Posts Tagged ‘Fed Model’
Monday, April 30th, 2012
by John P. Hussman, Ph.D., Hussman Funds
Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.
Why? First, with respect to 5-year prospective returns, it’s important to recognize that returns at that horizon are primarily driven by valuations – not the “Fed Model” kind, but the normalized earnings and discounted cash flow kind. Stocks remain strenuously overvalued here, and only appear “fairly priced” relative to recent and near-term earnings estimates because corporate profit margins are more than 50% above their long-term norm. Meanwhile, corporate profits as a share of GDP are about 70% above the long-term average. As I detailed in Too Little To Lock In, these abnormally high margins are tightly related (via accounting identity) to massive fiscal deficits and depressed household savings rates, neither which are sustainable.
Our projection for 10-year S&P 500 total returns – nominal – is about 4.4% annually, which is far better than the 2000 peak, far inferior to the 2009 trough, and save for the period before the 1929 crash, worse than any prospective return observed prior to the late-1990′s bubble – even in periods having similarly depressed interest rates.
Of course, rich valuations can persist for some time – predictably resulting in poor long-term returns, but often doing little to prevent short-run speculation and temporary gains. The issue is then to identify the point at which overvalued conditions are joined by sufficiently overextended conditions, and a sufficient loss of speculative drivers, to make rich valuations “bite” even in the shorter-term. This is where additional criteria come in, such as overbought technical conditions and extreme optimism in the form of low bearish sentiment, depressed mutual fund cash levels, and heavy insider selling. Presently, it doesn’t help that T-bill yields and long-term bond yields remain higher than 6 months ago, and we have signs of oncoming recession. This is particularly evidenced by collapsing economic measures in Europe, softening economic performance in developing economies including China and India, and jointly weak year-over-year growth in key U.S. economic measures such as real personal income, real personal consumption, real final sales, and reliable leading indicators from the OECD and ECRI, as well as our own measures.
The combination of rich valuations, overbought conditions, overbullish sentiment, and deteriorating leading economic evidence can still unfortunately persist for months before being resolved. But once the hostile syndromes we’ve seen recently have emerged in the data, attempts at continued speculation have amounted to playing with fire. Similar conditions have repeatedly resulted in disastrous outcomes for investors. It would be nice to be able to “time” these outcomes better. We haven’t found a reliable way to do so, and would still be concerned about robustness – sensitivity to small errors – even if we did. Yet even when unfortunate outcomes are not immediate, the fact that the S&P 500 has underperformed T-bills for 13 years is not very sympathetic to arguments that stock market risk has been worth taking overall, except in confined doses.
Tags: Corporate Profit, Corporate Profits, Discounted Cash Flow, Earnings Estimates, Fed Model, Fiscal Deficits, GDP, Household Savings, Hussman Funds, Kraken, Market Advance, Market Plunges, Model Kind, Profit Margins, Speculation, Term Earnings, Treasury Bills, Trough, Valuations
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Monday, April 2nd, 2012
Too Little to “Lock In”
by John P. Hussman, Ph.D., Hussman Funds
We’ve regularly observed that corporate profit margins (and economy-wide, profits as a share of GDP) have a strong tendency to “mean revert” over time – specifically, elevated profit margins are associated with unusually weak earnings growth over the following 5-year period, and depressed profit margins are associated with unusually strong earnings growth over that horizon (see last week’s comment, A False Sense of Security ). Notably, the ratio of corporate profits to GDP is presently nearly 70% above its historical norm. Of course, the most common valuation methods used by Wall Street analysts (whether they use the “Fed model” or “forward operating earnings times arbitrary P/E multiple”) rely almost exclusively on estimates of year ahead earnings. Embedded in these toy models is the quiet assumption that current profit margins will be sustained indefinitely.
By contrast, a wide range of measures that use “normalized” fundamentals of one form or another are extraordinarily stretched. Andrew Smithers recently took note of the elevated levels of cyclically adjusted P/E ratios and price to replacement cost (“q”) and observed “As of 8th March, 2012, with the S&P 500 at 1365.9 , the overvaluation by the relevant measures was 48% for non-financials and 66% for quoted shares. Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.”
At 1400 on the S&P 500, the market’s overvaluation has now reached 70% on these measures, which have a far stronger correlation with subsequent market returns than the Fed Model or other unadjusted methods using forward operating earnings. This is particularly true over horizons of 4 years or longer. As a side note, since the reliance on forward operating earnings is now an established Wall Street practice, Valuing the S&P 500 Using Forward Operating Earnings details how to improve the reliability of market valuations based on these figures.
We presently estimate a nominal total return on the S&P 500 averaging 4.1% annually over the coming decade. This modestly exceeds the yield available on a 10-year Treasury, but by a small margin that – outside the late 1990′s bubble period – has previously been seen only during the two-year period approaching the 1929 peak, between 1968-1972 (which was finally cleared by the 73-74 market plunge), and briefly in 1987, before the crash of that year.
