Wednesday, November 11, 2015

The message of TIPS, gold, and PE ratios

Starting from the premise that the world's capital markets are intimately bound together—that the expectations driving stock prices are the same ones driving bond yields, for example—it should be possible to infer from the prices of different assets the market's implied economic outlook and risk preference. In other words, there ought to be one "story" that explains the market prices we observe.

This post focuses on TIPS prices, gold prices, and PE ratios, and attempts to deduce what they tell us about the assumptions embedded in the market.

The chart above compares real yields on 5-yr TIPS with the real Fed funds rate. For one, this tells us that the real yield curve today is positively sloped (i.e., short-term real rates are lower than medium-term real rates), and that, in turn, means that the market expects the Fed to tighten monetary policy going forward. Real yields on 5-yr TIPS today (0.4%) can be thought of as the market's expectation for the average real yield on Fed funds (currently about -1%) over the next 5 years. This condition must hold in a market equilibrium, leaving investors indifferent between investing overnight or for 5 years.

The chart above compares the real yield on Fed funds to the slope of the nominal yield curve. Note that the yield curve is typically positively sloped in the early stages of a business cycle recovery, but that it becomes negatively sloped in the latter stages. Why? Because inflation has typically picked up as the business cycle matures, and the Fed typically uses tighter money policy (which takes the form of higher real yields) in order to "cool off" the expansion and suppress inflation pressures. Every recession in the past 50 years has been preceded by a significant rise in real short-term yields. The shape of the yield curve today and the low level of real yields tell us that we are probably years away from another recession, because the market doesn't expect any aggressive tightening from the Fed for many years.

The chart above compares the inverse of real yields on 5-yr TIPS (using that as a proxy for their price) to the price of gold. It's rather remarkable that the two have tracked each other so well for the past 8 years, since these two assets share almost nothing in common. The one thing they do share, however, is that they are both considered to be safe-haven assets. Gold is the favored port in any economic or financial storm, while 5-yr TIPS are not only risk-free but also inflation-protected. So the fact that they are moving together suggests that what is acting on these two prices is the market's degree of risk aversion. Risk aversion was high—and demand for TIPS and golds was strong—a few years ago, when gold hit $1900/oz. and real yields fell to close to -2%. Today we see less risk aversion, because the prices of gold and TIPS have fallen. But both are still well above their long-term averages. 

The market thus seems to be transitioning from a period of high risk-aversion to lower risk aversion. As a corollary we could say that optimism was in very short supply a few years ago and is now beginning to return. But we are still far from a market which is "irrationally exuberant." With the benefit of hindsight, the market was excessively confident when gold approached $250/oz and TIPS yields were 4%, in the 2000-2001 period. 

The chart above compares real yields on 5-yr TIPS to the PE ratio of the S&P 500 (as calculated by Bloomberg). Here again we see an interesting correlation, with the exception of the 2004-2007 period. This period was one in which the Fed was aggressively tightening monetary policy, which involves forcing real short-term interest rates higher. When the Fed is not forcibly intervening in the market, real yields show a strong tendency to track PE ratios.

What does this tell us? We know that rising PE ratios tend to correlate to a rising tolerance for risk and increased optimism about the future of the economy. Investors are willing to pay more for a dollar's worth of earnings when they believe the economy—and profits—are likely to improve. Today, PE ratios of 18-19 are only slightly above their long-term average. This confirms the message of gold and TIPS, which is that the market is transitioning from being very afraid to becoming cautiously confident. Valuations, in other words are somewhere between cheap and expensive.

The economy is growing at a sub-par 2-3% rate, the market is cautiously optimistic, and the Fed is about to begin raising short-term rates in a very gradual fashion. There's nothing big to worry or get excited about, and valuations are neither cheap nor particularly expensive. We've been in a sub-par recovery for years now, thanks mainly to very high marginal tax rates, excessive regulatory burdens, and policy uncertainty, and the market seems to have fully priced this in.

So: buy stocks if you think the policy environment is going to improve, and sell stocks if you think the policy environment is going to get worse. These choices are going to become easier to make as we approach the November 2016 elections.


Benjamin Cole said...

Excellent wrap up, in my humble opinion.

I am sorry to say there is one party in America.

