for higher yield takes them from U.S. government bonds to investment-grade U.S. corporates to high-yield U.S. corporates to emerging market corporates. In equities, as the Index becomes more overvalued, they go farther out on the risk spectrum by investing in, for example, emerging market funds.
This makes no sense to me; for their clients, this will end badly!
* An arcane point--in calculating his CAPE ratio, Shiller uses the average earnings (adjusted for inflation) over the last ten years. During the Great Recession which began in late 2007, Index annual operating earnings fell from 91 to 40 in eight quarters. During the next eight quarters these depressed earnings (adjusted for inflation) will be dropped and the expected strong current earnings will replace them. Absent a recession during this period, the result will be an additional significant temporary jump in Shiller's earnings in each of the next two years -- thus putting downward pressure on the CAPE ratio. However, during the next recession, this positive impact on Shiller's earnings will ultimately be reversed. Nevertheless, short term, this will be grist for the bulls' mill.
Tuesday, May 23, 2017
EXPECTED STANDARD AND POOR'S 500 INDEX TOTAL RETURNS
I was recently asked to write an article on observations gleaned over a half century of investing. Following is one observation.
MOST OF THE TIME STOCKS ARE THE PREFERRED ASSET—BUT NOT ALWAYS.
When the Standard and Poor's 500 Index ("the Index") is selling at its mean CAPE ratio, its expected compound annual return is 8% to 9%—6% to 7% from earnings growth and two percentage points from reinvested dividends. The 10-year U.S. Treasury note yield has averaged 6.4%, albeit with less risk than the Index. Treasury bills yield even less, but with almost no risk. Almost always, the Index outperforms U.S. Treasury fixed income.
However, in late December, 1999, a rarity occurred. The Index was more than 100% overvalued; and zero-coupon Treasury securities, from 5 to 25 year maturities, were yielding 6% to 7%. According to my analysis at that time*, if the Index’s P/E ratio reverted to its mean at any time before each of those 5 year intervals, the Treasury notes and bonds would outperform the Index! At that time the Index was 1435. Following are the results of my study.
Index Index
Mean Reversion Expected Compound Zero Treasuries'
by Year-End Annual Return** Yield to Maturity
2004 -3.3% 6.2%
2009 2,5% 6.5%
2014 4.4% 6.7%
2019 5.4% 6.5%
2024 5.9% 6.4%
**Including reinvested dividends
This year, in early March, the Index reached 2400. Since my study 17 years ago, the Index has compounded at 3.1% annually. Add 2 percentage points for reinvested dividends, and the total compound annual return has been a mere 5.1%—in line with my expectation shown in the table. The bond with that maturity yielded 6.6% at the time of my study—a 29% higher return with LESS RISK.
*This analysis was part of an article published in the December 27, 1999 issue of Barron's.
FUTURE RETURNS FROM HERE
In the same vein, I thought it might be interesting to calculate future total Index returns using the same methodology from 17 years ago. With that in mind, I have calculated what Index returns can be expected if mean reversion occurred immediately, within five years , or ten years. For the Index's mean CAPE ratio, I use my adjusted 19.8. The Index is currently again at 2400.
Index
Expected
Index Compound
Mean reversion Annual Return***
Immediately -33.0%
Within Five Years 0.7%
Within Ten Years 4,8%
***Including reinvested dividends
Were a cataclysmic event to occur, causing immediate mean reversion, the Index would drop 33.0%, to 1600. I would take an out-sized Index position at that price. Mean reversion within five years would result in an expected compound annual total return of a mere 0.7%; and within ten years 4.8%. This compares with a normal 8% to 9% total compound annual return for the Index. $100,000 invested at 4.8% a year reaches $160,000 in ten years; at 8.5%, it reaches $226,000—the beauty of compound growth, the “eighth wonder of the world!”
Saturday, March 4, 2017
"ANIMAL SPIRITS", the SNAP IPO, and CalPERS
The Standard and Poor's 500 Index ("the Index") flirted with 2400 last Wednesday. At that level, the Index became 80% overvalued according to Shiller's CAPE Index. He uses a mean P/E multiple of 16.7 to determine fair value. That is the mean over 145 years. I use a mean P/E of 19.6, the mean over the last 50 years. According to my approach, the Index is 50% overvalued. No matter how you slice it, the Index is way overvalued. If the Index reverted to fair value immediately, according to my valuation approach, it would decline by a third to roughly 1600.
