Model Abuse

A central bank is easing again! The only problem for U.S. market participants is that it isn’t the Fed that is easing, but the Bank of China, which last night dropped rates for the first time since 2008. This set markets up on a good tone heading into the day, and investors waited with breathless anticipation for Chairman Bernanke to echo his Jackson Hole speech and send us off to the races.

He didn’t. The Fed chief delivered what passes for moderation from the chief helicopter pilot, matching his comments somewhat obviously to ECB boss Mario Draghi’s comments from yesterday: the Fed is ready to act; long-term inflation expectations are well-anchored; but the U.S. budget trend is “clearly unsustainable” and must be put on a “sustainable path.” (Unremarked-upon was the fact that he contradicted himself when he called the so-called “fiscal cliff” at the beginning of next year “a significant threat.” Which is it? Are smaller deficits bad, or good? The answer is both – bad in the short run but really good in the long run – and the Chairman should say that. This just sounds intellectually sloppy. Then again, he is speaking to Congressmen, so using even using multisyllabic words is frowned upon.)

Any way you slice it, Bernanke did not deliver the promise of “more to come” that some investors anticipated.

Patience. Having played the stern paternal figure, Gentle Ben can now proceed to warm up the choppers. There is a growing chorus of other Fed voices in support of an ease, and in my opinion this is likely a somewhat intentional choreography in which the Chairman can appear to be persuaded by the others on the Committee to do what he wants to do. Chicago Fed President Evans today said bluntly on CNBC that “more accommodation would be good,” that he is very concerned about unemployment and doesn’t see evidence that inflation will rise (apparently he isn’t concerned with the lack of evidence that unemployment will fall due to monetary accommodation). San Francisco Fed President Yellen said yesterday at a speech in Boston that the Fed’s objective is a quick return to full employment (it seems like the Fed’s objective once contained something about price stability, didn’t it?), and that Fed action might be justified “to insure against adverse shocks,” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.”

Really? That’s the bar now? The Fed eases if growth is merely “not satisfactory”? If that’s the answer, then get ready for an enormous amount of easing, because growth isn’t going to be “satisfactory” for quite a while even if the nation skirts a recession.

I always laugh at the assertion that “inflation expectations are well-anchored.” Yesterday I compared this phrase to the analysis that a house has “good auras” by ghost-hunters. (That’s probably not fair to ghost hunters, who may have some science to back up what they are doing as far as I know.) But the phrase also seems to mean whatever you want it to mean. We all know that short-term inflation expectations have plunged, but as I argued in a post this week that is mostly because of energy prices until quite recently. But for market-based measures of long-term inflation expectations, the measure that is popular among policymakers is the 5y, 5y forward inflation rate. Often they take this reading of “expectations” from the TIPS/Treasury breakeven curve, which is wrong, but if you’re using it to tell fortunes I guess it doesn’t matter if you use pigs’ knuckles or rat bones. However, I do think it’s worth tracking 5y, 5y forward inflation from the inflation swaps market, if only to look at what the policymakers are looking at. A chart of 5y, 5y forward inflation in the US, UK (both on the left axis) and Eurozone is shown below. (Source: Enduring Investments)

In case the point isn’t apparent, let me make it so. Euro “long-term inflation expectations” are near the lows over the last year. In the UK, that measure is plumbing new 12-month lows. But in the U.S., we’re stable if not rising. Since February 8th, 5y forward inflation is down 2bps in the U.S. but down 35bps in the UK and 49bps in Europe (which already had the lowest long-term measure of the three, near 2%, due to the prior credibility of the ECB as a Bundesbank-descended inflation fighter).

So which is “anchored?” Mario Draghi has the best argument, if this measure is useful for this purpose: Forward Euro inflation expectations are around 2% and have declined markedly recently. The UK has relatively high inflation expectations, but they’ve declined quite a bit, so that’s “anchored” to some extent…at least, there’s a drag on it. But in the U.S., forward inflation expectations are well above the Fed’s ~2.25% CPI target, and have been for quite some time. If anything, those expectations are actually rising but they’re certainly not declining. In any event, Draghi and Bernanke both call inflation expectations “anchored,” but market-based measures of this concept are showing totally different things.


Because I didn’t annoy enough equity bulls with my historical and quantitative observations about equity valuations and likely real returns[1] yesterday, I am going to use the tool I deployed yesterday in a manner for which it was absolutely not intended. I was reflecting on the fact that the method forecasts future 10-year returns, but it therefore takes ten years to get the scorecard back to see how things actually turned out. So why not, I thought, pretend that the future really did turn out so that the figures were perfectly accurate? What would the future history of the S&P look like in that case?

So what follows is a make-believe future price chart of the S&P 500. This is not a forecast. I am not even using rat bones.

