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Meteorologists and Defenseless Receivers
The stock market really seemed to “want” to get to 2000 on the S&P. I hope it was worth it. Now as real yields seem to be moving higher once again (see chart below, source Bloomberg) – in direct contravention, it should be noted, of the usual seasonal trend which anticipates bond rallies in September and October – and the Fed is essentially fully ‘tapered’, market valuations are again going to be a topic of conversation as we head into Q4 just a few weeks from now.
To use an American football analogy, the stock market right now is in an extended position like a wide receiver reaching for a high pass, but with no rules in place to prevent the hitting of a defenseless receiver. This kind of stretch is what can get a player laid up for a while.
Now, it has been this way for a long time. And, like many other value investors, I have been wary of valuations for a long time. I want to make a distinction, though, between certain value investors and others. There are some who believe that the more a market gets overvalued, the more dramatic the ensuing fall must be. These folks get more and more animated and exercised the longer that the market crash doesn’t happened. I think that they have a point – a market which is 100% overvalued is in more perilous position than one which is a mere 50% overvalued. But we really must keep in mind the limits of our knowledge about the market. That is, while we can say the market is x% overvalued with respect to the Shiller PE or whatever our favorite metric is, and we can say that it is becoming more overextended than it previously was, we do not know where true fair value lies.
That is to say that it may be – I don’t think it is, but it’s possible – that when stocks are at a 20 Shiller PE (versus a long-term average of 16) they are not 25% overvalued but actually at fair value. Therefore, when they go to a 24 PE, they are more overvalued but instead of 50% overvalued they are only 25% overvalued because true fair value is, in this example, at 20. What this means is that knowing the Shiller PE went from 20 to 24 has no particular implications for the size of the eventual market break, because we don’t actually know that 16 really represents fair value. That’s an assumption, and an untestable assumption at that.
Now, we need assumptions. There is no way to keep from making assumptions in financial markets, and we do it every day. I happen to think that the notion that a 16 Shiller PE is roughly fair value is probably a good assumption. But my point is that when you’re talking about how much more overvalued a market is than it was previously, with the implication that the ensuing break ought to be larger, you need to remember that we are only guessing at fair value. Always. This is why you won’t catch me saying that I think the S&P will drop eventually to some specific figure, unless I’m eyeballing a chart or something. In my mind, my job is to talk about the probabilities of winning or losing and the expected value of those wagers. That is, harking back to the old Kelly Criterion thinking– we try to assess our edge and odds but we always have to remember we can’t know either for certain.
Bringing this back to inflation (it is, after all, CPI week): even though we can’t state with certainty what the odds of a particular outcome actually are, we can state what probability the market is placing on certain outcomes. In inflation space, we can look at the options market to infer the probability that market participants place on the odds of a certain inflation rate being realized over a certain time period (n.b. the market currently only offers options on headline inflation, which is somewhat less interesting than options on core inflation, but we can extract the latter information using other techniques. For this exercise, however, we are focusing on headline inflation.)
What the inflation options market tells us is that over the next year, market participants see only about an 18% chance that headline inflation will be above 2.25% (that is, roughly the Fed’s target, applied to CPI). This is despite the fact that headline inflation is already at 2%, and median inflation is at 2.2%. So the market is overwhelmingly of the opinion that inflation declines, or at least rises no further, from here. You can buy a one-year, 2.5% inflation cap for about 5-7bps, depending who you ask. That’s really amazing to me.
Looking out a few years (see table below, source Enduring Investments), we see that the market prices roughly a 50-50 chance of inflation being above the Fed’s target starting about three years from now (September 2016-September 2017, approximately), and for each year thereafter. But how long are the tails? The inflation caplet market says that there is no better than a 24% chance that any of the next 10 years sees inflation above 4%. We are not talking about core inflation, but headline inflation – so we are implicitly saying that there will be no spikes in gasoline, as well as no general rise in core inflation, in any year over the next decade. That strikes me as … optimistic, especially since our view is that core inflation will be well above 3% for calendar 2015.
| Probability that inflation is above | |||||
| in year | 2.25% | 3.00% | 4.00% | 5.00% | 6.00% |
| 1 | 18% | 5% | 3% | 1% | 0% |
| 2 | 41% | 19% | 8% | 3% | 1% |
| 3 | 46% | 25% | 11% | 5% | 3% |
| 4 | 50% | 31% | 15% | 7% | 4% |
| 5 | 52% | 35% | 18% | 10% | 6% |
| 6 | 50% | 35% | 19% | 11% | 7% |
| 7 | 50% | 36% | 21% | 13% | 8% |
| 8 | 49% | 37% | 22% | 14% | 9% |
| 9 | 48% | 37% | 23% | 15% | 10% |
| 10 | 47% | 37% | 24% | 16% | 11% |
What is especially interesting about this table is that the historical record says that high inflation is both more probable than we think, and that inflation tails tend to be much longer than we think. Over the last 100 years (since the Fed was founded, essentially), headline inflation has been above 4% fully 31% of the time. And the conditional probability that inflation was over 10%, given that it was over 4%, was 32%. In other words, once inflation exceeds 4%, there is a 1 in 3 chance, historically, that it goes above 10%.
