Friday, January 19, 2018

Putting bonds and stocks into perspective

There are some big things happening in the financial markets. Stocks are hitting record highs and bond yields are bouncing off record lows. The S&P 500 index is up almost 35% since just before the November '16 election. 10-yr T-bond yields are now 2.64%, almost twice as high as their all-time record low of 1.36% in July '16.

For some valuable perspective, I offer the following charts:

Chart #1

In Chart #1, I've drawn some admittedly arbitrary trend lines on this long-term chart of the S&P 500 index. The trend rate of growth they represent is a bit conservative compared to the 9.4% annualized long-term total return (including dividends) of stocks since 1927, according to Bloomberg. Stocks appear to be pushing the upper limits of growth, according to this chart. But further gains cannot be ruled out. After all, last year's tax reform slashed the corporate income tax rate from 35% to 21%, making future earnings streams suddenly worth 21% more.

Chart #2 

Chart #2 adjusts the S&P 500 index for the rate of consumer price inflation. The trend lines I've drawn represent 3% annualized real growth, which is very much in line with the economy's long-term trend growth rate. Still room on the upside, considering recent tax cuts. If businesses respond to their new investment incentives, we could see the economy grow by substantially more than 3% in coming years.

Chart #3

Chart #3 gives you the long-term history of 10-yr Treasury yields, with the green dashed line marking the all-time closing low of 1.3% (July '16).

Chart #4

Chart #4 zooms in on the last 28 years of Treasury yields. The trend line I've drawn suggests that the bond market is in the early stages of reversing its long-term declining trend. This would make sense if indeed the economy is on the cusp of a new wave of investment-led growth. If would also make sense if inflation is 2% or more, as it is today.

Chart #5

Chart #5 shows how 10-yr yields have been unusually low relative to inflation in the past decade or so. Since 1960, the average spread between 10-yr yields and inflation has been 2.3%, whereas today it is only 0.5%. If consumer price inflation averages just over 2% in coming years, as the breakeven spreads on TIPS and Treasuries suggest, then I would expect to see the 10-yr yield average at least 3.5 - 4%.

Chart #6 

Chart #6 compares the equity market capitalization of global equities and US equities, according to Bloomberg. A lot of wealth has been created in recent years.

Chart #7

Chart #7 shows that it's not just the US equity market that is on fire. For the past several years, the US and non-US equity markets have appreciated by roughly the same amount. Since 2004, US equity capitalization has actually fallen significantly relative to the rest of the world. We're smack in the middle of a global equity market boom and the US market does not stick out like a sore thumb.

15 comments:

Benjamin Cole said...

I guess 2018-2019 could be the latest iteration of, "Will the Fed Take Away The Punch Bowl?"

The Fed says it it targeting a higher national rate of unemployment than we have today, of 4.1%. The Fed wants a 4.75% unemployment rate, as a minimum.

In the last two years, Fed staffers have consistently posited the US economy is facing “labor shortages” and is “beyond full employment,” even as wages rise like redwoods in the Sahara.

And on Jan. 16 from the San Francisco branch of the Federal Reserve, we have this gem: “We expect the [unemployment] rate to fall below 4.0% in 2018 as the economy continues to strengthen. With the gradual removal of monetary policy accommodation, we expect the unemployment rate to return gradually to our estimate of the natural rate of unemployment of 4¾%.”

The Fed is genteel, but nevertheless, the Fed's NAIRU models say it has to get unemployment back up to 4.75% or risk "accelerating inflation."

If the Fed is successful in its quest for a higher unemployment rates, the public will see loosening labor markets right along higher corporate profits and the Trump tax cuts.

That is a great way to sell free enterprise and corporate tax cuts to the voting public.

There is hope that the new Fed Chief, Jerome Powell, is a lawyer and not an economists, was just appointed by the GOP and Trump, is a Wall Streeter and by outward appearances every smart and not doctrinaire.

Powell will want the corporate tax cuts to be seen by the public as working. Maybe he will be the GOP answer to Arthur Burns

So Powell will not tighten the monetary noose.

Which does pose another question: If Powell tries to help the tax cuts work, we will have a monetary policy that has been routinely described as "hyper-accommodative" and also huge federal budget deficits going forward. The Fed says there are "labor shortages."

So, should the inflation forecast…be adjusted?







steve said...

Scott, off point but what do make of this?

https://www.wsj.com/articles/trump-starts-his-trade-war-1516755083

Strikes me as utterly gormless.

Scott Grannis said...

Trump's tariffs are arguably his worst blunder yet. Utterly stupid. His ignorance regarding trade was always a major concern of mine, and at least we can find comfort in the fact that it has taken him more than a year to do one of the worst things he promised to do. And it isn't earth-shattering, if it is limited to solar panels and washing machines. Let's pray he doesn't do more of this. Journalists should be searching out some of the millions who will be adversely affected by these tariffs whose only good will benefit a handful of companies. Let's see articles which prove how tariffs are dangerously stupid, not more articles on Trump's tweets.

Frozen in the North said...

Don't forget he seems to have decided that NAFTA is a bad idea all around. As a Canadian, I saw how he's pushing Canada on milk and milk products saying that Canada has unfair trade practices and that that market should be open to all American producers. His solution is tariffs on all Canadian milk product -- while the US has a $400 million surplus with Canada...so no trade is not his thing, rather its pure mercantilism, at least until it affects his own businesses.


terex said...

