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Your Revenue is My Expense
I saw a chart a few weeks ago, which someone sent me from The Daily Shot. It has been bothering me since then. Here’s the chart:
Well, it looks amazing and a great reason to invest in global equities, right? Global earnings are surging due to the AI revolution![1]
What bothers me is the simple phrase which is the title of this article. I completely understand that the leaders of the exploding AI industry are going to have drooling analysts projecting great earnings growth far into the future. That may even be correct. But if a company is making bank because their AI tools are tremendous, and their revenues are surging…it means that other companies are paying for that product and so revenues and expenses should net across the corporate landscape. This is not only true of AI, of course; big earnings of oil companies are offset by added costs for businesses and/or declining revenues for other companies selling to consumers with less ex-energy discretionary income.
That is probably the reason that, most years, forward estimates start out high because we can see the concentrated winners clearly but then decline gradually as the dispersed losers become plain. But that doesn’t seem to be happening this time. In fact, it seems like both sides are claiming gains from AI: the suppliers who are selling it, and the buyers who analysts think will show remarkable gains from using AI.
This is a great moment to review again Brad Cornell/Rob Arnott’s “The ‘Basic Speed Law’ for Capital Markets Returns“. I wrote about this most-recently in 2024, in “AI: Even a Big Deal is Smaller Than You Think.” The upshot of their ‘Basic Speed Law,’ which has held up remarkably well over time, is that real earnings cannot grow much faster (or slower) than the growth rate in real per capita GDP. So, unless we decide that AI is going to accelerate per capita GDP growth drastically – and as you can tell from the link to my prior article, I don’t buy that – we need to be skeptical about forecasts of huge earnings growth rates.
Now, a 100-year chart can hide a lot of deviations in the average. The basic speed law here is grounded by fundamental accounting identities. GDP is total expenditure on all goods and services, so it makes sense that total corporate revenues (and expenses) should be pretty highly correlated to that figure. So if the share of that expenditure that is profits increases – which is what the analysts are saying is going to happen – then something else needs to be true:
- Margins – and in this case global margins – need to expand as companies take more money from labor (if revenues minus costs go up, and revenues are constrained by GDP, costs need to go down and there’s only so much you can do with materials costs). But at least in the US, margins have been historically wide for some time. NIPA profits as a percentage of GDP are in the 12% range, which is already almost double of what it was pre-GFC. How much can this go up? Populism is already on the rise.
- Government spending can increase – this is another way to extract money from others, and that is to get the government to buy your stuff and sell debt to get the money to pay for it. Government deficits are part of the Kalecki equation. However, at least in the US the government deficit is shrinking. This might not be true this quarter since the US had to refund huge amounts of tariff revenues, but the general trend is towards better balancing of US trade and fiscal deficits.
- Consumers can spend a higher percentage of their income, and save less. This is also part of the Kalecki equation, and indeed personal savings have been declining. Over the last two years, the decline in personal savings has been the source of about 90% of the rise in corporate after-tax profits. See the chart below showing net corporate profits versus net savings (inverted, right scale). So…how much less can Americans save? Currently, savings is 2.72% of GDP. The last time it was lower (with the exception of right after COVID when people were spending their stimmy checks) was 2005-2008. And that was the all-time low of 1.5-2%. Before COVID, we were around 5%. Back in the early 1980s when interest rates were more attractive, savings was more like 7-8% of GDP.
- US companies can increase revenues and profits at the expense of non-US companies. That doesn’t really help us with the chart at the top of this article, which is global.
- Public companies can make hay at the expense of private companies. I totally believe in this one, since I manage a private company that is perpetually running into rule systems put into place to protect the big companies. But it doesn’t square with the AI promise, nor the fact that new business formation is robust and has been so for several years…and does not appear to be ebbing. These could all be profitless businesses – but now you have to explain why profitless businesses are exploding.
- Earnings per share could be increased by decreasing share count. That’s been the game for many a year, adding several percentage points to EPS growth by decreasing the “S”. There are some suspicions that that trend is reversing, with a lot of high-profile IPOs throwing a lot of shares onto the market. I don’t have good data on that. But I doubt that share buybacks are increasing.
- An increase in overall leverage, either financial leverage (debt/equity) or operating leverage (more fixed costs), could cause forward earnings growth to look better. It is instructive that over the last hundred years – looking at the ‘speed law’ chart – the gradual, pervasive increase in both forms of leverage has been associated with only a tiny acceleration in profits growth over time. I do think it has been a factor, but additional leverage is not freely available without bound. However, this might be part of the story – not because leverage is increasing broadly and suddenly, but because the composition of the indices is shifting to more high-margin and high-operating-leverage (but interestingly, very low-financial-leverage) businesses. Still, that doesn’t really explain the upward scoop in the global indices that cover a huge number of companies. Even accounting for the fact that those indices are generally market-cap-weighted, it seems far too large an effect to be mere substitution.
In short, while I think parts of these explanations have a kernel of truth to them…I think a lot of what we are looking at is analyst myopia. Analysts are focusing on the shiny objects of great worth, and are missing, for now, some of the offsetting effects on other companies. It may be possible for those earnings estimates to even be realized, if enough revenues are shifted temporally relative to costs (exciting companies realize the revenues now; boring companies capitalize the AI expenditures or defer the costs to later quarters). Sooner or later, though, it all must add up. Right now, in my mind it doesn’t seem to add up.
[1] As an aside, for much of the rest of this article I will refer to the US case. Not only is the US contribution to these earnings the largest by far but also – if the source of the surge is AI, then the US is where we would expect that surge to be sourced. I just mention this here because someone will noted the disconnect between this global chart, and the commentary based on US trends.
A New Era of Positive Stock/Bond Correlations and What That Means
I read recently – I can’t find where – that stock/bond correlations in the US are the highest (most positive) they have been in decades. This of course is bad news for investors who commonly allocate to both stocks and bonds with the expectation that adding bonds will reduce the risk of a portfolio not only because they have a lower natural volatility than do stocks but also because the expectation of negative correlations between them have the effect of lowering the volatility of the portfolio further (since the variance of a 2-asset portfolio is equal to the weighted sum of the variances plus 2 times the product of the weights and the covariance between the two assets. So, when two assets are negatively correlated, total portfolio variance is lower than the sum of the weighted variances of the assets; when they are positively correlated, total portfolio variance is higher than the sum). That’s sort of Portfolio Management 101, but since most of my readers are not professional portfolio managers: think of one person pushing another person on a swing. If they’re pushing in rhythm with the swing (positive covariance), then the person on the swing goes higher and higher. But if they’re pushing in the opposite rhythm (negative covariance), then the swing goes up less and less and Dad is telling the kid it’s time to go home.
So, this matters a lot for portfolio construction and optimization, of course.
By the way, it isn’t like this just started happening. I’ve been warning about this (and showing the chart I am about to show) since at least 2019. In 2022 I even had a nice table to go with the chart (see this year-end piece, and scroll to the “Other Things” part at the end https://inflationguy.blog/2022/12/22/2022-year-end-thoughts-about-2023/ ). But let’s update it.
