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The Boredom Always Ends
After fairly boring trading through the first half of the month, the equity market has shot to new highs over the last few sessions. Could it be mere boredom on the part of investors, who are seeking more excitement?
Stocks have been expensive for a while, with Shiller P/Es near 25, yet the battle cry among bulls has been “but look, the trailing P/E is still low.” Although the trailing P/E recently has incorporated earnings that represented unusually high margins (see chart, source Bloomberg), the “see no evil” crowd brushed that complaint aside. But now, the trailing P/E ratio of the S&P 500 is at 17.6, and at 18.7 before the write-off of “extraordinary items” (which, while extraordinary for any given company in a given year, are not extraordinary for the index of a whole, which always has some of these write-offs).
So it isn’t as if the equity market is now rising because earnings have been rising and prices are just catching up. The trailing P/E is now at a level slightly higher than it was prior to the 2007 top, and on par with the levels of the Go-Go Sixties prior to the malaise of the 1970s (see chart, source Bloomberg). Let us not forget that earnings quality isn’t what it once was, either. And again: I am not a fan of a 1-year trailing P/E; I am merely pointing out that even this bullish argument is going away.
To be sure, trailing P/Es aren’t at the pre-crash levels of 1987 or 1999 – but, again, let us recall that margins are at cyclical highs, so that if we look at the S&P price/sales ratio, we again get a disturbing view that has equity valuations higher than at any time other than the 1999 bubble run-up. (See chart, source Bloomberg – note that Bloomberg history for this series only goes back to 1990.)
Now, some observers will draw exaggerated offense to the notion that stocks might be priced for somewhat poor forward returns, and insist that the recent rally in bonds means that the ratio of the “Earnings yield” to bond yields is merely being maintained. Aside from the fact that this “Fed model” is explanatory rather than predictive (that is, it helps explain why prices are high, while not suggesting they will remain high…and indeed, rather suggesting the opposite as future returns are inversely correlated with the P/E of the starting point of the holding period), we also can’t give credit for the equity rally to the bond market rally this year from 3% 10-year yields to 2.50% yields without simultaneously asking why investors didn’t sell stocks when yields rose from 1.70% to 3% last year.
Admittedly, I was probably saying roughly the same thing at this point last year. Sour grapes? No, it just concerns the question of investing rules versus trading rules. In other words: I’m not telling you how to vote; I’m telling you how to weigh. Nothing has changed valuation-wise since last year, other than the fact that the market as a whole is growing more expensive.
On the “good news” front, corporate credit growth has been re-accelerating again. This is somewhat of a sine qua non for faster economic growth. We had seen decent credit growth in 2011 and into 2012, but when QE3 kicked off loan activity had ebbed. But now quarterly growth in commercial credit is nearing a 10% annual rate (see chart, source Board of Governors), something that hasn’t happened since the beginning of 2008 – other than for a brief spike around the crisis itself.
While this is good news, it is not unmitigated good news considering that the Federal Reserve as yet has no viable plan for exiting QE before all of those horses leave the barn. One of the biggest concerns, in terms of a risk of unpleasant surprise, is that few seem to be giving the inflation risk much thought, either in markets where 10-year inflation swaps float in the middle of the 2.40%-2.60% range they have occupied for the last twelve months, or in policymaker circles. This is on my mind today because I was reading an article published on the BLS website entitled “One hundred years of price change: the Consumer Price Index and the American inflation experience” and ran across this passage:
“Why the return of inflation when it seemed to be guarded against and feared? One possibility is a change in the perspective of policymakers. Some have argued that inflation was tempered in the 1950s by a Federal Reserve that, believing that inflation would reduce unemployment in the short term but increase it in the long term, was willing to contract the economy to prevent inflation from growing. By the 1960s, however, the notion of the Phillips curve, a straightforward tradeoff between inflation and unemployment, ruled the day. Citing the curve, policymakers believed that unemployment could be permanently reduced by accepting higher inflation. This view led to expansionary monetary and fiscal policies that in turn led to booming growth, but also inflationary pressures. However much policymakers professed to fear inflation, the policies they pursued seemed to reflect other priorities. The federal government ran deficits throughout the 1960s, with steadily increasing deficits starting in 1966.