Scott, I am surprised that you do not comment on the flattening of the yield curve... The debt bomb is still part of the market psyche and Mr Market does not seem to believe - at this moment - that higher growth is structural/secular enough to substantially shrink that deflation bomb/risk. At least that's my take..., let's hope for rising let yields.

Also w regards to trade and China. I do for sure agree in principle w the open trade argument, but the level of cheating going on by the Chinese is just too much (at least for my taste). Try to buy a Chinese company as a foreigner and you will be discriminated so bad it is criminal. But foreigners have no alternative because you have to get presence, so you accept to run your business at double the cost, the harassment of gov officials and the loss of big contracts to less efficint local competitors... How do you change this if not via policy? Or how about the blatant level of IPR theft, etc... Just saying

Adam said...


Sp50cheaper than headline figures?

https://www.mckinsey.com/business-
functions/strategy-and-corporate-finance/our-insights/looking-behind-the-numbers-for-us-stock-indexes?cid=soc-web

Benjamin Cole said...

OT

I tend to be a contrarian, and lately, no one is worried about the national debt. Time for me to worry.

In past times, the national debt was a Bogeyman to slay America--or so said many.

Today, the CBO says the national dent will rise by about $1 trillion a year for the next 10 years, until the public holds $25 trillion in IOUs, up from about $15 trillion now.

At the same time, the national debt is no longer an issue anyone talks about.

Sure, some will say, "Cut entitlements, tra-la-la," and others will hint the $1 trillion a year spent on national defense has become folly, but no one is seriously proposing lining up revenues and outlays.

So, we can count on $25 trillion in national debt in 2027, and that is if the economy does fine, and we do not get in any wars.

A trillion here, and a trillion there, and then pretty soon you are talking about real money.

Maybe the Fed can buy back debt through QE. The Bank of Japan does it, and there seems to be no ill effects. The BoJ owns 45% of Japan's national debt. I call it Mobius Strip budgeting.

Interesting topic. I have my worry hat on.

steve said...

The ebb and flow over concern of the federal debt is interesting and Ben is right, it may be at an all time low. Of course, the true barometer of concern is the bond market which, while yields have picked up a little, has been remarkably quiescent. Time will tell.

Benjamin Cole said...

Steve-the bond markets appear to say, "Capital gluts forever!"

terex said...

Term premiums at ATL levels. Market accepts this as an insurance premium...

Scott Grannis said...

steve: re federal debt and the bond market. As I see it, the bond market has never been affected by the amount of federal debt outstanding, at least in the way that most people would expect it to. In fact, a long-term chart of bond yields and federal debt outstanding as a % of GDP shows a negative correlation: rising debt burdens appear to correlate with falling interest rates, and vice-versa.

The explanation for this seeming conundrum is simple: Treasury bonds are an asset market, not a flow market. In flow markets (e.g., strawberries), sharp increases in supply depress prices and vice versa. But in an asset market like Treasury bonds, prices (i.e., interest rates) are determined not by supply but by the public's demand to hold all the existing bonds (which include not only Treasuries but also mortgages and corporate bonds).

So: interest rates today are low because the world has a strong desire to own bonds (i.e., to pay high prices for bonds), in spite of the fact that the supply of Treasuries today is far larger than it has been for most of post-war history.

Buk Star said...

Thank you for posting. Re: your long-term price trend charts 1&2 - do you think that the new phenomenon of stock buybacks (which started in the late 1980s) would affect the trendline by giving it a higher slope than we have seen historically? This is because buybacks are about 50% of cash return to shareholders - where dividend yield use to be 4% it is now 2% with the other 2% going to buybacks (for the SP500). The effect of this is to increase price starting in the 90s and change the channels your drew.

Scott Grannis said...
This comment has been removed by the author.
Scott Grannis said...

Buk Star: re whether stock buybacks will boost the long-term trend growth in stock prices. While we are almost certain to see an increase in stock buybacks as a result of the recent changes to the corporate tax code (lower income tax rates and a sharply reduced rate on repatriated profits), I would note that the size of potential buybacks is likely to be quite small compared to the total value of the stock market. From the numbers I've seen, unrepatriated corporate profits total $2.5-3.0 trillion, whereas total corporate profits are roughly $1.8 trillion per year and the value of all US publicly-owned companies is about $30 trillion. Not all those overseas profits will be repatriated immediately (more likely over a period of 5-7 years), and not all those repatriated profits will be used to fund buybacks. In a very aggressive case, wherein 20% of corporate profits are repatriated annually for the next 5 years, and half of those profits are used for buybacks, that would amount to roughly $275 billion in annual buybacks. Would repurchasing $275 billion in stock each year make a big difference in a market that currently is worth over $30 trillion? (275/30000~1%). I seriously doubt it.

Buk Star said...

Hello and thank you for the response. I apologize for being unclear. My reference was not to the tax law changes. My reference was to the following: for most of the 1900s (your charts above) share repurchases did not exist for SP500 companies. In the late 1980s buybacks started to be used in corporate America. In the early 1990s they increased in popularity. What I am suggesting is that stock buybacks took over / replaced dividends. The average dividend yield use to be around 4% throughout history. It is now 2% with the "missing" 2% seen in buybacks as corporate CFOs split cash return via buybacks and dividends. While dividends never showed up in price charts (like the one you show), share buybacks do show up in the price charts since that money is directly used to reduce the share count. This would essentially change the slope of the charts you drew to be more steep starting in the 1980s. Thank you again for your thoughts on this.

Jeremy Siegel wrote about this here:
https://imgur.com/bQoXED0
And here is info on buybacks going back to the 1990s:
https://www.yardeni.com/pub/buybackdiv.pdf