Cautions remain the same as above: we cannot know the true probability of the event, either a priori or even in retrospect when the occurrence will be either probability=1 (it happened) or probability=0 (it didn’t). This is why it is so hard to evaluate meteorologists, and economists, after the fact! But in my view, the market is remarkably sanguine about the prospects for an inflation accident. To be fair, it has been sanguine…and correct…for a long time. But I think it is no longer a good bet for that streak to continue.
Ex-Communication Policy
Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.
To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.
The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.
Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.
Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.
Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.
Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.
Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…
Twit or Treat?
I guess we have to add to the list of uncomfortable comparisons to 1999’s equity mania the Twitter IPO. A widely-known company with no earnings…and no visible way to produce any revenues of note, much less earnings…went public and promptly doubled. Hedge funds which were able to get in on the IPO allocation cheered this nice kick to their performance numbers, and the backers of the now-$25bln-company are surely elated. But the rest of us have got to be thinking about Pets.com.
It was an article by Hussman Funds (ht rich t) that got me thinking more deeply about these comparisons. Although the article was referred to me partly because of the insightful comments about the Phillips Curve, which echo similar comments I have made in the past, I kept reading to the end as I usually do when trapped in a Hussman article! While there are a number of us (including Hussman, Grantham, Arnott, e.g.) who have been concerned for a while about equity market valuations since we use similar metrics, I really haven’t been terribly concerned about the possibility of an imminent and steep market decline for a while, though I think returns from these levels over the next decade will be close to flat in real terms as they were after the 1999 peak. However, Hussman had me thinking about this.
I do think that there is one key difference from 1999, and that is that not everyone is talking about stocks. That is, not yet…the Twitter IPO might get us there – on Fox Business News today a young talking head (who was no more than 10 years old in 1999) made sure that viewers were informed that anyone could buy Twitter, just by calling their broker. (Not just anyone, though, could get in at the IPO price…a point the cub reporter neglected to mention).
The counter-argument to “is this a 1999 set-up?” takes two forms. The less-sophisticated form is “nuh-uh”, although usually said in a slightly more elaborate way that implies the questioner is a mindless, not to mention soulless, Communist who isn’t getting enough loving at home. The more-sophisticated argument is worth considering, but isn’t particularly soothing to me. This hypothesis is that this isn’t 1999, it’s 1997, before the parabolic blow-off and with lots of room left to run. It wasn’t as if there was any lack of skepticism about the stock market’s levels (which, sweetly, we considered lofty at the time):
“Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such “new eras” that, in the end, have proven to be a mirage. In short, history counsels caution.” – Alan Greenspan, February 26th, 1997
The bubble, of course, did not pop in 1997. It popped in 1999, after Greenspan had abandoned his prior skepticism (in late 1998, as he came to believe that “I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible”). Between 1997 and 1999, there was plenty of time for investors to make money, and as long as they realized they were taking money for the future and got out before 2000…alas, very few of them did.
But, speaking from experience, the 1997-1999 period was very lonely. While investors who gradually sold their long positions out in 1998 and 1999 did much better than the ones they were selling to, they were also very unpopular at cocktail parties. The bearish analysts were put on the street, begging for tuppence. Which, considering that most of them were in the United States, was also unsuccessful.
The 1999 bubble…and the later property bubble…also did not burst until the Fed was actually tightening policy. It is on this point that many bullish arguments depend, but it is a weak one I believe. To be sure, there is no chance that the Fed will be tightening policy any time soon. The taper is not going to happen until 2014Q2 at the earliest, and I think it will take until later in 2014, when inflation figures will become uncomfortable, before they will start pulling back on QE. Some observers believe it will be much later. A Wall Street Journal article on Wednesday detailed a recent research paper written by the head of the monetary affairs division at the Fed; it argued that it may make sense for the Fed to lower its Unemployment Rate threshold and said that “an ‘optimal’ policy might keep rates near zero as late as 2017.”
The activist Fed continues to be one of the biggest risks to the market and the economy. As a trader, I know that 90% of trading is just sitting there, waiting for the ‘fat pitch’ you can do something about. It boggles my mind that a central banker doesn’t sit around at least that much, considering that they know even less about the complexities of the global economy than I know about the complexities of the market. And, unlike the global economy, the market doesn’t fight back when I act on it.
I actually have a feeling that we won’t be worrying about those Unemployment thresholds, either the old ones or the ones proposed in that paper. As I wrote late last month, the expansion is getting a bit long in the tooth and I would not be surprised to see another recession looming in 2014. I don’t have any reason for that outlook other than the calendar, but sometimes these reasons become obvious only in hindsight.
In any event, though, I wouldn’t wait around for the Fed to be tightening. It isn’t overnight funding rates that I would worry about, but longer-term interest rates, and there has already been a warning shot fired that indicates the Fed is not wholly in control of those rates.
So, it may be too early to be out of equities. Maybe even a lot too early. But one thing I am sure of is that it isn’t too late. It is the latter condition, not the former, that is the most damaging to one’s financial position.
