Wednesday, June 11, 2014

10 valuation charts

Here is a random selection of charts that track valuations of various securities and asset classes. It's somewhat of a mixed bag, with Treasury yields still very low, corporate debt approaching highly-valued levels, gold still expensive, and the dollar near the low end of its historical valuation.

5-yr Treasury yields are up over 100 bps from their all-time lows of last year (0.6%). But with the exception of last year and early this year, at their current level of 1.7% they are lower than at any other time in history. Relative to inflation, 5-yr Treasury yields are very near the lowest they have ever been. Treasury yields, in other words, are still exceedingly low these days and thus the are richly valued. For several years now I've been thinking that yields were more likely to rise than fall, but I have been wrong—with the exception of last year. I still think they are more likely to rise than fall, mainly because I think the Fed is going to be forced to raise interest rates sooner than expected.

The chart above compares 5-yr Treasury yields to core consumer price inflation. The scales are offset a bit to reflect the view that yields should normally trade at a level that is somewhat higher than current inflation, if only to compensate investors for the uncertainty surrounding the future level of inflation. 5-yr Treasuries yielding 1.7% today offer a very small cushion to investors, since core inflation over the past year has been 1.8%. The explanation for the noticeable divergence in yields and inflation that began in 2011 could be that the bond market became overly concerned about the risk of another recession and/or the emergence of deflation. Both those risks have receded in the past year, however, which is why yields are up from incredibly low levels.

Nominal and real yields on Treasuries are roughly in line with historical norms. The spread between the two—expected inflation—is right in line with current and historical inflation. Neither one looks attractive relative to the other, unless you are worried that inflation will rise. But if inflation rises, then both real and nominal yields will rise as the Fed tightens monetary policy. And nominal yields would rise by more than real yields because inflation expectations would rise. So the downside risk to nominal Treasuries looks greater to me than the downside risk to TIPS. TIPS would also benefit, of course, from rising inflation, since that would boost their coupon payment. But in a rising inflation rate environment TIPS would almost certainly suffer from declining prices because real yields would tend to track the rise in nominal yields. TIPS are not a slam-dunk investment if you are worried about inflation.

Corporate credit spreads are getting pretty tight (i.e., the spread between corporate bond yields and Treasury yields of comparable maturity is pretty small). As the chart above shows, both high yield and investment grade credit spreads are now at post-recession lows, and they are approaching their all-time lows. I note that they traded at current or lower levels for at least three years during the previous business cycle expansion, so it's not unreasonable to think that they might trade at or near current levels for the next few years. But, as is the case with 5-yr Treasuries, the cushion against uncertainty is pretty small. The upside potential of investments in corporate bonds is now relatively small, whereas their downside risk is relatively large. Asymmetrical risks like this argue for trimming one's exposure to the sector.

The chart above shows the spread between high yield and investment grade corporate bonds, otherwise known as the "junk spread:" the extra amount you are paid to accept the additional credit risk of high yield bonds. This spread too is very close to its all-time lows. High-yield debt can still be attractive to conservative investors because of its extra yield, but to realize that extra return you need the economy to continue to grow by 2-3% and you need inflation to remain relatively low. If the economy grows faster, then all yields are going to rise, and the extra yield on corporates will be consumed at least in part by declining bond prices.

Corporate bond yields are also very close to all-time lows. I don't worry so much about spreads getting wider as I do about yields going up, which would almost certainly accompany a general rise in Treasury yields. Owning corporate bonds these days exposes investors to two major sources of risk: default risk and rising interest rate risk. Of the two, I think rising interest rate risk is the bigger of the two, because I don't see a recession for the foreseeable future, but I do see the potential for the economy and/or inflation to pick up and for the Fed to raise short-term interest rates sooner than expected.

Credit Default Swap spreads tell the same story as corporate credit spreads. Default risk is quite low, but it could go lower. Investment grade 5-yr CDS yield about 60 bps more than 5-yr Treasuries, while high-yield CDS yield about 300 bps more.  These securities would likely provide decent returns if the economy continues to grow at a relatively slow pace of 2-3% and inflation remains subdued. Faster growth and higher inflation, however, would likely prove a bit painful.

The first of the above two charts shows the nominal, trade-weighted value of the dollar against a basket of major currencies. The second shows the inflation-adjusted, trade-weighted value of the dollar agains a basket of major currencies and against a basket of most currencies. By any measure, the dollar is only about 5-10% above its all-time lows. Barring some disastrous mistakes on the part of the Fed, the dollar's downside risk looks relatively small to me. I think it's more likely that the dollar strengthens over the next several years, especially if the political mood in Washington becomes more favorable to investment. In this regard, I note the rising chances of a bipartisan deal between Rand Paul and Harry Reid which would create a tax holiday for the repatriation of corporate profits. The asymmetrical risk of the dollar argues for approaching non-dollar investments with caution, unless one is extremely bearish about the future of the U.S. economy.

