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.

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!

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.” 

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. 

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

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.

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!

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%.

"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.
  

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!”

"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.