While it’s true that interest rates are depressed, apparently setting a low “bar” for equities, an additional question one should ask is whether interest rates themselves are “fair” in the sense of being adequate compensation for long-horizon risks. For example, back in 1982, stocks had a reasonable 10-year prospective risk-premium versus bonds, but both were priced to achieve extraordinarily strong returns. Presently, stocks have a weak 10-year prospective risk-premium versus bonds, but both are priced to achieve unsatisfactory returns. In 1982, investors had an incentive to lock in either, and were served well regardless of their choice. At present, investors have no reasonable incentive at all to “lock in” the prospective returns implied by current prices of stocks or long-term bonds (though we suspect that 10-year Treasuries may benefit over a short horizon due to continued economic risks and still-unresolved debt concerns in Europe, which has already entered an economic downturn).
It’s also inadvisable to view the present 4.1% projected (nominal) 10-year return on the S&P 500 as if it is some sort of “yield,” because even that expected return involves the risk of significant volatility and severe short-horizon loss.
But don’t low interest rates at least limit the potential downside in stocks, allowing stocks to remain at elevated valuations that are consistent with similarly low prospective returns? On that question, the historical record is instructive. Since 1930, the 10-year Treasury yield has been below 3% nearly 30% of the time. In 78% of those periods, the prospective 10-year total return on the S&P 500 exceeded 10% (based on our standard estimation method). In fact, the 10-year Treasury yield has historically been below 2.5% about 15% of the time (primarily in the period prior to 1952) and in fully 94% of those periods, the prospective 10-year total return on the S&P 500 exceeded 10%. The belief that prospective equity returns are tightly linked to bond yields is largely an artifact of the 1980-1998 period (when both enjoyed a persistent decline during a long period of disinflation), and is far less evident in broad market history.
Ignore the fact that long-term “secular” bull market advances have invariably started from valuations implying prospective 10-year total returns of nearly 20% annually (which is precisely why the secular advances that follow are so durable). The market decline required to build in prospective returns of that magnitude seems too extreme to even contemplate. Indeed, we estimate that the S&P 500 would presently have to decline by nearly 40% simply to reach valuations consistent with prospective 10-year total returns of 10% annually. It’s an open question whether we’ll see that level of prospective return in the next market cycle, but even if we touch that level of prospective returns 5 or 6 years from now, stocks will have gone nowhere in the interim (including dividends). Investors would need to have a terribly short memory in order to rule out that sort of risk. Last week’s valuation chart may be a useful reminder of where we stand relative to history.
On the subject of profit margins, James Montier at GMO published a nice piece last week, using a little-known national income identity (the Kalecki profits equation) to demonstrate that:
Profits = Investment – Household Saving – Government Savings – Foreign Savings + Dividends
Some might object that this is simply an identity (true by definition) and doesn’t imply causality. That’s a reasonable point, but as with all analysis, it’s not enough just to toss out an objection and walk away – you’ve got to go to the data and find out the truth. So let’s do that.
We can actually simplify things a bit to make the point more intuitive. As we’ve shown before, gross private investment has a very strong relationship with the current account deficit (“foreign savings”). Specifically, large increases in gross private investment are almost invariably financed by running a trade deficit in goods and services, and importing foreign savings to make up the difference. Meanwhile, dividends tend to be very smooth, so they don’t introduce a lot of variability to the equation.
What remains then is a fairly simple assertion: the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.
If we go to the data, we see the link between profit margins and deficits in the quarterly figures, but the tightest relationship is actually a causal one – large government deficits (as a percentage of GDP) coupled with weak household savings rates result in temporarily high corporate profit margins, with a lead of about 4-6 quarters.
The conclusion is straightforward. The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely. Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins. With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.
[Geek's Note: If you think in terms of equilibrium in the associated real output (actual goods and services of one sort or another), the Kalecki equation also means that the deficit-financed goods and services are essentially already spoken for, so the resulting corporate profits are not matched by similar increases in real investment. Instead, corporations accumulate claims on the government and households (i.e. they acquire a pile of government and consumer debt obligations). These obligations can only be "spent" in aggregate by the corporate sector on investment goods once households and the government begin to release a "surplus" of output by saving instead of spending beyond their means. Either that, or the trade deficit would explode as corporations accumulated investment goods by transferring their claims on the U.S. government and households to foreigners.]
A few quick economic notes. Real income declined month-over-month in the latest report, which is very much at odds with the job creation figures unless that job creation reflects extraordinarily low-paying jobs. Real disposable income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typically observed even in recessions. Real personal consumption growth ticked up slightly from 1.6% to 1.8% year-over-year, remaining in a range that is rarely observed except in association with recession. Given the contraction in real income, we also saw a sharp downturn in the savings rate in the latest report, to the lowest level since just before the last recession. While the slight bump in consumption could help near-term corporate profits, the income dynamics aren’t supportive of a continuation at all.