Gold is substantially off its highs, but I think it's still very expensive. I note that the inflation-adjusted value of gold over the past century has averaged about $500-600 per oz. As the chart above shows, gold is still significantly more expensive than commodity prices. An investment in gold is likely to pay off only if the Fed makes a huge mistake and inflation soars. As it is, I think gold today is priced to a substantial increase in inflation, and has been for years. The fact that inflation has failed to rise as the gold bugs hoped is a major reason that gold has declined from its peak of $1900/oz.


William said...

Thank you, Scott, as always.

Just wanted to say (off topic per usual) that I am surprised that - with the advance of Sunni radicals in Iraq encroaching upon the oil exploration areas in the East and their takeover of an oil refinery - the price of crude oil didn't rise more. Not only is Syria a failed state but it looks like Iraq will be one too.

Together, these two countries border upon Turkey, Lebanon, Jordan, Saudi Arabia, Kuwait and Iran and share opposing tribal groups and religions.

Joseph Constable said...

Valuations don’t look excessive though a tad high. Everything seems stable. There is no denying that. It is that I am so into cycles I find the low volatility to be weird. So I bought the VIX.

With 97.5% of S&P500 bottom line earnings reported for 3/31/14, I can only conclude that GAAP earnings stalled. The last 4 quarters earned $100.77. The previous 4 quarters, 2014, earned $100.20. So I bought silver as a hedge when it went below $19 per ounce.

I am ready for earnings to resume growth and for the bad GDP print of Q1 to be followed by the usual slow to moderate but stable growth. I am ready for a decline regardless of the strength and stability of the U.S. economy. The lack of world leadership and the mess made in the Middle East by Obama and Clinton is coming home to roost in the form of uncertainty. (Yes yes, I know, Bush). There is a lot of newly made profit in the broad markets which can be taken if uncertainty takes a good grip. Cantor losing his primary is more uncertainty. And Ukraine.

I would not bet on a deep decline in stocks at this time. But you never really know how confident or uncertain investors feel.

Benjamin Cohen said...

We may be entering an era of low interest rates. So say Bernanke and Bill Gross, and maybe they are right.

Certainly, from the 1980s to the present, the secular trend was to lower rates of inflation and interest rates, through all the major economies. Now, interest rates cannot go lower, as they are ramming against zero lower bound.

So, what was driving inflation and interest rates down for 30 years? Has that changed?

My guess is that the world's central banks drove inflation down, and thus interest rates. Generally, they hewed to tight money.

The central banks did so, even while the world generated enormous pools of capital, in sovereign wealth funds, pension funds, private equity, hedge and so forth. The world has never known such huge pools of capital.

Well, supply and demand. There is plenty of capital, so interest rates will be low.

This will come a an unpleasant surprise to many, especially those who want some sort of return on risk-free passive investments.

That is the problem with free markets: You are entitled to a return on your savings, and you are also entitled to a loss on your savings. The idea of sure-thing return on savings is a government fiction, FDIC-fantasy.

Right now the market is telling savers, your savings are not valuable. That is not a nice message for many. It is not the message many of us feel entitled to, that we were brought up on in the 1960s, when capital was scarce.

In the long-run this glut of capital should be good for the world. Lots of capital should translate into more investment. No good business idea will go unfunded.

But for investors, I see potholes. Herd investing, chasing of yields etc. If you are late to a party you will take losses. If you want security, your returns may be slightly negative.

That is a message no investor likes to hear.

steve said...

"High-yield debt can still be attractive to conservative investors because of its extra yield, but to realize that extra return you need the economy to continue to grow by 2-3% and you need inflation to remain relatively low. If the economy grows faster, then all yields are going to rise, and the extra yield on corporates will be consumed at least in part by declining bond prices."

Actually, HY much more sensitive to DEFAULT rate which of course is linked to economic growth NOT rising rates. Default rate for HY is also at historic lows (.5% or so) hence the very low yields. That said, IF (big if) defaults remain low (which requires decent growth) rates could feasibly work their way even lower (prices higher) as HY approaches yields on investment grade debt.

theyenguy said...