This heavy line in this chart shows the rolling 3-year correlation of monthly returns of stocks and bonds, going back to 1948 (I sourced equity returns from Ken French’s site based on CRSP data; bond returns I estimated based on Shiller’s lengthy series). You will notice that stock/bond correlations are not guaranteed to be negative – in fact, for the 35 years or so prior to 1998, correlations were positive. The shaded area illustrates the salient point, and that is that correlations tend to flip when inflation gets sustainably over about 2.5% (the shading is positive when 3-year compounded inflation is above 2.5%, and negative when it is below). That’s not coincidence. The simple way to explain it is that stocks and bonds react very similarly to the inflation factor and very differently to the growth factor. That is to say, when there’s news about good economic growth, then stocks tend to rise and bonds tend to sell off (yields rise because real yields rise). But when there is bad news about inflation, then stocks tend to fall and bonds also tend to fall (yields rise because inflation expectations rise). So, in periods where inflation is low and stable, the growth factor dominates and stocks and bonds move in different directions; in periods where asset markets perceive inflation risk, stocks and bonds tend to move together more often.
By the way, this shifting of correlations isn’t only true with stocks and bonds. The entire correlation matrix between many asset classes experiences a shift when the inflation-state changes. But since portfolios tend to be most heavily weighted in stocks and bonds, and because the math gets quite a bit uglier when we add more assets, we tend to focus this sort of discussion on stocks and bonds.
Again, the point of this is that portfolio optimization routines – which tend to be built on covariance matrices built from some recent window of historical data – will tend to completely miss this shift unless portfolio managers intervene, and portfolio managers are loathe to mess with the models.
How much does it matter?
Let me introduce another concept. A ‘risk parity’ portfolio is one in which the assets are weighted in such a way that they each contribute the same amount to the overall variance of the portfolio. So, since bonds are lots less volatile than stocks in general, a risk-parity allocation means that you’ll tend to hold a lot more weight in bonds.[1] Suppose stocks have over time a 15% standard deviation and bonds have a 7.5% standard deviation (which isn’t that far off, actually). Then the weight in stocks, ignoring the stock/bond covariance for now, is 7.5% / (15%+7.5%) = 33.33%; the weight in bonds is 15%/(15%+7.5%) = 66.67%. The 2/3 of your portfolio that is in bonds will contribute 66.67% x 7.5% = 5% to your portfolio risk, and the 1/3 that is in stocks will contribute 33.33% x 15% = 5% to your portfolio risk. That’s the ‘parity’ in risk parity.
Now, true risk parity is done with variances, not standard deviations, and also takes into account the correlation between the assets – and here’s where it gets interesting. If I assume stocks and bonds have a correlation of -0.3, then my weight in stocks is more like 26% and my weight in bonds 74%. But, if the stock/bond correlation is +0.3, the weight of stocks drops to 10.5% and bonds go to 89.5%. So that correlation shift should cause you to cut your holdings of stocks by 60%, from 26% of your portfolio to 10.5% of your portfolio!
[“Heck,” you say. “I gotta hold more stocks than that! I can handle the risk!” That’s fine. The risk parity proposition is merely that you get better returns per unit of risk if you equate the marginal contribution of risk. With stocks, since 1948 you’ve earned 11.74% annualized through the end of April (relax, we are ending this accounting in the middle of a bubble so of course it looks stupid), on annual risk of 14.85%. So every 1% of risk got you 0.79% return. On the other hand, the naïve risk parity got you 7.47% return on 7.15% risk, so you got 1.04% return per unit of risk. And that’s where the risk parity firms will lever up that portfolio so you get similar to equity risk or at least 60/40 risk.]
Again, my point though is not to argue for risk parity. My point is that shifting the correlation between stocks and bonds given even basic approaches to portfolio construction implies a significant reduction in equity risk is in order in an inflationary environment – and that doesn’t even consider the fact that inflation tends to lower market-clearing equity multiples so that prospective equity returns are lower in that kind of environment. So if the new higher-inflation era (and it appears ever more difficult to refute the notion that we are in one) means that investors either need to accept higher levels of portfolio risk or to shed equity risk…where is the stock market selloff?
Your guess is as good as mine. Either (a) investors still don’t believe that inflation is going to be persistent (although the flip in correlations suggests they do), or (b) investors are willing at least for now to hold more portfolio risk in order to harvest the fruits of the AI valuation explosion, or (c) portfolio managers are loathe to cut equity exposures because they don’t want to lose performance to their peers (since actual customers tend to look at returns, not risk-adjusted returns!). I think the answer is some combination of (b) and (c). But both of those reasons are ephemeral, and depend on continued momentum. Given the valuation levels in the equity market, a prudent manager will be at least trimming risks opportunistically these days.
[1] Since over time, stocks have better returns than bonds, people tend to hold more stocks than bonds and firms who deploy risk-parity portfolios typically employ leverage so that they aren’t sacrificing stock allocations so much as adding levered bonds. Anyway, a mean-variance optimization done correctly makes more sense than risk parity, but I’m just using risk parity as a way to illustrate the size of the effect a correlation shift can have on a portfolio.
The Effect of Crazy Time on Portfolio Allocations
I am continually fascinated by how many second-order ‘understandings’ are missed, even by those people who have a really good first-order understanding of finance. For example, every financial advisor understands that bonds are less volatile than stocks. Most financial advisors understand that stocks and bonds in a portfolio together also benefit because they’re not correlated. Some financial advisors, and most CTAs, understand that diversifying a portfolio works because when you add uncorrelated assets together, the risk of the whole is less than the sum of the risks because of the offset from the correlation effects. Those are all coarse understandings that any financial professional should ‘get.’ However, it is fairly unusual for advisors or even CTAs to understand that the correlation of stocks and bonds undergoes a state shift when inflation get above about 2.5% for a few years, and become correlated, and that means more risk for the same combination of stocks and bonds. Here’s that chart I love to show, updated through the end of the year.
While that’s an example of a ‘second-order understanding’ that isn’t widely known, it isn’t what I want to write about today. Actually, for a change what I want to discuss is something that has nothing directly to do with inflation, and that is the effect of volatility on asset allocation.
This is an important discussion right now, because whether or not you have gotten the message yet that President Trump is going to be much more Machiavellian in his approach to the global world order than prior Presidents have been – and whether you think that’s a good thing or a bad thing – you surely must have noticed that the volatility of the markets under this regime is likely to be somewhat higher than under Sleepy Joe and also higher than it was during Trump’s first term. And that leads to the second-order understanding about what that implies for markets. Hang with me here; if you’re not a finance person this gets a little hairy.
The next chart shows Modern Portfolio Theory on one chart.
The blue line is the Markowitz efficient frontier: every point on the line represents a portfolio of assets that is the least-risky for that level of expected return. So, the highest vertical point is a portfolio of 100% in the asset with the highest expected return…you can’t get more return without leverage.[1] In this case, let’s assume that is equities. As you go down the curve, you allocate more to other less-risky assets and give up some portfolio return. Because assets are not 100% correlated, you can always get a portfolio that has at least as good (and usually better) returns for a unit of risk than any single asset – that’s the benefit of diversification. As you get to very low expected returns, you get to the part of the curve you’d have to be irrational to be on because you get higher risk and lower returns, and so we usually ignore that part of the curve that bends back.