Finally, we’ve been watching the new unemployment claims data for some time. Almost without fail, when a new number is released, the new claims figure for the previous week is revised upward by about 3000 or so. Last week, we saw an unusual revision in new claims data, not just for the previous week, but in months of prior releases, with upward revisions averaging about 10,000 in the most recent reports (e.g. the Feb 25 figure was revised from 354,000 to 373,000). This reflects an annual update in the seasonal factors used by the Labor Department (which is why the revisions weren’t matched by similar changes in the non-seasonally adjusted data). It’s not clear what this implies for revisions in the monthly employment figures, if anything, but our “unobserved components” models continue to suggest a general trend toward disappointments in economic data, particularly over the next 6-8 weeks. Given that so much investor enthusiasm has focused on the new claims figures, it’s interesting that the large and generally upward revisions in months of prior data seemed to go virtually unnoticed.
As of last week, the Market Climate remained characterized by a hostile syndrome of overvalued, overbought, overbullish, rising-yield conditions. We’ve reviewed a variety of operational definitions of this syndrome in numerous prior weekly comments. Forget about the major declines that typically followed the handful of other instances we’ve observed this syndrome in the past, including the major peaks in 1972, 1987, 2000, and 2007. Even if we look over the past two years – and despite some early signals where market weakness was postponed by extraordinary monetary interventions – we still have not observed these conditions without resulting market declines of more than 15% (one in 2010 and another in 2011) that wiped out all of the gains since the earliest signal occurred, and then some.
Monetary interventions can periodically fuel speculative runs, which defer and spread out the adjustments that result from persistent overvaluation and misallocation of capital. But they can’t get around the inevitability of those adjustments. The only real choice policy makers have is how large a bubble they choose to see collapse. On that front, we’re clearly in better shape than we were at the peaks of 2007, 2000 and 1929, but conditions are generally more hostile than they have been in the vast remainder of market history. This will change. By our analysis, now remains one of the worst times on record to assume that market risk is acceptable.
Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value remains 50% hedged, its most defensive position, and Strategic Total Return continues to carry a duration of just under 3 years in Treasuries, with about 5% of assets allocated across precious metals shares, utilities, and foreign currencies. We don’t view the prospective returns in any asset class as being desirable enough to “lock in” on an investment basis, which means that most financial risks here are essentially speculative, and rely on the emergence of investors willing to accept even lower prospective returns. Again, the one constant in the financial markets is that these conditions will change. Patient opportunism remains essential here.
Tags: 8th March, Andrew Smithers, Assumption, Corporate Profit, Corporate Profits, Correlation, Earnings Growth, Extremes, False Sense Of Security, Fed Model, GDP, Horizons, Hussman Funds, Profit Margins, Ratios, Sense Of Security, Stock Market, Toy Models, Valuation Methods, Wall Street Analysts
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Monday, May 16th, 2011
Hanging Around, Hoping to Get Lucky
John P. Hussman, Ph.D., Hussman Funds
The stock market continues to be strenuously overvalued here, with a variety of historically reliable methods indicating probable total returns for the S&P 500 of only about 3.5% over the coming decade. This does not necessarily imply much about near-term market returns, though the continuing syndrome of overvalued, overbought, overbullish, rising-yield conditions does contribute to near-term risk.
That said, we had some good opportunities to modify our hedges in recent weeks to allow for a broader range of possible outcomes. As the market rose to its recent highs, triggering an unusually extended set of conditions (see Extreme Conditions and Typical Outcomes ) we raised our index put strikes close to at-the-money levels. The recent decline placed those options in-the-money. That in turn gave us the opportunity to cover about one-third of our short call options while still keeping a good line of protection in place. In short, we are well hedged against the potential for significant market losses, but with the implied volatility on index options fairly low, we’ve used shorter-term market fluctuations to modify our hedges in a way that better allows for any extension of the market’s advance.
With respect to the market’s valuation, there is a phrase in the first paragraph that is particularly important – “historically reliable methods.” This, for us, is a critical requirement for investors, because there are dozens of garbage models that purport to measure stock market valuation, but have little (and sometimes zero or negative) correlation with subsequent market performance. Long-term shareholders have seen enough discussion of “Fed Model” weaknesses in this regard (see any number of weekly comments from around the 2007 market peak, when I was railing about the dangers of gulping down that particular flavor of Kool Aid).
In contrast, I’ve often quoted the Shiller P/E (which essentially uses a 10-year average of inflation-adjusted earnings) as a simple but historically informative alternative, but I should emphasize that we strongly prefer our standard methodologies based on earnings, forward earnings, dividends and other fundamentals, all which have a fairly tight relationship with subsequent 7-10 year total returns (see Lessons from a Lost Decade , The Likely Range of Market Returns in the Coming Decade , Valuing the S&P 500 Using Forward Operating Earnings , and No Margin of Safety, No Room for Error ).