The motto of that party is, "I'm for those regulations and tax codes that benefit me, my interest group, my party and my class. I against those that do not. That is my bedrock principle, from which I will not waver!"

William said...

Five Strange Things Happening in Financial Markets

1. Negative swap spreads
2. Fractured repo rates
3. Corporate bond inventories below zero
4. Market moves that aren't supposed to happen keep happening
5. Volatility is itself more volatile

Matthew Grech said...

William: I have noted the same things you have. I know firm conclusions are hard to come by these days. But I'm wondering what you make of the strange things you identified. Also, if you care to say, I'm curious as to how you're positioned these days... As I recall, you reduced your exposure pretty meaningfully about a year ago. MG

Scott Grannis said...

Seems pretty clear to me that Dodd-Frank is the cause of most of the "strange things" happening out there. This is otherwise known as the unexpected consequences of dumping a slew of new regulations on the financial industry. However, I don't think this poses an existential threat. It merely alters the relative values of financial instruments, making owning swaps (receiving fixed) more attractive/cheaper than owning Treasuries. In the end, there appears to be plenty of demand for owning swaps, which means that institutional investors have a decent appetite for risk.

Thinking Hard said...

Subpar recovery is an understatement for many people in the U.S. Here are a few things pulled directly from governmental data sources.

EBT (aka food stamps) Recipients by Year
2000: 17.19M
2007: 26.32M
2015: 45.51M

SSDI (Social Security Disability Insurance) Recipients by Year
2000: 5.04M
2007: 7.10M
2015: 8.92M

Core (25-54) Labor Force Participation Rate by Year by Percentage
2000: 84.03%
2007: 83%
2015: 80.9%

Core (25-54) Labor Force Participation Rate by Year by Total People
2000: 85.2M
2007: 86.6M
2014: 81.5M (2015 population data not yet available)

Median weekly real earnings for wage and salary workers employed FT >16yo
2000: 334
2007: 332
2015: 340 (3Q data)

This is a bifurcated recovery where those with capital are experiencing a strong recovery and those without capital are not participating at nearly the same rate. The part of the population with capital seems very optimistic and the part of the population without capital seems very pessimistic. This is also visible in the political division we are currently seeing with a lot less people in the center, but instead bifurcating into more left and more right oriented ideologies.

Any thoughts on the bifurcated recovery and potential ramifications over the next 5 years?

William said...
This comment has been removed by the author.
William said...

@ GM

Believing that this 6 1/2 year bull market needed more than an 11% correction to restore skepticism and guessing that this quick rally would fail, I sold another 14% of equities last Thursday and am now 36% long. Here are some reasons that legendary investor, Stan Druckenmiller, concludes that there is again a Financial Bubble. My notes:

"80% of 2015 IPOs have no earnings. At the 1999 NASDAQ / Internet peak, it was 83%.
Corporate credit is growing at a record pace, faster than in 2007.
71% of new bonds are rated B or worse; in 2007 31% were rated B or worse.

This year there will be $300 billion of "covenant-lite" loans - remember those - and 58% are B rated. That's up from $260 billion in 2014. In 2007 there were only $100 billion "covenant-lite" loans and only 38% B were rated or worse.

We are at once in a century emergency interest rate levels {the US has never had such low rates before}; low credit rated bonds are exploding in volume. Corporations are very short term oriented: selling bonds; buying back stock; increasing dividends; and many mergers and acquisitions at top of market prices - like always. Like individuals, that is when corporations buy the most of their own shares or other company's stock. There is a Bubble!!

AND Corporate capital spending / sales ratios are the lowest they have been in 30 years. That's the reason productivity is down. Very short term thinking!!

IBM is the poster child for many, many American companies! IBM has purchased $40 billion of its own stock at an average price of $189 per share. Today, their shares are selling at $133. IBM's capital spending is down - even though their sales haven't increased in 6 years!

Fortunately, the bad credits are not in the banking system - so far at least. Not a systemic problem yet, unlike 2007."

Watch for yourself:

20 JUL 15

3 NOV 15

Scott Grannis said...

Thinking Hard: I had a post last year on this subject that is a partial response to your question:

Thinking Hard said...