The red line is popularly called the “Capital Asset Line.” Assuming there is some zero-risk instrument (that’s not already in the assets we’ve considered, so there’s some hand-waving here) and you can both borrow and invest at that rate, you can think of a portfolio that is the ‘best’ portfolio on the blue curve, either combined with the zero risk instrument (sliding down the red line to the left) or levered at the zero risk instrument (moving up the red line to the right). The ‘best’ portfolio here is defined as the place where the red curve is tangent to the blue curve.
A lot of times you’ll just see those two lines, but it doesn’t answer the question of which portfolio an actual investor prefers. It turns out that investors do not have linear risk preferences…that is, if I make my portfolio 10% more risky, perhaps I require 1% more return but if I make it another 10% risky, I’m going to need more than 1% additional return. I’m not only risk averse, but I get more risk averse the larger the potential risks. [Lots of experimental data on this. If I offer you a bet where you pay me $1 and on the basis of a coin flip I will either pay you $2 or $0, you are much more likely to take that bet than if I offer you a bet where you are risking $10,000 for the chance at $20,000…or zero]. So the purple dotted line is a hypothetical ‘investor indifference curve’. I just made up that term because I can’t remember what the theoreticians call it. The curve represents all of the combinations of risk and return that make the investor equally happy. So, the best portfolio for this investor is where the purple line – the highest purple line we can find, indicating the MOST happiness – touches the red line.
With me? Now consider the next chart. All I have done here is to increase the risk of every asset and shift the whole portfolio efficient frontier to the right.
What happens? The Capital Asset Line (red) now flattens out. And that means that the prior purple line no longer has a point of tangency. We have to go to a lower purple line, and since the purple line is concave upward the red line becomes tangent to the purple line at a point further to the left (the slope of the red line is flatter, and the flatter parts of the purple line are to the left). I’ve put the new ‘optimal portfolio’ as a dot in purple.
The implication is this: if overall risk in markets is perceived to have permanently increased, then rational investors will move from portfolios with more risky assets to portfolios with fewer risky assets.
You probably could have guessed that without all of the curves. If I am comfortable with a certain amount of risk, and the overall risk of things goes up, then it stands to reason that I’d work to reduce my overall risk. The second-order understanding here is, then, that if President Trump is perceived by investors to increase the overall volatility in markets and individual country and company outcomes, we should expect investors to lighten up on equities.
And that brings me to the final chart. This is the Baker, Bloom and Davis news-based Economic Policy Uncertainty Index, which counts the number of articles in US-based news sources that contain a set of predefined terms that indicate uncertainty about economic policy. The dotted lines below show weekly data; the heavy red line shows the 12-week moving average to get rid of the noise.
Notice the three prior spikes on the chart are during and immediately following the end of the internet/stock market bubble in the early 2000s, the end of the housing bubble and the Global Financial Crisis in 2008-09, and the COVID crisis. All three of those episodes were associated with significantly lower markets, although you could argue that harsh bear markets might trigger some policy uncertainty (that certainly happened after 2008). The jump on the right is the Trump jump, and it is already higher than any other period on this chart other than COVID.[2] Volatility we have. Uncertainty we have. And even if you like the President’s policies, the volatility means that we should not be surprised to see investors pull some chips off the table.
[1] If you take this best-returning asset and leverage it, you basically get a straight line going up and to the right forever; the slope of the line depends on the cost of leverage.
[2] Incidentally, the index goes back to about 1985 and although I didn’t show it there are two more bumps that are similar to the leftmost two on this chart: around the 1993 recession, and around the time of the stock market crash in 1987. They are all lower than the Trump jump.
Inflation Market Valuations and Tactics in the New Year
There is so much to talk about, since it has been such a long time since I posted, that it is a little hard to know where to begin. So let’s begin 2025 with a few quick notes about inflation markets and markets generally. I wouldn’t call this an outlook, per se…I am trying to resist making that year-end/year-beginning offering to the jinx gods…but an update with some observations. As an aside, later today I’m planning to post a new Inflation Guy Podcast (this is a Podbean link but it’s available anywhere you get your podcasts) with some comments on the trajectory of inflation (as opposed to markets), and how that may be affected by things such as the massive California wildfires.
I will begin with a content warning: this note is much denser than most of my columns. If you’re a retail investor and/or only interested in developments in inflation rather than inflation instruments, then you might skip this one. I’ll talk more about expectations for inflation, of course, in other posts. But that’s not today’s post.
Let’s start by looking at 10-year real yields. The blue line in the chart below is 10-year TIPS yields; the black line (because it’s topical) is 10-year UK Gilt linker (real) yields. TIPS yields are up to 2.25%. Normally, when they get to around 2% I think of them as roughly fair in an absolute sense, because long-term risk-free real yields ought to in principle look something like long-term real economic growth. Instructive in the chart below is that as far as nominal UK yields have risen, inflation-linked yields are still well below US real yields.[1]
That’s partly a clientele effect, since there are many forced holders of UK linkers. But still, while US real yields ran up from -1% to +2.25% once inflation started (that is, TIPS declined in a mark-to-market sense when inflation went up – very, very important to understand if you think of TIPS as an inflation hedge. They are, but only at maturity), Gilt real yields went from -3% to +1.19%. The selloff was 100bps worse. Yikes.
The next chart shows my quantitative measure of relative cheapness (negative indicates richness, because I’m a bond guy). I said before that TIPS are now roughly fair in an absolute sense; relative to nominal bonds, they’re also roughly fair to slightly cheap. That’s the blue line. You can see that TIPS for most of the past decade were pretty cheap relative to nominals (even while they were absolutely rich because of negative real yields), but since people started caring a bit about inflation they’ve gone back to being mostly fair. However, Gilt linkers have been massively rich for a long time – again, because of the forced-holders problem. But they are starting to get cheaper. That 100bps greater selloff I mentioned above happens to show up here as 100bps cheapening relative to nominals, and relative to TIPS!
Today’s column is supposed to be mostly about US markets, but I can’t help myself. I ought to also point out that breakeven inflation in the UK is roughly 100bps higher than it is in the US, even though core inflation in the UK is 3.6% and in the US it’s 3.5%. So, possibly, part of the relative richness of UK linkers – since I’m looking at each country’s linkers in relation to its own nominal bonds – is actually cheapness of UK nominals, compared to the actual inflation there. Or maybe it’s the richness of US nominals, compared to the actual inflation here. (This is why relative value trading is so useful and important – we don’t need to have an opinion about which of these two things is true. Are US nominals too rich, maybe because they can be financed cheaply in repo markets at ‘special’ rates? Or are UK nominals too cheap, maybe because the UK budget situation is perceived to be somehow even more precarious than our own? I don’t know.)
Sorry about the digression there to the UK. I just got excited. The inflation markets and inflation in Japan are also really interesting right now, especially as wage growth is surging and the yen is bordering on collapsing…yet 10-year inflation in Japan is quoted around 1.5%. If you can get someone to transact. Maybe I’ll talk about Japan another time.