Note that all of these models estimate 7-10 year prospective total returns for the S&P 500, rather than kicking out a “fair value” number. This is a subtle distinction, but it is important. We believe it is much more useful to investors to evaluate a menu of projected long-term returns that can be directly compared across stocks, Treasuries, corporate securities, and so forth (see The Menu ). In order to turn a projected return figure into a “fair value” number, you have to take the extra step of assuming, on behalf of investors, what level of long-term returns is “fair” – and this is one of the ways that the Fed Model invites absurdity. For example, if we choose to believe that long-term investors will be sustainably happy to achieve long-term returns of 3.5% annually over the coming decade, then it follows that the S&P 500 is fairly valued here. I view that as a terribly dangerous assumption. Still, we can’t argue that stocks might be “fairly valued” for investors who see a very risky 3.5% expected long-term return as perfectly acceptable. At least they know what they’re getting into.
It’s interesting that historically, a Shiller PE above 24 (where it is presently) is also associated with average subsequent 10-year total returns of 3.5% for the S&P 500 (see Anatomy of a Bubble ). To make a plausible case against these expectations, one can’t simply trot out an expected forward operating earnings number, multiply it by an arbitrary forward multiple, and claim that stocks are reasonably valued. No – show your work. Analysts who claim that stocks are “cheap” when a market advance is mature and profit margins are elevated should be expected to demonstrate that their approach is historically reliable. Specifically, there should be long-term evidence (since at least the 1950′s, to capture a substantial amount of variation) that their methodology provides highly predictive information about the subsequent performance of the stock market.
Last week, the renowned value investor Jeremy Grantham threw his own hat into the defensive camp (see Grantham’s quarterly letter ). In truth, he’s been there for a while on the valuation front, but proved more nimble than us in conceding the influence of QE2 – “a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow but two!” Grantham described his willingness to suspend some concerns about valuation as an “experiment in going with the flow,” but added that this was personal, and ” emphasized the caveat that more serious, risk-averse, long-term investors would not want to play fast and loose with a market then worth only 900 on the S&P. I also added that GMO played pretty strictly by the value book for our clients, shading only a little here and a little there.”
Grantham presently estimates fair value at “about 920 on the S&P 500,” and warns “the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky.” Now, since it is easy to show that the long-term peak-to-peak trend of S&P 500 earnings and other fundamentals has advanced at an annual growth rate of roughly 6% annually nearly as far back in history as you care to look, a 920 fair value today, coupled with a roughly 2% dividend yield and a current S&P 500 of 1340, works out to an implied total return over the coming decade of [(1.06)(920/1340)^(1/10) + .02 - 1 =] 4% annually. In my view, that’s right in the ballpark.
Of course, that 6% underlying peak-to-peak growth would still have to come from somewhere. Part of it, in my expectation, will come from real GDP growth that will be about a half percentage point faster than the 2.5% expected growth in “potential GDP,” as I expect the current “output gap” to gradually close over the coming decade. The remainder is likely to come from inflation. But be careful – it is tempting to assume that if inflation comes in higher (as seems likely in the back half of the decade), the long-term return on stocks will also be commensurately higher, but that is the inflation-hedger’s first mistake. While stocks have been a fine long-term inflation hedge, they tend to perform miserably (particularly in inflation-adjusted terms) during periods where inflation is rising – particularly if the rising inflation is unanticipated. It’s only when inflation expectations are well recognized that stocks finally become priced to compensate accordingly, and of course, they typically do swimmingly when high expectations of inflation prove to be unfounded and inflation rates decline persistently, as we saw in the years following the 1982 market low.
Grantham’s valuation figure implies that the S&P 500 is just over 45% overvalued, by his measures. That’s clearly in general agreement with our own metrics, and is also consistent with other historically reliable metrics such as the Q ratio. Doug Short provides a nice overview:
Grantham concedes that his increased willingness to “go with the flow” was born of a “long and ignoble history of being early on market calls,” noting that GMO tends to “arrive at the winning post with good long-term results and less absolute volatility than most, but not necessarily the same clients that we started out with.” That comment reminded me of a study by Dalbar, which showed that for the 20 years ended in 2008, the Dow Jones Total Stock Market Index averaged an annual total return of 8.3%, the average equity fund returned 7.3%, but the average fund investor only achieved a return of 1.9% annually because of the tendency to chase investments at their peaks and bail out during weak periods.
As for us, we’ve certainly made our own adaptations to improve our ability to “go with the flow” with a greater frequency, even in markets that appear objectively overvalued from a long-term perspective. Still, whatever constructive opportunities there might have been in 2009 and early 2010 are now well behind us. We are close to the point where investors can ensure themselves maximum damage by shifting away from a defensive stance and buying the market, in hopes of reaching for return in an already richly valued and overextended advance.