William - I think you linked to the NYT dealbook series last week with Stan Druckenmiller and others talking about short vs. long term corporate planning. ZIRP has allowed many zombie companies to remain standing and appear alive. There will be a flushing of weak companies when ZIRP is no longer providing the necessary life to sustain themselves.

Carl Icahn's video in that series was interesting too. Pretty accurate analysis about corporate leaders more concerned about short term quarterly earnings instead of long term growth. Looks like a good reason to undertake buybacks versus increasing CAPEX.

Thanks for the Druckenmiller link btw. (Link above is the same - were you meaning to link different videos?) I agree that the Euro is likely to go to parity or below, especially following rumors of increasing ECB QE by Q1 2016. The euro looks to be on the second leg down. Looks like monetary policy is setting up European equities to outperform over the near term.

Scott - Thanks for the link. Just wanted to point out the bifurcated recovery. Looks like the probability of major shifts in the political landscape is increasing as the bifurcation deepens. Political risk is increasing substantially, and doesn't appear to be diminishing anytime soon.

Thinking Hard said...

William - Is there another option except to push the bubble higher? Even if this one bursts, what option is there except to push it higher next time? We live in a central bank controlled WORLD at this point and the BOJ is setting the example. Buying bonds, ETFs, and anything else to keep assets going UP!

Benjamin Cole said...

As someone who detests complex regulations or tax codes as undemocratic or capital-unfriendly on their very face, I do not understand the position of American banks regarding Dodd Frank. The industry seems to prefer Dodd Frank rather than a clear and simple alternative, such as a much higher reserve ratio.

Lawyer in NJ said...

Under Reagan, the economy was mostly ok, whether one credits the Fed cutting rates or the magic of supply-side or both.

Yet Glass/Steagall was the law of the land.

So it can't all be about regulatory burden.

The policy problem, as I see it, is the unwillingness of the House to compromise.

My proof: Boehner rejected a pretty sweet deal in 2011.

How do we know that?

He tried to get Obama to put it back on the table in 2012 after the election.

Anyway, love the Econ analysis part.

Oeconomicus said...

Where are all these financial innovations coming from? I didn't realize the complexity that is all these derivatives. As Buffet says: "Weapons of mass destruction."

I would love to see the model that relates all of them together although I would not understand much of it.

Well functioning market prices are suppose to provide valid and dependable signals thus allocating resources efficiently.

But with all these innovative financial instruments it seems that the "Financial Markets" may be too complex to derive useful and valid signals.

Scott: Which Financial Market prices can you "Take to the bank." So to speak.

Which are the ones that are most unobfuscated that could be used to judge all these other Financial Market price signals?

Oeconomicus said...

The above statement I made is in reference to Williams link:

Scott Grannis said...

Lawyer: I'd recommend Robert Bartley's "The Seven Fat Years" for a good description of what went right in the Reagan years. As for Glass Steagall, it pales in comparison to the combo of ACA and Dodd-Frank. Read John Allison's "The Financial Crisis and the Free Market Cure" for a good description of how bad regulatory burdens are today for the financial industry.

William said...

@Thinking Hard & Oeconomicus I have viewed 4 or 5 recent Druckenmiller interviews and linked the best two above.

Prolonged ZIRP has resulted in the mis-allocation of capital and the excesses in financial engineering that Druckenmiller outlined above. But it is a world wide problem. For example as Druckenmillelr points out, emerging market countries and their corporations were able to borrow vast amounts of money which the markets would never have lent them previously under more normal interest rates.

The market feedback signals which Oeconomicus mentioned - "suppose to provide valid and dependable signals thus allocating resources efficiently" - are lacking when interest rates are artificially held at extremely low levels. The result has been mis-allocations of capital worldwide.

With regard to Thinking Hard's question about another option? The only other option is too devastating to contemplate: complete the necessary recession, get rid of the Central Banks' put, wipe out the zombie companies and get rid of self-interested, short term focused, corporate managers. The problem is that total global debt is about 2 1/2 times greater today than at the end of 2007 ~ $70 trillion!!!

But on a happier note as Druckenmiller also points out: the present value of the US government' stream of payments for Social Security, Medicare and Medicaid through 2030 is - are your ready - $205 trillion which dwarfs the current US total debt of $19 trillion.

Oeconomicus said...