US markets. First, note the weird shape of the US CPI swaps curve.
I have several issues here, with one of them being the overall optimism that inflation is definitely going back to be close to target, despite any real sign that is going to happen. It borders on religious conviction, frankly. But also, we have a weird implied path where inflation droops, then spikes near the 10-year point, and then declines. To be sure, I’m committing a chart crime here with the y-axis; if you stepped back this would look almost flat. But this is more than enough for a hedgie to be interested, usually. What is really happening is that if we had a core inflation swaps curve (I do, but you don’t) it would show a gentle decline out to 8 years. It’s steep on the CPI swaps curve because the energy curves imply that energy inflation will drag core inflation lower for years.
Of course, they won’t but you can hedge the energy. Out to about 5-8 years, probably. And that’s probably why we have that little dip in the CPI curve – it’s really an energy thing.
So I’ve said that 2.25% real yields on TIPS are fairly attractive. About as attractive as they’ve been for some time, actually. But be aware of a couple of things. One is that the bond market as a whole is under pressure and probably will stay under pressure for a bit as investors worry about financing the government in a world where the trade deficit is probably going to be coming down (implying that domestic savings will have to go up, and the only good way to make that happen is with higher yields). Real yields could go higher, and probably will at some point. But you should recognize that seasonality works in favor of the TIPS buyer right now.
Breakevens have a strong tendency to rise in the early part of the year. In 22 of the last 26 years, 10-year breakevens have risen in the 60 days following January 8th. To be sure, some of that is because TIPS bear flat-to-negative accretions in the early part of the year because CPI in December almost always declines on an NSA basis, so the rise in price/decline in real yields that helps widen breakevens is partly reflecting a change in the source of total return in TIPS during those months to being more price and less yield.[2] The point being that buying nominal bonds in the beginning of the year, up until about May, runs into difficult seasonal patterns but this is not true with TIPS. Indeed, it means that if you’re buying fixed income at all in Q1, it probably should be TIPS.
Finally, I really should say something about equities here. I think it’s always important to realize that TIPS yields are a direct competitor with equities. Nominal yields are not, necessarily, because 7% nominal yields in a world where prices (and earnings) are going up at 9% are much worse than 5% nominal yields in a world where prices (and earnings) are going up at 3%. Equity earnings do tend to rise with inflation (but stocks are a poor inflation hedge because multiples also tend to contract significantly when there is inflation, so you need to hold equities for a long, long time for them to be a good inflation hedge), and since they do it means that inflation-linked yields are a more-fair comparison. Real yields at 2.25% are neither rich nor cheap in the grand scheme of things. But equities are, once you discount expected earnings growth for expected inflation. I calculate the expected long-term S&P real return assuming that the current multiple of long-term average earnings (the Shiller PE) reverts 2/3 of the way to its mean over 10 years. By making it 10 years, and not demanding full reversion, I lessen the impact of apparent overvaluation on expected returns. But high returns do, historically, tend to precede low returns! In any event, you can debate my approach but below you can see my point.
This first chart shows 10-year TIPS yields set against my calculated expected 10-year annualized real returns from the S&P 500. Granted, the S&P 500 is cheaper outside of the Magnificent 7. But you can see that while stocks and TIPS cheapened together in the inflation spike of 2022, equities have ‘forgotten’ that they should be priced for higher real yields…resulting in the chart below, which I call the “Real Equity Risk Premium” of expected equity returns minus TIPS real yields.
Some of you will say “that’s a trend. Let’s get on that and buy stocks.” To me, that sounds like the fellow falling out a window on the 29th floor and declaring as he passes the 6th floor ‘so far, so good.’ The point of the chart is that when you buy stocks now, you should be expecting to lose money, in real terms, over the next decade. Maybe you’ll average 3% and inflation will be 4%, for example. But TIPS will guarantee you will make 2.25% after inflation. As this spread gets more and more tilted against stocks, it gets harder and harder to explain why anyone would choose equity risk over TIPS risk, other than as a diversifier.
[1] This is not wholly unique to the UK. US 10y inflation bonds have higher real yields than linkers in Australia, Italy, Israel, Canada, France, the UK, Germany, and Spain.
[2] This is wonky stuff. If the expected forward price level doesn’t change, then the breakeven needs to go up because we are starting from lower and lower current price levels due to the (short) lag between the reporting of CPI and its realization in the carry of TIPS. If you don’t understand this because you’re not a rates strategist, don’t worry about it and take my word for it.
2024 Balance of Risks
I am a risk manager, both literally and figuratively. Literally, since whether it is with our own funds and strategies or allocations for individual investor clients, or with my trading book back when I worked on Wall Street, the hard constraints are always capital, capital, and capital and so managing risk is part of how you make sure you don’t lose that capital. But also figuratively – my natural disposition is conservative, which is why I am a bond guy (concerned with getting my original investment back at par, at the end) rather than an equity guy (filled with dreams of a 10-bagger because I’m the first guy to figure out that Blockbuster Video is going to revolutionize video rental, and not so worried about how it will vanish almost overnight to Netflix).
So when I look at the investing landscape, I’m generally not focusing very much on ‘what I think is going to happen’; rather I spend more time thinking about the range of possible things that might happen, and their relative likelihoods. In theory, all rational investors do this but the markets do not trade like it. For example, currently Crude Oil trading at $72.60 does not seem to put any weight on the possibility of a hot war in the Middle East that could abruptly spike prices to $125/bbl or more. That’s not a prediction there will be a conflict that disrupts oil production or distribution (which, since there’s already a conflict – even though it hasn’t impacted oil production and only marginally impacted distribution – doesn’t seem like the sort of tiny-risk possibility we can ignore), but merely an observation. If you think there’s even a 10% chance that oil spikes $50/bbl, it would be worth $5/bbl. “But Mike,” you say, “maybe that’s already in the price and but for that possibility oil would be $5 lower?” Well, the risk manager in me looks for confirmation that the market is at least a little nervous, and with the Oil VIX trading at its long-term average and well below the average of the post-2020 spike it strikes me as hard to characterize the energy markets as ‘nervous.’
Anyway, this is why I dislike year-end ‘outlook’ pieces and why when I forecast CPI for a year or two out I almost always focus on a range of probable outcomes rather than a point estimate.[1] Honestly we should all do this, but not enough people have studied enough statistics to understand the significance of the error bars. If you have an experimental mean, and a nice large error bar, it signifies that you can’t reject the possibility that the true mean is anywhere in the range covered by the error bar. And that’s why, when someone introduces a new rent index that supposedly is more current but by their own admission has 15 times the standard error…I ignore it.