Even with our own “ignoble” miss during this cycle, Strategic Growth remains ahead of the S&P 500 since its 2007 peak, with substantially less volatility and drawdown. It’s certainly not an overall performance that we think is “representative,” particularly now having solved the infuriatingly difficult “two data sets problem” that we faced during the financial crisis. But recapturing a stronger lead will be a matter for the next cycle. Provided that our shareholders are long-term and fully understand our process, I have little concern about “growing” our number of shareholders, which is why we don’t advertise, and why we regularly do “anti-marketing” to discourage short-term investments. Still, I feel an enormous amount of personal responsibility toward our existing shareholders, and honestly, my greatest worry is that the challenges we’ve had during the recent cycle will provoke any of them to capitulate and chase the market at these levels, possibly capturing some short-term gains, but ultimately doing damage to their financial security. At least going with another risk-managed approach would be preferable. Thankfully, we haven’t seen much of either, and I’m continually grateful for your trust.
Overall, we view the stock market as strenuously overvalued, with the likelihood of poor long-term returns in the area of about 3.5-4% over the coming decade. That’s certainly better than the valuations we observed in 2000 (when the S&P 500, by our estimate, was priced to achieve negative 10-year returns). But unless one expects a reprise of that bubble, or at least a reprise of the sort of enthusiasm we saw during the housing bubble (when valuations ascended high enough to drive 10-year prospective returns below 3% annually), the odds of sustained durable gains from present levels are weak. Still, our estimate of 10-year return prospects says very little about the profile of returns that would get us there. For example, a series of market fluctuations -40%, +85%, -36% and +100% within a 10-year period would produce a 10-year return about 3.5% annually, so a poor long-term expectation doesn’t rule out the likelihood of significant investment opportunities in the interim. The real difficulty at present is that at already elevated valuations, it’s less likely that those opportunities will be front-loaded.
As Howard Marks puts it, “participating when prices are high rather than shying away is the main source of risk. Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.”
Notes on Cyclical and Secular Markets
Historically, the “typical” market cycle has averaged about 5 years: about 3.75 years of advance at an average gain of 28% annually, and about 1.25 years of decline with an average loss also near 28% annually. Though the individual variations have been very wide, that has put the typical bull market gain at about 152% from trough-to-peak, followed by a bear market of about 34% from peak-to-trough, for a full-cycle total return of about 67% (roughly 10.7% annualized).
Of course, if we could rely on these averages, it would be unnecessary for investors to think at all. Unfortunately, things are not so simple, partly because these “cyclical” fluctuations are embedded within a broader context of longer “secular” movements in market valuations.
Historically, extended “secular” moves from extreme undervaluation (e.g. Shiller P/Es of about 7, as we saw in 1950 and 1982) to extreme overvaluation (multiples over 24, as we saw in 1929, 1965, 2000, and well, now) have taken about 15-18 years in each direction. Secular bull markets typically involve a whole series of bull-bear cycles, with each bull market peak achieving successively higher levels of valuation. Secular bear markets also involve a series of bull-bear cycle, but with each bear market trough achieving successively lower levels of valuation.
Though some analysts discuss these secular periods as if they are some sort of magical 17-year periodic structure that is inherent to the markets, our view is much simpler: over the long-term, markets fluctuate between extreme optimism / high valuations and extreme pessimism / depressed valuations. Secular bull markets do not begin because the calendar says they are due. They begin at the point that valuations become so depressed – again, about 7 on a Shiller P/E – that strong and sustained long-term returns are baked in the cake. Similarly, secular bears tend to begin at the point where valuations are so extreme – about 24 or higher on a Shiller P/E – that weak and ephemeral long-term returns are baked in the cake. The intervening secular moves simply take the market from one extreme to another over the course of something on the order of 15-20 years.
Though it’s clear that 2000 was a major peak and the start of a secular bear, it’s notable that despite more than a decade of meager returns, the Shiller P/E is again above 24. Since March 2000, when the Shiller P/E briefly touched an unprecedented level of 43, we’ve worked about 19 points off of the P/E, but it’s not nearly enough. The market’s valuation in 2000 was so extreme that the resulting secular bear has the potential to be more extended than others, unless the market was suddenly to collapse to valuations near those where historical secular bulls have started (where stocks have typically been priced to achieve 10-year prospective returns near 20% annually).
From that standpoint, there’s no chance that the 2009 low was the beginning of a secular bull, both because valuations weren’t nearly low enough (prospective 10-year returns briefly exceeded 10% annually, but were nowhere close to those accompanying the beginning of previous secular bulls), and also because at present, valuations are already about the point where one would look for a secular bear to start.
You might expect that when the market is gradually working down from a high level of overvaluation, bull markets would tend to be shortened, and bear markets would tend to be deeper. In fact, that’s exactly what we observe. As the guys at Nautilus Capital note, cyclical bull markets within secular bears have tended to average just 26 months, with an average gain of 85%, while cyclical bears within secular bears have averaged 19 months, with steep average losses of -39%. So market cycles tend to be truncated during secular bears, averaging a full bull-bear cycle duration of just 45 months (3.75 years), for a full-cycle average gain of just over 12% (3.3% annualized). Of course, fundamentals still tend to grow faster than 3.3% over the cycle, resulting in valuations that are lower at each bear market trough, even if prices are higher in absolute terms. I recognize that outcomes like these are unpleasant and inconvenient to contemplate, but denying the possibility doesn’t make anyone a better investor.