Aside from the dates, it strikes me that this paragraph could have been written today. The Phillips Curve, now “augmented,” is still a key tool in the Fed economist’s toolkit even as responsible control of the money supply is deemed passé. As for accepting higher inflation the FOMC changed its inflation target a couple of years ago to be 2% on the PCE, which was implicitly a bump higher from the previous 2% CPI target since PCE is normally 0.3% or so below CPI, and various officials have mooted the idea of letting price increases exceed that rate “for a time” since expectations are well-grounded. And then, of course, you have economists like Krugman arguing for a higher inflation target. Not that we ought to pay any attention to Krugman, but somebody invited him to speak at that conference and that suggests he still has credibility somewhere.
I must say that I don’t believe in an end to history, in which a permanent and pleasant equilibrium exists in capital markets and economies, which both can continue to expand at a reasonable pace with low and fairly stable inflation and interest rates and generous profit margins. If I did believe in such a thing, then I might think that we had arrived; and then perhaps I would see equity multiples and bond yields as reasonable and sustainable. But I do not, because I have already lived through three periods where the VIX was in the 10-12 range: in the 1990s, in 2005-2007, and in 2013-2014. The first two periods produced very exciting finishes. The boredom always ends, and usually abruptly.
Deal Or No Deal? Yes.
Although it didn’t happen until after the U.S. market had closed – funny how that happens – there is yet another delay in the Greece-Euro deal. The Greek leaders, who were discussing the austerity measures, “agreed on all the points of the program with the exception of one which requires further elaboration and discussion” with the Troika. The ‘discussion’ seems to be brought about because Greece was told it needs to cut pensions, and the socialist party said they won’t agree to such a thing. I wonder how they’ll discuss that thing out.
Equities managed another small gain before that news came out, on still-ephemeral volume. After the close, stocks slipped, but not terribly. We will see what the morning brings.
I have been ‘bullish’ on equities for a few weeks. I put the word in quotes because although I believe stocks have a better chance to rise than to fall while the Fed and ECB (and everyone else) are pumping away, I recognize that equities are still richly valued and I am not completely sure that being long is worth the risk. I must say that for all the consistency of the advance in the S&P since mid-December (see Bloomberg chart below), the steady step higher on tiny volume scares me. It scares me because of the old market maxim that “the stock market goes up on the staircase and down on the escalator.”
I am also frightened by comments today from Blackrock Chairman and CEO Larry Fink. He suggested that investors should have 100% in equities. According to Mr. Fink, “I don’t have a view that the world is going to fall apart, so you need to take on more risk. You need to overcome all this noise. When you look at dividend returns on equities vs. bond yields, to me it’s a pretty easy decision to be heavily in equities.” It doesn’t scare me because it’s a unique thought: the talking heads on CNBC often advocate ridiculous concentrations to equities and don’t care about the price. It doesn’t scare me because he’s wrong to look at relative valuations of dividend yields versus bond yields when making a call on future performance of either asset class – the absolute level of both of them augurs poorly for future returns. Although the Chairman of a firm that supposedly has quant DNA should know better than to say something that wrong, in his role he’s really chief marketing officer and he’s trying to sell product. No, what scares me (perhaps “saddens me” is more accurate) is that anyone in a position of authority who might be listened to would actually be so cavalier as to advocate a 100% investment in anything, especially given the huge list of global risks, and especially in a market that isn’t exactly priced with a margin of safety. By contrast, Enduring Investments’ asset-allocation model currently has 3-4% in equities.
But all of that aside, the stock market isn’t going up because of heavy buying. It is going up because there is rotten liquidity and so any buying pressure pushes prices higher, and there are plenty of people who see the money spigots open and reflexively buy real assets. I don’t mind that for a trade, and I admit to being long some stocks myself just in case I am wrong and Fink is right. And I suppose that is the point. I feel I need to protect against the possibility that I am wrong. Fink doesn’t feel the same need.
One thing I am not worried about is the price of gasoline. This is not to say that I am excited about the fact that gasoline futures are right about at $3 and retail unleaded gas is nearing $3.50. If this is a demand-side phenomenon, then it could actually be good news. However, as far as I can tell, domestic gasoline demand is actually down, not up, according to the Department of Energy (see Chart below, source Bloomberg).