Enough of the preliminaries. Let me get on with this. Here are my thoughts about the balance of risks for just a few important items:
Interest rates: balance of risks is clearly higher. This was even more true at the end of the year. But with 10-year rates at 4.11%, down from 5% in October, keep in mind that two ways to get lower interest rates are already priced in: the short end of the curve reflects expectations (despite Fed officials’ protestations to the contrary) of roughly 150bps of cuts in the overnight policy rate this year, and the long end reflects inflation expectations of only 2.27% inflation over the next 5 years and only 2.30% inflation over the next decade. On top of this, consider that with the trade deficit declining but the budget deficit not declining, more of the budget deficit will have to be funded from domestic saving – and the Fed is still shrinking its balance sheet, so it is pushing in the opposite direction. The balance of risks in the bond market is to higher rates.
Stock market: balance of risks is lower, with the caveat that the picture is much better if looking at the market ex-the ‘Magnificent 7’ hot stocks (Apple, Nvidia, Meta, Tesla, Amazon, Microsoft, and Google). The S&P currently has a P/E of 21.4 and is up 24% since the end of 2022. The S&P ex-Mag7 has a P/E of 18.4 and is up 11% since the end of 2022. The Magnificent 7 themselves have a P/E of 39.5 and are up 110% over the last year.
The overall market P/E looks not-too-bad, until you remember that this is only because profit margins are currently only just a bit below at least 30-year highs (and probably lots longer – this is as far back as Bloomberg has trailing-12-months margins). The balance of risks is definitely for lower margins, which means lower earnings, which means the same equity prices would represent higher P/Es. Oh, and whatever happened to those people saying that the high equity prices were due to the really low interest rates? Haven’t heard from them in a while.
Where I have clients who are long equities, they’re long equal-weight indices so as to lessen exposure to the Magnificent 7. But even if those stocks were the only ones overvalued, it’s not reasonable to think that they can come back to earth and not bring down the rest of the market. If Apple, Nvidia, Meta, and Microsoft drop 30%, the rest of the market isn’t going to go up. However, if such a thing were to happen the market outside of the Mag 7 could feasibly eventually get to looking cheap.
Credit spreads: balance of risks is wider, with the 10-year Baa credit spread near 30-year lows. Really, how low does this go? And the tails are obviously one-way.
So I’ve said the balance of risks favor higher interest rates, wider credit spreads, lower corporate margins, and lower equity prices. It’s also useful to think about where the risks are in my risk assessments. If we get lower interest rates, instead of higher, then it’s very likely due to the economy being a lot weaker than it currently is, and the Fed ends up having to ease more than 150bps in 2024. That seems unlikely to me, but if it happens then notice that probably also means that credit spreads will widen and corporate margins, earnings, and stock prices decline. So, if you’re bullish on bonds and stocks, it seems to me you’re taking a dangerously narrow path. The balance of risks to me look bearish on both sides of that, but the bullish outcome for bonds implies (I think) a bearish outcome for stocks. It’s difficult for me to see an environment with appreciably higher stocks and bonds, unless the Fed eases aggressively without any economic weakness. So that’s your implied bet.
On the other hand, being bearish both stocks and bonds doesn’t carry such a narrow path risk. Unless the Fed eases despite a solid economy, It isn’t hard to envision an environment with lower stocks and bonds. Heck, we had just such an environment a few months ago, pre-‘pivot.’ It’s not a reach.
None of the preceding is a forecast. But investing and trading are about evaluating the range of risks, and trying to take positions with asymmetric risk-adjusted payoffs. In my opinion, long-only investors should be playing short on the yield curve (and going up credit, and inflation-linked rather than nominal) and anti- cap-weighting their stock holdings.
That’s as close to an outlook piece as I am doing this year. Have fun.
[1] In the last few years, I’ve started putting a point estimate for CPI in my Quarterly Inflation Outlook, but I also report what I see as the 1 standard deviation range so I can indicate the skewness of the risks in my view.
We Are All Bond Traders Now
When I started working in the financial markets, bond traders were the cool kids. The equity guys drove Maseratis and acted like buffoons, but the bond guys drove sensible style like Mercedes and cared about things like deficits and credit. The authoritative word on this subject came from the book Liar’s Poker by Michael Lewis, about 1980s Salomon Brothers, where the trainees dreaded being assigned to do Equities in Dallas.
Back then, equities guys worried about earnings, the quality of management and the balance sheet, and the really boring ones worried about a margin of safety and investing at the right price. That seems Victorian now, but I guess so does the idea that sober institutions should only own bonds.
Down the list of concerns, but still on it, were interest rates. Ol’ Marty Zweig used to have a commercial in which he said “if you can spot meaningful changes (not just zig-zags) in interest rates and momentum, you’ll be mostly in stocks during major advances and out during major declines.” The reason that interest rates matter at all to a stock jockey is that the present value of any series of cash flows, such as dividends, depends on the interest rate used to discount those cash flows.
In general, if the discount curve (yield curve) is flat, then the present value of a series of cash flows is the sum of the present values of each cash flow:
…where r is the interest rate.
As a special case, if all of the cash flows are equal and go on forever, then we have a perpetuity where PV = CF/r. Note also that if all of the cash flows have the same real value and are only adjusted for inflation, and the denominator is a real interest rate, then you get the same answer to the perpetuity problem.[1]
I should say right now that the point of this article is not to go into the derivation of the Gordon Growth Model, or argue about how you should price something where the growth rate is above the discount rate, or how you treat negative rates in a way that doesn’t make one’s head explode. The point of this article is merely to demonstrate how the sensitivity of that present value to the numerator and the denominator changes when interest rates change.
The sensitivity to the numerator is easy. PV is linear with respect to CF. That is, if the cash flow increases $1 per period, then the present value of the whole series increases the same amount regardless of whether we are increasing from $2 to $3 or $200 to $201. In the table below, the left two columns represent the value of a $5 perpetuity versus a $6 perpetuity at various interest rates; the right two columns represents the value of a $101 perpetuity versus a $102 perpetuity. You can see that in each case, the value of the perpetuity increases the same amount going left to right in the green columns as it does going left to right in the blue columns. For example, if the interest rate is 5%, then an increase in $1 increases the total value by $20 whether it’s from $5 to $6 or $100 to $101.
However, the effect of the same-sized movement in the denominator is very different. We call this sensitivity to interest rates duration, and in one of its forms that sensitivity is defined as the change in the price for a 1% change in the yield.[2] Moving from 1% to 2% cuts the value of the annuity (in every case) by 50%, but moving from 4% to 5% cuts the value by only 20%.
What this means is that if interest rates are low, you care a great deal about the interest rate. Any change to your numerator is easily wiped out by a small change in the interest rate you are discounting at. But when interest rates are higher, this is less important and you can focus more on the numerator. Of course, in this case we are assuming the numerator does not change, but suppose it does? The importance of a change in the numerator depends not on the numerator, but on the denominator. And for a given numerator, any change in the denominator gets more important at low rates.
So, where am I going with this?
Let’s think about the stock market. For many years now, the stock market has acted as if what the Fed does is far more important than what the businesses themselves do. And you know what? Investors were probably being rational by doing so. At low interest rates, the change in the discount rate was far more important – especially for companies that don’t pay dividends, so they’re valued on some future harvest far in the future – than changes in company fortunes.