Despite the unique challenges of the most recent market cycle, I do expect that we will observe frequent opportunities to accept market risk in the coming years, even in an environment where valuations gradually work lower from a secular perspective. Even here, if we can clear some element of the hostile overvalued, overbought, overbullish, rising-yields syndrome that has characterized the market, we will be open to moderate, if transitory exposure to market fluctuations, provided that we maintain a line of index put option protection against any abrupt deterioration. In any event, however, I believe that the prospects for strong, durable, long-term stock market gains are dim at present. To repeat Grantham’s observation, “the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky.”
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile for stocks. Strategic Growth and Strategic International Equity remain well hedged here. We expect to establish a moderately constructive, if transitory exposure to market fluctuations if we can clear some component of this syndrome without a decline steep enough to significantly damage market internals. Still, at present, there are enough headwinds from valuations, fiscal strains, unsustainable monetary policy, sovereign default risks, and other factors that we expect to maintain a “line” of downside protection with index put options even if we shift to a more constructive stance. Even here, about one-third of the hedge in Strategic Growth represents modestly in-the-money put options without a short-call side, so any significant advance will take those puts out-of-the-money and naturally produce a more constructive position. The upshot is that there are conditions even here that could encourage a greater market exposure, but none in the near term that would lead us to do so without some form of safety net.
In bonds, we continue to observe some easing of yield pressures, but with the Fed’s SOMA portfolio now at $2.51 trillion, with a $2.60 trillion target, it is equally clear that the Fed buying that has almost completely financed ongoing fiscal deficits will end abruptly in a few weeks, absent a fresh round of quantitative easing. Bernanke noted in his recent press conference that the Fed subscribes to the “stock” view of the monetary base – which essentially means that so long as they don’t contract their portfolio, they would view policy as being in a sustained “easing” mode. That’s actually true in the sense that as long as the monetary base amounts to an unprecedented 17 cents of base money per dollar of nominal GDP, short-term interest rates will tend to hold between 1-3 basis points (though with significant inflation risk if any exogenous interest rate pressures emerge).
However, once the Fed’s aggressive purchases stop, the fiscal deficits will not, so the markets will certainly be forced to absorb far more new Treasury debt than they have in recent months. In the event of economic weakness or significant concerns of credit defaults, that will be easy, and could even be associated with dollar strength. Otherwise, something will have to act as the adjustment variable to produce the requisite capital flows as new debt is issued. The potential adjustments might include further dollar weakness, higher interest rates, or a shortfall in gross domestic investment. In any event, it seems clear that simply keeping the SOMA portfolio constant will not be enough to claim that the policy environment is unchanged.
In Strategic Total Return, our overall position remains fairly conservative given the wide range of potential outcomes. Still, easing pressures on yields, rising unemployment claims, and other factors have been reasonably favorable for modest maturities in the 5-year range, where Strategic Total Return holds much of its roughly 3-year duration. On significant weakness in precious metals shares, we added modestly to our holdings, bringing the total to a still-conservative 6% of assets, with another 2% of assets in utility shares.
I noted a couple of weeks ago that the implied default probability for Greek debt had reached about 100% on the basis of 2-year yield spreads. Indeed, about 85% of global bond managers now anticipate a Greek debt restructuring. That expectation is also reflected in longer-term yield spreads such as 10-year and 20-year debt. Still, it is important that when we work the implied default figures across multiple maturities, we get a roughly 100% expectation for default about 1.7-2.3 years from today. This general time-frame is supported by the fact that default expectations are clearly not reflected in shorter-term debt maturities. Indeed, in the event of a near-term expectation of debt default, we would probably see 1-year Greek yields spiking above 40%, and 3-month yields well above 100% annualized (which would be associated with 3-month bills trading well below 85% of face). If the markets become truly concerned about Greek debt, those are the sorts of extremes that one would expect.
As a side note, in the U.S., 3-month Treasury bill yields are now down to 2 basis points. This means that $1000 investment in 3-month bills now gets you a nickel of interest over the life of the investment.
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Monday, March 7th, 2011
Quantitative Easing and the Iron Law of Equilibrium
by John P. Hussman, Ph.D., Hussman Funds
Last week, I had the pleasure of speaking to investors at the Ibbotson-Morningstar 2011 investment conference. Since I rarely travel outside of charitable work, it was a nice opportunity to talk with shareholders and other investors. The topic was “Useful Laws and Dangerous Myths of Investing,” and I’ve attached the slides as a PDF, which provide an overall outline.
