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.
Monday, October 23, 2017
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.
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