However, as interest rates rise this becomes less true. As interest rates rise, investors should start to care more and more about company developments. I don’t know that there is any magic about the 5% crossover that I have in that chart (the y-axis, by the way, is logarithmic because otherwise the orange line gets vertical as we get to the left edge!). But it suggests to me that stock-picking when interest rates are low is probably pointless, while stock-picking when interest rates are higher is probably fairly valuable. What does an earnings miss mean when interest rates are at zero? Much less than missing on the Fed call. But at 5%, the earnings miss is a big deal.
Perhaps this article, then, is mistitled. It isn’t that we are all bond traders now. It’s that, until recently, we all were bond traders…but this is less and less true.
And it is more and more true that forecasts of weak earnings growth for this year and next – are much more important than the same forecasts would have been, two years ago.
But the bond traders are still the cool kids.
[1] I should also note that r > 0, which is something we never had to say in the past. In nominal space, anyway, it would be an absurdity to have a perpetually negative interest rate, implying that future cash flows are worth more and more…and the perpetuity has infinite value.
[2] Purists will note that the duration at 2% is neither the change in value from 1% to 2% nor from 2% to 3%, but rather the instantaneous change at 2%, scaled by 100bps. But again, I’m not trying to get to fine bond math here and just trying to make a bigger point.
Tight Spreads’ Cost: Orderly Markets
In this article I am taking a brief break from writing about inflation. There have been lots of great stories and anecdotes recently about inflation. I loved the Wall Street Journal article about how “Inflation and Other Woes Are Eating Your Girl Scout Cookies”, and we have seen several contributions from former Treasury Secretary Larry Summers that are worth reading. One was an opinion piece in the Washington Post (“Opinion: The stock market liked the Fed’s plan to raise interest rates. It’s wrong.”) and one was a very good NBER working paper on “The Coming Rise in Residential Inflation,” in which he confirms and extends the normal way inflation people forecast rents and comes up with even higher numbers than I’ve been working with for a while. Incidentally, if you haven’t seen these stories before now, consider installing the Inflation Guy mobile app. I don’t curate every single inflation story; just the ones worth curating.
Moreover, the Fed increasingly sounds like they want to be aggressive with rates. That’s half the battle, though on the more important half (the balance sheet reduction) they don’t yet have a plan. I should note that saying hawkish things on half the plan isn’t really all that hawkish, especially when your notion of “pushing rates above neutral” means 3%: a level well below inflation. But it’s progress that these folks have finally realized that inflation is a real phenomenon and not just due to port congestion. They still don’t seem to see the role of money growth in causing that phenomenon, but it’s nice we’re making baby steps.
As I said, though, in this article I’m going to talk about market structure, and the deal with the devil we have made to seek ever-tighter-spreads at a cost of orderly markets.
Since the 1970s, the cost of trading equities has moved from a bid/offer spread of a half point or a quarter point ($0.50 or $0.25 per share), on round lots, plus large brokerage fees, to sub-penny spreads on any size trade, often with zero brokerage costs. The cost of bond execution has similarly declined, as has the cost of futures and swaps brokerage. Volumes, across all markets, have responded to the decrease in costs. Some of this improvement in the median cost of trading has come from increased transparency, and a lot from increased competition.
Those improvements have not come without a cost, but at most times the cost is less apparent. The way the stock market used to be structured was around a number of market-making firms whose job it was to maintain orderly markets – including the distasteful task of being the buyer when everyone else is selling. What this means for the profit of a market-maker is that they generally made steady, small profits (a quarter of a point on every share, day in and day out) and occasionally lost huge amounts in market panics. It’s a classic “short gamma” position of picking up nickels before the bulldozer, and well-understood by the market-makers to be so. But that was the deal: you let the market-maker take his spread as an insurance premium, and collect on that premium when a calamity hits. Primary dealers in the government bond markets worked the same way: in exchange for the privilege of building an auction book (and being able to bid on the auction with that knowledge) and making spreads as a market-maker most of the time, it was understood that they were supposed to work to keep markets liquid in the bad times.
Then, we decided that we didn’t like paying all of these insurance premiums, which we called the “cost of trading” but could also be considered “the cost of providing continuous liquidity in bad times.” So stock prices were decimalized, which immediately started narrowing spreads. Electronic trading made the deal even worse because anyone could jump in front of the market-maker and be the bid or the offer, meaning that the market-maker wasn’t earning the spread. In many cases, there wasn’t any spread left to earn.
There is a parallel to something else I’ve written about recently, and that’s the trend over the years to lower and lower costs, and longer and longer supply chains, in manufacturing. Such a system is lower cost, but the price of that cost-savings is fragility. A long, international supply chain gets snarled much more easily and much worse than a short, domestic one. That cost/fragility tradeoff is the bargain that manufacturers made, although not thoughtfully.
Similarly, the price of the cost-savings from sub-penny equity spreads is fragility in the market-making system. It is difficult to find dealers who will accept the responsibilities of being the buyer or seller of last resort, and maintaining orderly markets, when that cost is not counterbalanced by an increase in profit opportunities during placid times.
As with international trade, we have begun to see the downside of this tradeoff when trading risks increase. Not that this is the first time, but it seems these days that liquidity conditions get sketchier more quickly now than they used to. Of course, we saw this as recently as March 2020, when trading in credit got so bad that the Fed had to step in and backstop corporate bond ETFs by buying corporate bonds and ETFs under the Secondary Market Corporate Credit Facility.[1] Recently, the Nickel market basically broke when prices went vertical and the resulting margin calls would have put some LME brokers out of business (conveniently, the LME decided to just cancel the trades that they didn’t like, which means those brokers are still in business but probably won’t have a market to broker). Prices went vertical partly because there are fewer highly-capitalized market-maker shops to stand in the middle and make orderly markets. Also recently, the European Federation of Energy Traders pleaded for “emergency funding mechanisms” so that they can continue to trade energy markets that have had greatly increased volatility recently.[2]
Now, the disturbing thing is that we are starting to see declines in liquidity even in fairly unremarkable periods. The last seven months’ worth of volatility in interest rate markets was higher than we’d seen in some years, but not exactly unprecedented. This month, 10-year Treasury yields are up 57bps. In 2002, 10-year yields fell 170 bps between May and October, in something close to a straight line driven by mortgage convexity. In about 6 weeks from May to June in 2003, yields dropped 81bps and then immediately reversed 129bps higher over the ensuing 6 weeks (same reason, different direction). I mention those two episodes because I was making markets in rates options and remember them not-very-fondly.
But these recent 57bps have been a lot more stressful on the market with fewer strong hands responsible for maintaining order. The chart below shows the BofA MOVE index, which measures normalized implied volatility on 1-month Treasury options. Recently, that index reached its second-highest level since the Global Financial Crisis. The highest prior level was in the March 2020 shutdown crash…understandable… and during the GFC banks were undercapitalized and in risk of failure. What’s the reason now?