As I have written in previous posts, whenever the CAPE becomes ten percentage points more overvalued, it triggers an automatic rebalancing of my equity exposure back to 30% of my financial assets. Accordingly, yesterday I rebalanced.
Recently, the phrase "animal spirits" has appeared frequently in investment news letters. "The animal spirits are behind the stock market melt up since the Trump victory." "This is only the beginning of the last phase of the bull market that began eight years ago this month."
This week's SNAP IPO is evidence of this phenomenon. It is the first large tech company to go public in quite some time. The offering was priced at what I would euphemistically describe as "full" and then appreciated 50%! Shades of 2000 when the dot.com bubble burst--when Professor Shiller published his book "Irrational Exuberance" almost exactly at the top of that bull market. (That effort won him the Nobel Prize for Economics.)
Furthermore, the percentage bulls at Investors Intelligence reached its highest level since 1987!
Another example of a pricey stock market is that CalPERS, the California public employees retirement fund, one of our country's largest institutional investors. recently reduced its long-term expected return on its assets from 7.5% to 7.0% and announced this week that it would reduce it again! (According to my calculation, a conventional 60% stock/40% bond portfolio would, at best, return 2% during the next five years if a reversion to stock and bond market means occurred during that period.)
Unfortunately, the "animals" are the retail investors, many of whom have missed the entire move in the Index from 666 in March, 2009 to roughly 2400 last Wednesday. It is a shame that, historically, the retail investor tends to buy at the tops of bull markets and sell at the bottoms in bear markets. (This is borne out by mutual fund inflows and outflows.) This behavior wreaks havoc with baby boomers' retirement funds.
Yes, the animal spirits could propel the Index higher from here. I look upon such a happening as an opportunity to rebalance again. This raises the question "How overvalued must the market be to warrant your selling your entire equity position?"
If the Index soon reached 3200 (up a third from here) and the U.S. Treasury note yield reached 4% (it is now at 2.5%), I would liquidate the entire equity position and buy the Treasury note. While such an overvaluation did occur in 2000 when the Index reached its most overvalued in at least a century, I attach a de minimis probability to that event, (See my recent post entitled "WAITING FOR GODOT" for why I think so.) Meanwhile, for financial planning purposes, I assume that the Index valuation reverts to its mean P/E of 19.6; and I take a "haircut" of one-third off the current equity valuation for a more accurate view of reality. I find this especially useful for long duration accounts such as my grandchildren's Section 529 college savings plans.
As I have written in previous posts, whenever the CAPE becomes ten percentage points more overvalued, it triggers an automatic rebalancing of my equity exposure back to 30% of my financial assets. Accordingly, yesterday I rebalanced.
Recently, the phrase "animal spirits" has appeared frequently in investment news letters. "The animal spirits are behind the stock market melt up since the Trump victory." "This is only the beginning of the last phase of the bull market that began eight years ago this month."
This week's SNAP IPO is evidence of this phenomenon. It is the first large tech company to go public in quite some time. The offering was priced at what I would euphemistically describe as "full" and then appreciated 50%! Shades of 2000 when the dot.com bubble burst--when Professor Shiller published his book "Irrational Exuberance" almost exactly at the top of that bull market. (That effort won him the Nobel Prize for Economics.)
Furthermore, the percentage bulls at Investors Intelligence reached its highest level since 1987!
Another example of a pricey stock market is that CalPERS, the California public employees retirement fund, one of our country's largest institutional investors. recently reduced its long-term expected return on its assets from 7.5% to 7.0% and announced this week that it would reduce it again! (According to my calculation, a conventional 60% stock/40% bond portfolio would, at best, return 2% during the next five years if a reversion to stock and bond market means occurred during that period.)
Unfortunately, the "animals" are the retail investors, many of whom have missed the entire move in the Index from 666 in March, 2009 to roughly 2400 last Wednesday. It is a shame that, historically, the retail investor tends to buy at the tops of bull markets and sell at the bottoms in bear markets. (This is borne out by mutual fund inflows and outflows.) This behavior wreaks havoc with baby boomers' retirement funds.