Nearly a century ago, Charles Dow said “to understand values is to understand the meaning of the market.” So I began with what I call The Iron Law of Value: An investment is nothing more than a claim on an expected stream of cash flows that will be delivered to investors over time. Much of that topic is very familiar to readers of these weekly comments – I focused the discussion on the difference between the “fundamentals” that are reported over the short-term (trailing net earnings, forward operating earnings, etc) and the long-term stream of cash flows that is actually delivered to investors, which depends on much broader considerations such as profit margins, sustainability of revenue growth, return on invested capital, the extent to which repurchases simply offset dilution from options grants to insiders, and so forth.
We also talked about simplistic valuation methods such as the Fed Model, which takes the simultaneous decline in 10-year Treasury yields and S&P 500 forward earnings yields from the early 1980′s to about 2000, and presumes that there must be a one-to-one correspondence between 10-year yields and S&P 500 earnings yields – which is clearly not supported by longer-term evidence. Likewise, we discussed the uses and drawbacks of “multiples-based” valuation methods (price = fundamental x “fair” price/fundamental ratio) – particularly the large amount of “work” that is quietly required of that “fair” multiple, and the danger of choosing it arbitrarily. As an alternative to those uses of forward operating earnings, I presented our standard methodology, and the historical record of the 10-year total return projections from that model, compared with the actual realized total returns that the S&P 500 subsequently achieved.
Next, I discussed what I call The Iron Law of Equilibrium: Every security that is issued must be held by someone until it is retired.
There are three corollaries to that Law: 1) No security can be under- or over-owned. Prices and expected returns adjust to ensure that the exact quantity outstanding is the exact quantity held. The investor’s challenge is to ask whether those prices and expected returns are reasonable; 2) The outstanding stock of issued currency and money market securities always remains effectively “on the sidelines” and held by someone – until the time those securities cease to exist; 3) Money never goes “into” or comes “out of” a secondary market. It is always “home.”
If you think carefully about equilibrium, it helps to clear up all sorts of fallacies that people hold about the financial markets. For example, the currency and money market securities that are held by investors will – in aggregate – never “find a home” in any other form or any other market. If somebody takes their cash and tries to buy stock, they get the stock and the seller gets the cash. Nothing disappears, and nothing is created – only the owner changes. As I wrote years ago in the Freight Trains and Steep Curves piece that anticipated the recent financial strains, the mountain of money-market securities held by investors is not a reflection of “liquidity looking for a home,” but is rather a measure of how dependent borrowers are on short-term sources of credit. Investors are holding a lot of money market securities because a lot of money market securities have been issued, and those securities will stick around until they are retired.
As I noted last week, an understanding of equilibrium is particularly important when it comes to the Federal Reserve’s program of Quantitative Easing (QE), so some further discussion may be helpful.
Essentially, QE has added to what will soon be $2.4 trillion of non-interest bearing cash and bank reserves, which someone will have to hold. The first effect of QE is therefore to immediately drive the interest rate on near-substitutes of cash (such as 1-month and 3-month T-bills) to nearly zero. This happens because any significant positive interest rate would induce people to try to shift their holdings from non-interest bearing cash to T-bills, and they bid up T-bills to the point where they are indifferent between the two. In the end, all the T-bills that have been issued are held, and all the cash is held (if interest rates could not be pressed lower, the competition between interest-bearing stores of wealth and zero-interest cash would make cash a “hot potato,” causing it to rapidly lose value relative to goods, services, and everything else, which is what we call inflation).
Technically, the Fed is buying Treasury securities and creating currency and bank reserves to pay for them. This would simply be an asset swap were it not for the fact that the U.S. is running a budget deficit of about 10% of GDP, so the Fed’s purchases don’t even absorb the amount of newly issued Treasury debt. The government budget constraint is simple: spending = taxes, plus the change in Treasury securities held by the public, plus the change in Treasury securities held by the Fed (base money creation). So the overall effect of QE is to reduce the amount of debt that the public would otherwise have to buy, and to instead create money and bank reserves to indirectly finance government spending.
The main effect of QE on the financial markets has little to do with stimulating spending, and everything to do with the fact that the currency and bank reserves bear zero interest, and yet have to be held by someone. In equilibrium, QE requires that the interest rates on near-cash securities must also be nearly zero.
Of course, a similar process happens for riskier and longer-term assets, but the resulting returns are less exact. For stocks, we’ve seen investors drive prices up to the point where probable 10-year returns are only about 3.2%. But of course, you can get a 3.2% 10-year return by having zero returns for 1-year, and returns averaging about 3.6% for the next 9 years. So depending on the overall profile of returns expected by investors, it’s quite possible that near term stock returns have already been driven to zero on a risk and maturity-adjusted basis. The key point, in any event, is that the primary function of QE is to distort market equilibrium by raising the price and depressing the future prospective returns on nearly every asset class.