We also see it in various market ecosystems. For example, there are roughly two dozen “Lead Market Makers” in the ETF ecosystem. In order to launch an ETF, you need to find someone to be the LMM. The function of the LMM is to make markets in virtually all conditions. But it is exquisitely hard to get an LMM signed up nowadays because the math for them works out badly. If your fund is very small, they make a decent spread but on tiny volume so it’s not very lucrative. As soon as your fund gets large, everyone else jumps in front of your markets, because they can and there’s money there to be made, so the LMM either makes no spread at all or makes a very small spread. Of course, those other Johnny-come-latelies will scatter the first time there is volatility, leaving the LMM there all alone to make orderly markets. So the market-making itself is a bad deal for the LMM in almost all circumstances. Their models are only tenable if they are able to make money on the relationship with the ETF issuer in other ways – being a broker for fund rebalancing, etc. This means that fewer good ETFs come to market than otherwise would. I have lamented this elsewhere. And the root cause and ultimate result are the same: we’ve engineered a very low-cost, high fragility system for investors to deal in.
The bottom line is that as any insurance agent can tell you people really hate paying for insurance. But no one expects insurance companies to provide insurance without being paid at least a fair premium. What would happen if we did? Well, then we wouldn’t have any insurance. Financially speaking right now, we don’t have much insurance because it’s too costly to stand in the middle. That looks like a win, until something catches on fire.
[1] For the Fed to buy corporate bonds was long held to be impermissible, since the Federal Reserve Act listed the assets the Fed was authorized to buy and that list did not include corporates and equities. Clearly, this was meant to follow Bagehot’s dictum that a central bank, to avert panic, “should lend early and freely, to solvent firms, against good collateral, and at ‘high rates’”, but thanks to clever lawyers who note that the Act does not explicitly prohibit the Fed from buying these things the Fed has in recent years decided that since it wants to, what could go wrong?
[2] A sad aside is that the movement to remove “pricey, greedy market-makers” and replace them with bailouts provided by central bank or treasury is the opposite of what Dodd-Frank was supposedly trying to do in ensuring that systemically-important institutions were adequately capitalized. They’re adequately capitalized now, but they don’t provide the market-braking function they used to because that’s ‘speculative activity’ that penalizes capital severely.
Low Real Yields – You Can’t Avoid Them
Recently, 10-year real yields went to new all-time lows. Right now, they’re at -0.96%. What that means is that, if you buy TIPS, you’re locking in a loss of about 1% of your purchasing power, per year, over the next decade. If inflation goes up 2%, TIPS will return about 1%. If inflation goes up 8%, TIPS will return 7%. And so on.
With that reality, I’ve recently seen lamentations that TIPS are too expensive – who in the world would buy these real yields?!?
The answer, of course, is everybody. Indeed, if you can figure out a way to buy an asset without locking in the fundamental reality that the real risk-free rate is -1%, please let me know.
Because when you buy a nominal Treasury bond, you are buying them at a nominal interest rate that reflects a -1% real interest rate along with an expectation of a certain level of inflation. The whole point of the Fisher equation is that a nominal yield consists of (a) the real cost of money, and (b) compensation for the expected deterioration in the value of that money over time – expected inflation.[1] So look, if you buy nominal yields, you’re also getting that -1% real yield…it’s just lumped in with something else.
Well golly, then we should go to a corporate bond! Yields there are higher, so that must mean real yields are higher, right? Nope: the corporate yield is the real yield, plus inflation compensation, plus default risk compensation. Your yield is higher because you’re taking more (different) risks, but the underlying compensation you’re receiving for the cost of money is still -1%.
Commodities! Nope. Expected commodity index returns consist of expected collateral return, plus (depending how you count it) spot return and roll return. But that collateral return is just a fixed-income component…see above.
Equities, of course, have better expected returns over time not because they are somehow inherently better, but because buyers of equities earn a premium for taking on the extra risk of common equities – cleverly called the equity risk premium – over a risk-free investment.
In fact, the expected returns for all long positions in investments consist of the same basic things: a real return for the use of your money, and a premium for any risk you are taking over and above a riskless investment (the riskless investment being, we know, an inflation-linked bond and not a nominal bond). This is the whole point of the Capital Asset Pricing Model; this understanding is what gives us the Security Market Line, although it’s usually drawn incorrectly with T-bills as the risk-free asset. Here is the current market line we calculate, using our own models and with just a best-fit line in there showing the relationship between risk and return. Not that long ago, that entire line was shifted higher more or less in parallel as real interest rates were higher along with the expected returns to every asset class:
So why am I mentioning this? Because I have been hearing a lot recently about how people are buying stocks because TINA (There Is No Alternative) when yields are this low. But if the capital asset pricing model means anything, that is poor reasoning: your return to equity investment incorporates the expected real return to a riskless asset. There is an alternative to equities and equity risk; what there’s no alternative to is the level of real rates. The expected real return from here for equities is exceptionally poor – but, to be fair, so are the expected real returns from all other asset classes, and for some of the same reasons.
This is a consequence, of course, of the massive amount of cash in the system. Naturally, the more cash there is, then the worse the real returns to cash because a borrower doesn’t need to compensate you as much for the use of your money when there’s a near-unlimited amount of money out there. And the worse the real returns to cash, the worse the real returns to everything else.
You can’t avoid it – it’s everywhere. I don’t know if it’s the new normal, but it is the normal for now.
[1] Unhelpfully, the Fisher equation also notes that there is an additional term in the nominal yield, which represents compensation being taken on by the nominal bondholder for bearing the volatility in the real outcome. But it isn’t clear why the lender, and not the borrower, ought to be compensated for that volatility…the borrower of course also faces volatility in real outcomes. In any event, it can’t be independently measured so we usually just lump that in with the premium for expected inflation.
Inflation Shocks, Inflation Vol Shocks, and 60-40 Returns
Not surprisingly, there has been a lot of debate about the ultimate outcome of the current crisis in terms of causing inflation or disinflation, or even deflation. It is also not surprising that the Keynesians who believe that growth causes inflation have come down heavily on the side of deflation, at least in the initial phase of the crisis. Some nuanced Keynesians wonder about whether there will be a more-lasting supply shock against which the demand-replacement of copious governmental programs will force higher prices. And monetarists almost all see higher inflation after the initial velocity shock fades or at least levels out.
What is somewhat amazing is that there is still so much debate about whether investments in inflation-related markets and securities, such as TIPS and commodities (not just gold), make sense in this environment. A point I find myself making repeatedly is that given where inflation-sensitive markets are priced (inflation swaps price in 1% core inflation for the next 7 years, and commodities markets in many cases are near all-time lows), the potential results are so asymmetrical – heads I win, tails I don’t lose much – that it’s almost malpractice to not include these things in a portfolio. And it’s just crazy that there’s any debate about that. The chart below shows the trailing 10-year annualized real return for various asset classes, as a function of the standard deviation of annuitized real income.[1]
Most of the markets fall along a normal-looking curve in which riskier markets have provided greater returns over time. No guarantee of course – while expectations for future returns ought to be upward-sloping like this, ex post returns need not be – and we can see that from the extreme deviations of EAFE and EM stocks (but not bonds!) and, especially, commodities. Wow! So if you’re just a reversion-to-the-mean kind of person, you know where you ought to be.
