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!
Saturday, January 7, 2017
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?"
Monday, August 24, 2015
WILL THE TAIL WAG THE DOG?
The traditional money management approach assumes that the stock market discounts the future economy--the stock market is the dependent variable and the economic outlook is the independent variable.
However, since the Great Recession, the opposite may have occurred. The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP), has sought to inflate asset prices. Higher asset prices would result in a " wealth effect", which, the Fed believed, would stimulate consumption, and would kick start the economy into escape velocity, when the economy could resume growth at historical rates without ZIRP. In other words, the stock market would determine the economy, rather than vice versa.
The Federal Reserve has been successful in inflating assets. After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years. I have argued that the Index is now vastly overvalued.
However, the economy has so far failed to respond as expected. Growth has been sub-par since 2009. Only recently has the economy shown signs of a pickup in real growth. There has been talk of the Fed's soon raising the federal funds rate for the first time in many years. Unfortunately, events in China may thwart this virtuous cycle.
I have discussed that China is trying to morph from an export-driven economy into one relying more on internal consumption. That transition has proven to be difficult. The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there. However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.
The ramifications of a much slower growth in the Chinese economy are significant. For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and stock markets of the raw material supplying countries.
If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?" In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.
As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure? The answer is 1600. (The Index closed Friday at 1971, down from the bull market high of 2130.)
Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement of the bull market from the 2009 low. That is an important Fibonacci number. Because many traders believe in such numbers, I pay attention to them.
However, since the Great Recession, the opposite may have occurred. The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP), has sought to inflate asset prices. Higher asset prices would result in a " wealth effect", which, the Fed believed, would stimulate consumption, and would kick start the economy into escape velocity, when the economy could resume growth at historical rates without ZIRP. In other words, the stock market would determine the economy, rather than vice versa.
The Federal Reserve has been successful in inflating assets. After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years. I have argued that the Index is now vastly overvalued.
However, the economy has so far failed to respond as expected. Growth has been sub-par since 2009. Only recently has the economy shown signs of a pickup in real growth. There has been talk of the Fed's soon raising the federal funds rate for the first time in many years. Unfortunately, events in China may thwart this virtuous cycle.
I have discussed that China is trying to morph from an export-driven economy into one relying more on internal consumption. That transition has proven to be difficult. The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there. However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.
The ramifications of a much slower growth in the Chinese economy are significant. For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and stock markets of the raw material supplying countries.
If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?" In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.
As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure? The answer is 1600. (The Index closed Friday at 1971, down from the bull market high of 2130.)
Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement of the bull market from the 2009 low. That is an important Fibonacci number. Because many traders believe in such numbers, I pay attention to them.
Monday, March 23, 2015
TINA--The Greater Fool Theory In Disguise
As you who have been reading my posts know ad nausea, I believe that fair value for the stock market (the Standard and Poor's 500 Index) is the discounted cash flow of future dividends. The discount rate is a function of the ten-year U.S. Treasury note. I believe that both the stock and bond markets ultimately revert to historical norms. The key factors--discount rate, earnings, and earnings growth rate--each undergo this mean reversion.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
Subscribe to:
Posts (Atom)