Demand in Europe can’t be strong right now, and the large emerging economies are struggling as well. This is all bad news, because collectively it takes away the demand-side explanation. But the answer isn’t necessarily supply-side (that is, peak oil, Hormuz fear, or low inventory levels). I think at least some of the answer is monetary-policy side. The chart below (source: Bloomberg) shows retail gasoline versus the stock market for the last five years. Some of the correlation, for example in 2008, is clearly demand-related. But the equity run-up into and through QE2, from mid-2010 into early-2011, I think we all know was mostly inspired by cheap money. Gasoline responded in the same way at that time, as did of course most commodities.
I think the gasoline and equity rallies right now are occurring for the same reason. It wouldn’t be my first guess – my first guess would be demand-side, but that argument is clearly flat. I think loose monetary policy is at least part of the story here.
And speaking of loose monetary policy, I must share the following exchange with you. Bloomberg published a provocatively-titled article (“Bernanke Economy Proves Critics Clueless on Fed”) that was so lopsided the article is either a plant or the author’s kids just broke Chairman Bernanke’s window and she’s trying to make it up to him. Quoting John Lonski (Moody’s…how have they done with forecasting?) and Mark Gertler, the article bashes a number of fairly successful forecasters (such as Paul Kasriel of Northern Trust, who is consistently one of the nation’s top forecasters) by essentially saying that the failure of inflation to immediately surge following aggressive Fed easing meant that all of those forecasters were “clueless.”
One of those economists, Stephen Stanley of Pierpont Securities, took umbrage at being called “clueless” and fired back a broadside that is fantastic in that it points out clearly many of the weaknesses in the reasoning of the “I heart Bernanke” lobby (readers of this column will be familiar with many of these arguments). I have not always agreed with Stanley’s perspective on the economy – no honest economist always agrees with anyone – but he hits the nail on the head here and I will quote a large part of his response. He first points out that the article attacks a straw man because no reputable economist forecast a huge immediate surge in inflation just because of a surge in bank reserves. He then notes:
… And keep in mind that the inflation rate accelerated in 2011 by roughly a full percentage point for both headline and core. That is in fact a pretty “rapid” pickup in inflation that would get us into trouble if it persisted.
Importantly, this acceleration in inflation in 2011 was absolutely not predicted by the Fed or its apologists. The Phillips Curve model that dominates the FOMC’s thinking (and evidently Lonski’s and Gertler’s) does not even allow for the acceleration in inflation seen in 2011. In fact, the Fed models are unambiguous that inflation should be falling substantially now (because there is a lot of slack in labor markets), which is a main reason that Fed officials had such unwarranted concerns about deflation in recent years and why they now so confidently predict that inflation will decelerate from here, even as growth improves and “slack” diminishes. And herein lies the problem. We have a central bank that apparently believes that inflation is driven by wages which are in turn driven by the degree of slack in labor markets (i.e. the unemployment rate). I had thought that this dusty old Phillips Curve framework was thrown in the dustbin of history after the disaster of the 1970s, but clearly (like some bad 1950s horror film) a new generation of academic economists has dug it out of the trash, cleaned it off, and attempted to dress it in new clothes and sell it as the unquestioned consensus of the economics community. When the central bank does not allow for an important role of money in the determination of inflation, an acceleration in prices is a clear and present danger.
… The problem with the Fed is not so much that inflation is currently way too high, it is that the reaction function from economic and inflation data to policy is radically easier than it has been at any time in the Fed’s history. I do not disagree that policy should be accommodative, but there is no credible framework to defend the notion that it needs to be as or more accommodative in late 2014 than it is now. This is a train wreck waiting to happen, but it is a train wreck that will play out over years, not minutes. Happily, this means that much of the damage is preventable/reversible if the proper course correction is taken soon enough. If not, the latter part of this decade may look a lot like the 1970s.
As I say, he makes some powerful points that you have read in this space before. Economists who say we don’t need to worry about inflation because of slack growth (the Phillips Curve argument) need to explain away several data points that don’t fit that model. For example, the 1970s. They also need to explain why prices haven’t fallen over the last few years (outside of energy) despite immense slack in the economy. And he absolutely nails the vulnerability now, which is less that the transactional money supply is growing at a steady 10% rate (although it is) and more that there is no reason at all to expect that the Fed is about to take drastic actions to trim its balance sheet and begin to restrain the money supply. Indeed, quite the opposite is true.
We will get money supply tomorrow, and next week CPI. But no matter what those numbers say, some of us will still be called clueless. I guess I don’t mind being clueless, as long as I’m right.