But, as I understand it, the Fed is not so much trying to hold interest rates "artificially low," they are attempting to set the interest rate (short term) where the money supply equals the money demanded.

To achieve the dual mandate of price stability (2% inflation target) and full employment or NAIRU. Full emplyment without overshooting their 2% inflation target.

The economy, (like a growing production possibilities frontier), is suppose to tell the FED how to set interest rates.

The institutions of the United States allow productive economic improvements and as the economy grows, the FED is just trying to accommodate that growth with the correct supply of money.

Benjamin Cole said...

Gold may tell a tale, but how about the much more useful metal copper? Or Dr. Copper, as Scott Grannis has dubbed the metal.

Copper prices are now half of five years ago, and about even with 10 years ago.

Here is a sleeper: New auto prices in the United States have hardly budged in...20 years.

Nov 1996 index 144.6
Nov 2016 index 147.2

Auto prices have risen two decades.

The auto story is especially compelling. The number sold has doubled since 2008. No inflation.

Demand-pull inflation is just not there anymore. There was a time when the Big 3 and the UAW would have gone to town on doubled demand. No more.

The Fed is fighting the wars of yesteryear, or wars that cannot be won.

The supply of housing in the US is restricted by local zoning laws. No one wants a 40-story condo, ground-floor retail, in their single-family detached neighborhood. NIMBYISM trumps party or class or ideology.

The Fed cannot increase the supply of housing...but it can suffocate the economy enough that housing does not inflate.

Really, I wish there was a U.S. Constitutional amendment requiring no zoning, or that highest-and-best use be the default law of the land. The U.S. Supreme Court stripped property owners of their rights in 1926, and we have hardly heard a peep since.

steve said...

As far as I can tell, the one thing that is def in a bubble is "bubbles". I am sick and tired of reading about how many damn bubbles there are! If we're reading about them, they don't exist.

Thinking Hard said...

Steve - Check out the Druckenmiller video and also check out this Carl Icahn video

I'm all for open debate and ears are open to counter arguments regarding ZIRP and QE blowing bubbles. Also check out Druckenmiller's take on governmental finances and Icahn's take on earnings, M&A, buybacks, and junk bonds. Icahn ends with "those that do not learn from history are doomed to repeat it, and I am afraid we are going down that road." The road has been paved, but how long can we keep adding to the road?

William - The video above references some of the same issues as the Dealbook series. Worth a watch if you haven't seen it.

Benjamin Cole said...

Seems to me the banks ought to craft an alternative to Dodd Frank, goes like this: "Banks that keep 33% reserves are exempt from Dodd Frank and all other regulations pertaining to bank management and capital adequecy."

Matthew Grech said...

Benjamin: You are absolutely right. Martin Wolf (of FT writer fame) wrote a book. In it, just simply raising the reserve requirement was one of his core recommendations. As it turns out, defining exactly what constitutes the definition of reserve is not all that important.

The fact that the government doesn't implement such a simple system begs the question: why not? And I think the answer has much to do with control and the ability to dole out favors and jobs. Plus, established companies love regulatory complication (for obvious reasons).

Scott Grannis said...

RE: derivatives and "Which Financial Market prices can you take to the bank?"

Derivatives sound mysterious and even dangerous, but they play a very important role in financial markets. It took me many years to understand them, even with my background in finance. The main thing they do is allow people (e.g., large institutional money managers) to more efficiently manage their risk. The derivatives market is multi-faceted and generally very liquid, and as such I think its price signals (e.g., swap spreads) are definitely worth paying attention to.

In fact, I think it's important to watch the prices in any and all markets where government intervention and regulation are largely absent. That goes for the bond market and most futures markets. Stocks, however, are not immune to regulation and intervention, so their price signals are not as robust. Insider trading prohibitions, for example, can mean that prices don't fully reflect underlying fundamentals.

Prices are a fundamental part of free markets. Don't ignore them just because it's sometimes hard to understand where they came from.

Matthew Grech said...

It has never made any sense to me that in a fiat currency system we have a mere 10% reserve requirement. A bank's asset base must decline just 10% before all equity is wiped out. It would seem such a system is just asking for a major problem every dozen years or so... which is exactly what we've gotten!

Seems to me we need to either implement an asset-based monetary system (which is a good idea in any event) or we must raise the reserve requirement.