There be only one valuation chart; that being World Stocks, VT, relative to Aggregate Credit, AGG; and it, that is VT:AGG, shows Equity Investments are terrifically overvalued relative to Credit Investments, and the former are now turning lower.

On Wednesday, June 11, 2014, global debt deflation commenced, as the chart of the EUR/JPY currency carry trade showed a strong turn lower, as the currency traders called the Yen, FXY, higher, and the Euro, FXE, lower, on the failure of trust in the monetary policies of the world central banks to continue to stimulate investment gains, as well as global growth, with the result that investors derisked out of World Stocks, VT, Nation Investment, EFA, Global Financials, IXG, and Dividends Excluding Financials, DTN, and by which the world passed through an inflection point and entered into Kondratieff Winter, the final phase of the Business Cycle, where regional fascist leaders rule in diktat.

Competitive currency devaluation, coming at the hands of the currency traders calling the Euro, FXE, lower, caused investors to deleverage out of currency carry trades with the result of a stock market reversal from its Elliott Wave 5 High Top. The trade lower in Equity Investments evidences the beginning of the extinction of the investor.

Aggregate Credit, AGG, traded higher, yet resides below May, 28, 2014, rally high, having been led lower by the 30 Year US Government Bonds, EDV, the US Ten Year Notes, TLT, and Long Term Corporate Bonds, LWC. Emerging Market Bonds, EMB, and Junk Bonds, JNK, traded lower. Thus all Credit Investments are trading lower from their rally and market tops, evidencing the failure of credit.

The currency traders in selling the world’s leading sovereign currencies, following the bond vigilantes, that is the Primary Dealers and their clients, in calling the Benchmark Interest Rate, that is the Interest Rate on the US Ten Year Note, ^TNX, higher from its October 23, 2013, value of 2.49% to 2.64%, and in steepening the 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, seen in the Steepner ETF, STPP, steepening, have underwritten the currency traders in commencing the final phase of the business cycle, that being Kondratieff Winter.

The end of the US Dollar as the International Reserve Currency is at hand. Soon the US Dollar, $USD, UUP, will buckle and trade lower with the rest of the World Major Currencies, DBV, as well as the Emerging Market Currencies, CEW, which will commence an investment demand for Gold, GLD, whose price will rise from its current range of $1,240 to $1,260. Gold is in the middle of an Elliott Wave 3 Up, and as such only God knows how high it will go.

The June 11, 2014, and June 10, 2014, trade lower in the Euro, FXE, evidences the death of currencies.

Fiat money, defined as the combination of Aggregate Credit, AGG, and Major World Currencies, DBV, and Emerging Market Currencies, CEW, is starting to die.

With the Euro, FXE, trading lower, coming on the failure of trust in the world central banks’ monetary authority to continue to stimulate investment gains and global growth, sovereign currencies, are no longer floating, they are sinking; and as a result, World Stocks, VT, Nation Investment, EFA, Global Financials, IXG, and Dividends Excluding Financials, DTN, are trading lower; fiat wealth is starting to die.

There has been an economic death; and there has been a economic birth.

The death of sovereign currencies communicates that the sovereignty of the Banker Regime has come to an end. And, the June 5, 2014, Mario Draghi, ECB, Mandate for TLTROs, and a Negative Interest Rate Policy, that being a sovereign mandate, communicates that the sovereignty of the Beast Regime, ruling in the iron of diktat of regional governance in the all of the world’s ten regions, and occupying in the clay of totalitarian collectivism in every one of mankind’s seven institutions.

Scott Grannis said...

Re the "glut of capital." Everything is relative. If there is a glut of capital it is because there is a dearth of investment opportunities. The barriers to a successful business are huge: high taxes, burdensome regulations. Not many new ideas can turn into new businesses as a result. A lack of investment is what is causing slow growth, not a glut of capital. The glut of capital will only be good for the world if government policies reduce the barriers to new investment.

Joseph Constable said...

The economy isn’t going to grow much as long as the 25 -54 year olds participation rate relative to the population of 25-54 year olds doesn’t improve (*). I agree that the chicken or is it the egg of supply side improvement needs to happen more than anything on the monetary side. Giving money to 25-54 year olds isn’t going to kick start aggregate demand no matter how you contrive the program into looking like it is a good thing. The actual cost of education and medical care need to drop 30 to 50%, not having student loans and government and company paid heathcare making it “affordable”.

(*) FRED chart “Employment Level – 25 to 54 years” divided by FRED chart “Civilian Noninstitutional Population – 25 to 54 years”. The intermediate trend of this is down. Since the recession it is up modestly. But May had a nasty down turn.