If the Index soon reached 3200 (up a third from here) and the U.S. Treasury note yield reached 4% (it is now at 2.5%), I would liquidate the entire equity position and buy the Treasury note. While such an overvaluation did occur in 2000 when the Index reached its most overvalued in at least a century, I attach a de minimis probability to that event, (See my recent post entitled "WAITING FOR GODOT" for why I think so.) Meanwhile, for financial planning purposes, I assume that the Index valuation reverts to its mean P/E of 19.6; and I take a "haircut" of one-third off the current equity valuation for a more accurate view of reality. I find this especially useful for long duration accounts such as my grandchildren's Section 529 college savings plans.
Saturday, January 7, 2017
Sentiment Indicator Flashes RED!
I wrote a post December 26, 2013 whose title was a famous Mark Twain quote, "History doesn't repeat itself, but it does rhyme!" I discussed how, as a contrarian investor, I find extremes in investors' bullishness and bearishness to be calls to action--selling when a bullish extreme occurs and buying when a bearish one is reached. In short, I view sentiment as a contrary indicator.
The sentiment indicator I have followed for decades is the weekly Investors Intelligence Sentiment Index Survey ("II"). If the percentage of bullish investors reaches 60% or more and the percentage of bearish investors 20% or less, that's a call to reduce my risk exposure to equities.
In that post I discussed how this call to action occurred five times during the last 25 years, and the average change in the Standard and Poor's 500 Index ("the Index") one year later was a MINUS 2.6% compared to average appreciation per year of 6% to 7% during that period. On the surface, this relative performance is outstanding! However, it is due primarily to having nailed the 2007 top in that bull market, from which there occurred a 39% drop in the Index during the ensuing year. The other four observations were false positives, albeit three led to subpar appreciations during the following year, but one was a glaring error with an above average appreciation of 12.4%.
At that time, I reduced my exposure to equities from 42% of financial assets to my core level of 30% due to that extreme in bullishness. In hindsight, that was a mistake! The Index appreciated 14% during the following year! So that was another glaring false positive. Still the average appreciation for the six observations during the last 28 years is still only a plus 0.2% a year. One might argue that we could experience another half dozen consecutive false positives and still the overall performance would be good.
The latest II reading is 60.2% bulls and 18.4% bears. Despite evidence that this sentiment indicator seems to be losing its predictive value, I did rebalance again back to my 30% core equity exposure. This is in addition to my rebalancing a few weeks ago when the Shiller CAPE ratio reached 28. So now both valuation and sentiment indicators are flashing RED!
The sentiment indicator I have followed for decades is the weekly Investors Intelligence Sentiment Index Survey ("II"). If the percentage of bullish investors reaches 60% or more and the percentage of bearish investors 20% or less, that's a call to reduce my risk exposure to equities.
In that post I discussed how this call to action occurred five times during the last 25 years, and the average change in the Standard and Poor's 500 Index ("the Index") one year later was a MINUS 2.6% compared to average appreciation per year of 6% to 7% during that period. On the surface, this relative performance is outstanding! However, it is due primarily to having nailed the 2007 top in that bull market, from which there occurred a 39% drop in the Index during the ensuing year. The other four observations were false positives, albeit three led to subpar appreciations during the following year, but one was a glaring error with an above average appreciation of 12.4%.
At that time, I reduced my exposure to equities from 42% of financial assets to my core level of 30% due to that extreme in bullishness. In hindsight, that was a mistake! The Index appreciated 14% during the following year! So that was another glaring false positive. Still the average appreciation for the six observations during the last 28 years is still only a plus 0.2% a year. One might argue that we could experience another half dozen consecutive false positives and still the overall performance would be good.
The latest II reading is 60.2% bulls and 18.4% bears. Despite evidence that this sentiment indicator seems to be losing its predictive value, I did rebalance again back to my 30% core equity exposure. This is in addition to my rebalancing a few weeks ago when the Shiller CAPE ratio reached 28. So now both valuation and sentiment indicators are flashing RED!
Friday, December 2, 2016
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.
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
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.
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.
Thursday, November 10, 2016
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.
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.
Saturday, June 25, 2016
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.
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.
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?"
Subscribe to:
Posts (Atom)