If you look at the commodity markets, the same factors are at play. Regardless of whether one expects modest or significant inflation, it’s clear that the inflation expectations of the market are generally positive. So people expect that a year or two from now, goods and services will be more expensive. But if they are holding cash or money market securities, it is clear that interest earnings will not make up for those higher prices. So what do people predictably do? They hoard commodities now. When does it stop? At the point where commodities are priced high enough that they are expected to have the same negative return, relative to a broad basket of consumer goods, as cash is expected to have.
Tags: 10 Year Treasury, Cash Flows, Charitable Work, Charles Dow, China, Commodities, Dangerous Myths, Dilution, Earnings Yields, Fed Model, Forward Earnings, Hussman Funds, India, Insiders, Investment Conference, Iron Law, Law Of Equilibrium, Morningstar, oil, Profit Margins, Return On Invested Capital, Shareholders, Simultaneous Decline, Valuation Methods
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Sunday, September 27th, 2009
This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.
The S&P has skyrocketed 58% since its bottom in early March, while the Dow is up 50% and the Nasdaq has surged 68% during that time. Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business.
Meanwhile, across the country, Main Street investors are weighing whether they should jump back into the market. However, the price correlation between equities and bonds of late has some argue that typically, if equities are trending higher, then bonds would head lower, and yield would be higher, due to concerns of higher inflation. This essentially describes “the Fed Model“, which is a theory of equity valuation popular among security analysts.
Now, the fact that bonds and equities in general are both firm seems to beg the question – which rally would end first – equities or bonds? This is an intriguing question which I will attempt to examine here.
A Split Personality Spells Uncertainty
Based on the Fed Model, bond yields should have an inverse relationship with the stock market in general. We can start by comparing the S&P 500 index (SPX) and the 10-year Treasury notes yield. As displayed in Fig. 1 by the two dotted trend lines, the correlation between stocks and bond yields is time-varying and, on average, negative over the last decade. Nevertheless, it appears, within the last two years, the negative correlation is more pronounced during the bear phase of the stock market from approximately May 2008 to March 2009 (Fig. 2 green circle).
This simple observation is actually supported by economic research suggesting that the lower expected inflation and the real interest rate is likely to increase the negative correlation between stock prices and bond yields; and that the sharp inverse between stock prices and bond yields in the 1990s bull market can be partially attributed to the lower inflation risk during this period.
The following are some plausible drivers of the current price co-movement between bonds and the equities market:
1. Fast money from Institutional and hedge funds is being allocated to both equities and bonds.
2. Flight from money markets to Treasuries due to the ultra-low interest rates in money markets and massive amounts of cash in the system as a result of the most synchronized global quantitative easing in history.
3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds.
4. Market’s low expectation of future inflation signaled by the TIP spread of only about 1.75%. That is bond market’s 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%. Low inflation expectation tends to push down bond yields and drive up the equities market.
5. Investors over-react to the “positive assertions” such as Federal Reserve Chairman Ben Bernanke statement that the recession is “likely over.”
Inflation & Interest Rate Expectations
There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices). So, even though we will probably be in the deflationary phase for the next 12 months or so, once economic growth starts kicking in, we’re bound to experience inflation.
What’s more, the current low inflation expectation of 1.75% is signaling the stock market is most likely mispriced and overvalued right now. Wider recognition of the inflation problem will eventually emerge. Inflation plus a recovery means sooner or later the Fed is going to have to start raising rates.
Higher interest rates and inflation expectations, coupled with the overvaluation in the equity markets could lead to a bear phase and the dreaded W-shape double dip economic scenario. This would mean a major decline in both the stock market and Treasury bond prices (a major rise in bond yields) and borrowing costs for companies will increase exponentially, thus further hindering future growth prospects in the economy.
Expect A Major Correction
The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt.
It’s ironic that the takeaway from all this is that both the equities & bond market are mispriced and headed in the opposite direction over the next 24 months. Equities are way overpriced and headed for a major correction (Dow 8,000 level) is a more rational valuation even taking into account improved earnings in 2011.
Expect the 10-year Treasury yield to rise above the 5.25 level in 2011. Increased borrowing costs, a jobless recovery, the collapse of commercial real estate will provide quite a headwind for anyone thinking of making a killing in equities over the next 2 years from the long side.
Bottom Line – Portfolio Repositioning
Start investing in alternative investments like residential real estate, which is where most of the smart money will seek outsized returns, as slowly but surely the favorable long-term demographics start to kick in, as the population increases, excess housing inventory evaporates completely providing for a housing squeeze in 2011. Real estate is actually the best inflation hedge of all, as they call it “Real” for a reason, unlike the US currency.
Source: Dian Chu, Economic Forecasts & Opinions, September 24, 2009.
* Dian Chu is a market analyst, trader and financial writer for Zero Hedge, Seeking Alpha and Daily Markets. Her articles are also syndicated to Reuters, USA Today and BusinessWeek. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. She is currently working in the US in the energy sector.
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