Now, that’s true even if we completely ignore the state of play of inflation itself, and of the distribution of inflation risks. Let’s talk first about those risks. One of the characteristics of the distribution of inflation is that it is asymmetric, with long tails to the upside and fairly truncated tails to the downside. The chart below illustrates this phenomenon with rolling 1-year inflation rates since 1934. Just about two-thirds of outcomes in the US were between 0% and 4% (63% of total observations). Of the remaining 37%, 30% was higher inflation and 7% was deflation…and the tails to the high side were very long.
This phenomenon should manifest in pricing for inflation-linked assets that’s a little higher than implied by a risk-neutral expectation of inflation. That is, if people think that 2% inflation is the most likely outcome, we would expect to see these assets priced for, say, 2.5% because the miss on the high side is potentially a lot worse than a miss on the low side. This makes the current level of pricing of inflation breakevens from TIPS even more remarkable: we are pricing in 1% for the better part of a decade, and so the market is essentially saying there is absolutely no chance of that long upward tail. Or, said another way, if you really think we’ll average 1% inflation for the next decade, you get that tail risk for free.
Finally, there’s the really amazing issue of how traditional asset classes perform with even modest inflation acceleration. Consider the performance of the classic “60-40” mix (60% stocks, 40% bonds) when inflation is stable, compared to when it rises just a little bit. The following table is based on annual data from NYU’s Aswath Damodaran found here.
Note that these are not real returns, which we would expect to be worse when inflation is higher; they are nominal returns. 60-40 is with S&P 500, dividends reinvested and using Baa corporate bonds for the bond component. And they’re not based on the level of inflation. I’ve made the point here many times that equities simply do poorly when inflation is high, and moreover 60-40 correlations tend to be positive (on this latter point see here). But even I was surprised to see the massive performance difference if inflation accelerates even modestly. Regardless of how you see this crisis playing out, these are all important considerations for portfolio construction while there is, and indeed because there is, considerable debate about the path for inflation. Because once there is agreement, these assets won’t be this cheap any more.
[1] Credit Rob Arnott for an observation, more than a decade ago, that an inflation-adjusted annuity for a horizon is the true riskless asset against which returns over that horizon should be measured. The x-axis here is the volatility of the return stream compared with such a (hypothetical) annuity. This is important because it illustrates that TIPS, for example, are lots less volatile in real space – the one we care about – than are Treasuries.
Half-Mast Isn’t Half Bad
As I watch the stock market, implausibly, rise to levels no one expected so soon after the crash, I am also sickened by the cheerleading from those whose fortunes – not to mention egos – are wrapped up in the level at which the Dow trades. Stock market fetishism always fascinates me as much as it repels me. Although my experience as a trader (and a short-term options trader, at that) would seem to suggest otherwise, my makeup is as a long-term investor. I want to buy value, and the mathematics of investing for me is that I want (a) high intrinsic value at (b) a low price. While people who are buy-and-hold investors of a certain age clearly benefit from higher prices, young investors clearly benefit from lower prices since they’re going to be net buyers for a long time. And the price at which you acquire intrinsic value matters. So does the price at which you sell, but not until you sell.
So to me, there’s nothing great about a price that’s high relative to intrinsic value, unless I am preparing to sell. In a broader sense, the idea that we should cheer for higher prices (as opposed to higher intrinsic values) is not only unseemly, but destructive and I’ll explain why in a minute. I will note that the fascination with watching prices ticking every second goes back a long ways: you can read in Reminiscences of a Stock Operator about the bucket shops of the early 1900s where speculators would watch and trade the stock market tape. The general increase in investor twitchiness and short-termism that has accompanied the growth of financial news TV, online investing, and the development of ETFs to trade broad market exposures intraday certainly adds numbers to the cheerleading crowd. But it isn’t new. Depressing, but not new.
The most fascinating example of this belief in the (non-intuitive, to me) connection between the value of the stock market and the value of ‘Merica was presented to me in the aftermath of 9/11. When we first trudged back to lower Manhattan, there were people handing out these cards:
Fight Osama! Buy Cisco! I never did see the connection, and it seemed to me at the time either delusional (the terrorists win if my investment in Lucent goes down) or nakedly self-serving. Certainly the way I feel about my country has nothing to do with where I’m able to buy or sell eBay today. And actually, they really weren’t coming for our 401(k)s, they were coming for our lives. But I digress.
The point I actually want to make is that when the Fed works to stabilize market prices, they’re having a negative effect by destabilizing economic variables. An analogy from manufacturing might be an entry point to this explanation: a truism in manufacturing is that you can stabilize inventory, or you can stabilize production, but you can’t stabilize both (unless your customers are accommodating and provide very smooth demand). If you want to stabilize inventory levels, then you need to produce more when business is high and less when business is low, so you’re on the production roller-coaster. If you want to keep production level, then inventory will be low when business is high and high when business is low, so you’re on the inventory roller-coaster. Only if business itself is stable – which is rare – can you do both.
A similar thing happens in capital markets. You can stabilize the cost of capital, but then you destabilize growth rates. Or you can stabilize growth rates, and the cost of capital (stock and bond prices) will fluctuate. This is true unless you can do away with the business cycle. If you choose, as the Fed has in recent years, to try and stabilize market prices at very high levels (stabilizing the cost of capital at very low levels), then when underlying activity is strong you’ll get a ton of speculative investment in capacity, new ventures that depend on the availability of cheap capital, and strong growth. And then when economic activity heads lower, you’ll find that lots of businesses go bust and the recession is deeper. In fact, it’s not just the speculative businesses that go bust, but the overbuilding in the expansion can cause even prudent enterprises to have more difficulties in the downturn.
The Fed’s historical response to this has been to let the speculative activity happen when the cost of capital is held too low, but not let companies go bust when economic activity wanes…so they lower the cost of capital even further.
I’m obviously not the first person to point out that the Fed’s constant intervention has deleterious effects and tends to increase the amplitude of boom and bust. And, for what it’s worth, I’m not blaming the current recession on the Fed. Clearly, the proximate cause of this recession was COVID-19 and the global economic shutdown. What made it worse was that the Fed, by holding down the cost of capital, had previously precipitated the development and preserved the success of many more speculative enterprises. And the fetishism about stock prices, and about how important it is to have lots of money “working for you” in the stock market, is also one of the reason that people don’t save enough.
Of course, right now is probably not the time for the Fed and Congress to pull back and let huge numbers of people and companies go bankrupt. There’s a case to be made for the sort of government response we are having in this episode, in which personal income is being replaced by money creation while workers are ordered to stay home. There will be a piper to pay for that policy – a loss of price stability which is a consequence of trying to preserve output stability, but a consequence that it’s arguably acceptable to pay. Afterwards, though, I hope that central banks can start to let natural rhythms replace the autocratic ones. I am not hugely optimistic on that score, but one place to start is this: stop lowering the bar for central banks to intervene in markets. Stop targeting equity prices and interest rates. It’s okay to let the Dow trade at half-mast, and the bull will come back without the Fed’s help.
In fact, if we don’t keep trying to artificially increase the length of the mast, the Dow might never need to trade down to half-mast in the first place. Certainly, intrinsic values don’t retrace 50% in a recession!