Benjamin Cole said...

Matthew G -- I agree with you, that the complexity of bank regulation must involve the complicity of banks. It ain't the boys down in the ghetto pool hall that are designing these bank regulations.

Benjamin Cole said...

PPI down 0.4% in Oct. after 0.5% drop in Sept.

Benjamin Cole said...

Side note to Matthew G: I decided to look at the American Bankers Association website regarding Dodd-Frank. There are some segments about complying with Dodd Frank, and about times when the industry negotiated about this or that rule under Dodd-Frank---but nothing like a clear statement, "We are against Dodd-Frank."

Then there is the American Banker publication.

They are running this article:

"Why GOP Debate Was a Bad Sign for Big Banks

WASHINGTON — There were at least two bad signs for large banks in the Republican debate held late Tuesday — even the most business-friendly candidates felt free to sharply criticize them and many seemed ill-informed about the current system.

Former Florida Gov. Jeb Bush repeatedly — and wrongly — asserted that bank capital levels had declined since the 2010 Dodd-Frank Act, while Sen. Marco Rubio erroneously claimed big banks openly brag about their "too big to fail" status. Meanwhile, the retired neurosurgeon Ben Carson, the No. 2 GOP candidate in the race, offered a view on financial regulation that most analysts found hard to follow, much less understand."


The good news is that Jeb Bush evidently likes higher capital requirements for banks, or says he does. The bad news (at least in regards to this one issue) is Jeb Bush is dead in the water.

I guess the banks have accepted Dodd-Frank. What you have is right-wing pundits writing against Dodd-Frank, while the industry lives with it, or learns to turn it to their advantage.

My sense now is that Dodd-Frank is a zero, but a huge waste of bank compliance officer time.

Scott Grannis has indicated there are negative impacts from Dodd-Frank. Perhaps he can specify what they are.

honestcreditguy said...

The FIRE industry is complex so people bankers can control the game...

Dodd Frank is easy compared to Glass Steagal..

Reinstate Glass Steagal so banks can be controlled. No hedge, pe or bank should own real estate to rent. Every MM and IB is fixing everything, name one market not fixed by bankers, try to find it....

you banker shills crack me up....Pigmen elitist are at war against the 99%...that is all anyone needs to know....

Benjamin-You auto price the same fantasy is rediculous. I buy ABS paper and can tell you the cost of an auto is much higher today...Add it up...

just because you have fed induced low interest rates, longer terms and subprime lending back at full throttle doesn't mean it's cheaper to own an auto...

Benjamin Cole said...


The above is the link to the St. Louis Fed data on new vehicle prices, revealing no inflation in 20 years. Of course, it is based on BLS data.

At first, this is astounding. Then, one realizes we today have global steel gluts, and the UAW negotiates wage givebacks, not gains. The Big 3 has been supplanted by Totota, Honda, Mercedes, BMW, Hyundai, and more. Rubber and plastics would be cheaper today than five years ago.

And course, the private-sector gets better continuously at everything it does.

Here is another one: Aluminum prices are lower today than in 1987, so you get nearly 30 years of deflation.

A better conspiracy theory would be, "Why do we have price indices that keep showing inflation?" And some right-wingers do say the CPI overstates inflation, when they discuss long-term middle-class incomes.

I do not think there is a cabal at the Fed to suppress accurate price data. I do ponder if Fed officials realize that inflation today is largely tied to housing. And the supply of housing is restricted by ubiquitous socialist local zoning entanglements.

Everyone is a pinko when it comes to their own neighborhood.

The Fed is fighting the last war, much in the manner of every public organization.

Oeconomicus said...

Another interesting article on debt market price signals.

Scott Grannis said...

Oeconomicus: Thanks for the link. The article makes good points (i.e., regulatory issues have made it more attractive to for hedgers and investors to deal in swaps instead of Treasuries), but I would argue that it is unnecessarily alarmist. Governments distort prices frequently, but that doesn't necessarily lead to a market collapse. Furthermore, it doesn't invalidate the message of swap spreads, since it remains the case that there is no shortage of players who are willing to receive fixed (i.e., to take on risk), and it is easy for those wanting to pay fixed (i.e., to shed risk) to do so.