What I did was take the 10-year real return forecast, (which as I’ve explained in the past takes the long-run real growth rate of the economy, adds dividends, and adds or subtracts most of the “pull to fair value” over the next ten years), and subtracted a 2% dividend to get the expected real index price appreciation. Then I assumed that the CPI index rose at the rate implied by the inflation swaps curve (I calculated the forward 1-month rates and accreted the CPI index by that rate each month, so roughly a 2.46% compounded rate over the whole period but around 1% in the beginning and more like 3% towards the end, as implied by the swaps curve). I took the real index price appreciation and added back inflation to get the nominal price appreciation, and voila! I have a hypothetical series which is the set of S&P index values that, if the projected real return forecast is realized and the inflation swaps curve is accurate, would occur in the future.

I am happy to report that based on this “method,” the S&P ought to break to new all-time highs sometime in 2016. (Please remember, this is not a forecast. It’s “for entertainment purposes only,” although the practical value of it is as a test to see if the 10-year-real-return-forecasting method produces predictions that aren’t necessarily ridiculous or overly morose. Frankly, it doesn’t seem so bad to me – the chart shows an initial 20% or so discontinuity since the current trailing 10-year return is about 2% higher than what the a priori forecast was in 2002, but then doubles over the next 10 years.

For investors that have been through a 15-year period in which the index went essentially nowhere, and actually fell appreciably in real terms, I would submit that’s not a horrible result. Yes, it’s slower than during the 1980s boom but the difference is we started that boom with stocks at very low valuations while we stand today at above-average valuations.

Let me repeat it one more time: this is not my forecast. I would certainly never forecast an actual path. It is simply the result of taking the forecasting model and essentially cranking it in reverse. And now everyone can tell me why this is stupid and implausible. Ready, go!

[1] Please do note the use of the term real return. To get the nominal return, add your expectations for inflation. But as investors, we don’t really care about the nominal return, but the returns in terms of how much additional stuff we get to consume, so I don’t normally worry about nominal returns, or look at them.

  1. photoncourier
    June 8, 2012 at 7:05 am

    Could you link the post/article where you describe the “pull to fair value” methodology? Thanks.

    David Foster

    • June 8, 2012 at 7:31 am

      You can find my general discussion here: , which further links to a paper by Rob Arnott. Actually, I guess you’re asking about the pull-to-fair-value, which I don’t discuss there (and don’t think I’ve ever written formally about). It’s quite straightforward: I compare the current Shiller P/E to the long-run historical average (which can be measured several ways, but I use 16), and assume that two-thirds of that over- or under-valuation is bled away over the next 10 years. So it’s a very gentle effect, and the 2/3 ratio allows for the possibility that long-run fair value has shifted. So, if the Shiller P/E is 20.3 right now, I’d see a drag of [(20.3-16) * 2/3] / 16 = 17.92% over ten years, or (1.1792)^0.1 – 1 = 1.66% per year.

      Adding that to 2.25% for long-run real growth and a dividend yield of roughly 2.07% and you get an expected real return of 2.65% or so.

  2. Keith
    June 8, 2012 at 7:39 am

    Cliff notes version- Back the truck up at S&P 1000

    Message received!


  3. Jim H.
    June 8, 2012 at 9:33 am

    ‘I calculated the forward 1-month rates and accreted the CPI index by that rate each month, so roughly a 2.46% compounded rate over the whole period but around 1% in the beginning and more like 3% towards the end, as implied by the swaps curve).’

    That is so cool — it’s the Excel equivalent of making a bear dance on a barrel using a whip and a chair.

    But the results make sense. Take a 2.65% real return, add nearly 3% for inflation, and the stock index HAS to set new nominal highs. Here’s to the anodyne balm of money illusion!

    • June 8, 2012 at 9:50 am

      Yessir! Stocks for the long run! 🙂

  4. JP Koning
    June 8, 2012 at 11:46 am

    “But for market-based measures of long-term inflation expectations, the measure that is popular among policymakers is the 5y, 5y forward inflation rate. ”

    Another rookie question. What is the 5y5y forward inflation rate? Is it the same as the 5 year zero-coupon inflation swap rate, perhaps derived from it somehow? I googled around for a while and couldn’t find the answer.

    • June 8, 2012 at 12:10 pm

      Good question. It’s the market price for an inflation swap that starts in 5years and ends in 10 years. So this price represents what the market perceives as “fair value” for 5 year inflation, starting the count 5 years from now. (We derive it from the 5-year and 10-year points of the curve, so it’s mathematically [ ((1+CPIswap10)^10) / ((1+CPIswap5)^5) ] ^ (1/5) – 1

      • JP Koning
        June 8, 2012 at 3:05 pm

        Got it. Thanks.

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