Thursday, January 29, 2015

Walls of worry persist

The market is still climbing walls of worry, and that's a good sign.

As I see it, here's the bearish case for equities: The Fed is no longer "printing money" and is soon going to begin to raise short-term interest rates. The market has enjoyed a great party for years, but the Fed is about to take the punchbowl away. Equity valuations are stretched, and earnings reports are turning mixed. The energy sector has been savaged, and there may well be nasty ripple effects: layoffs and defaults. China is in a slump and over-burdened with debt. Europe is in another slump and no amount of QE is going to make things better. Countries all over the world are trying to devalue their currencies in the hopes this will boost exports—but that's a fool's game. Policymakers have run out of tools to stimulate growth; growth is likely to be meager for the foreseeable future. The market's enthusiasm is likely to founder on the rocks of slow-growth reality.

In contrast, here's what I think the bullish case for equities is: QE was never about printing money; it was mainly about transmogrifying notes and bonds into T-bill substitutes in order to accommodate the world's demand for safe assets. Confidence is returning, however, and demand for safe assets is declining, so ending QE was the right thing to do. The economy still has plenty of unused capacity, but growth has definitely picked up in the past year. Congress is very unlikely to raise taxes, and may even succeed in lowering them, especially for corporations. Regulatory burdens are more likely to lighten than to increase further. Even if interest rates start moving up soon, they will still be very low relative to inflation for a long time. Equity valuations are no longer cheap, but relative to the yields on safer assets, equities still look quite attractive. There are still plenty of signs that the market is cautious, and that worries are more prevalent than exuberance. Absent a recession—which looks unlikely—equities are likely to outperform most other asset classes because of their superior earnings yield.

Here's how I read some of the more important market-based tea leaves:

The chart above represents the yield menu that investors have to choose from. If you don't want to bear any risk, you are not going to earn anything on cash. Cash (and cash equivalents such as 3-mo. T-bills) yields zero because the demand for safety is extremely strong. The market seems indifferent between owning equities with an earnings yield of about 5.5% and owning cash, with a yield of zero. That can only be taken as a sign that the market is still quite risk averse.

Risk aversion can also be seen in the chart above, which shows that spreads on corporate bonds have risen meaningfully from their recent lows. When confidence and the appetite for risk are strong, spreads are tight; that is not the case today. But doesn't the recent rise in credit spreads signal a coming recession? I don't think so, since swap spreads—the best leading indicator of economic and financial trouble on the horizon—are still quite low. Systemic risk is low, but there's still a lot of worrying going on, and that makes for a healthy market environment. The time to get really worried is when the market is priced to perfection. As it was in early 2000, when the economy was expected to grow 4-5% per year indefinitely.

The chart above shows that the market has been climbing walls of worry (worry being quantified here by the ratio of the Vix index to the yield on 10-yr Treasuries) for most of the past several months. The Vix index is high, which means investors are willing to pay up for the relative safety of options. The 10-yr Treasury yield is quite low, which means investors don't expect the economy to be very strong.

The chart above shows that the earnings yield on equities is significantly higher than the yield on 10-yr Treasuries. This is a clear sign that the market worries that the outlook for corporate profits is troublesome, to say the least. During times of strong growth (e.g., the 1980s), the earnings yield was well below the yield on 10-yr Treasuries. The equity risk premium has been unusually high for several years, during which time equity prices have marched continually higher. It's been climbing walls of worry all the way up.

The chart above compares the earnings yield on equities to the price of 5-yr TIPS (I use the inverse of their real yield as a proxy for their price). When the price of TIPS peaked in 2012, that was a sign of extreme risk aversion: the market was willing to pay a huge price for the relative safety of TIPS, which are default free and inflation-protected. At about the same time, the earnings yield on equities was also at or near a peak, which reflected great distrust concerning the outlook for corporate profits. In the past few years, demand for TIPS has weakened and confidence in the future of corporate profits has improved. But both are still far from where they would be in "normal" times. The market has become less fearful, but it is still somewhat risk averse.

As the chart above shows, it's unusual for the earnings yield on equities to exceed the yield on BAA corporate bonds, as has been the case for the past several years. Bonds are senior in the capital structure to equities, so they should normally yield more, especially since they don't have the upside price appreciation potential that equities do. Today's level of yields suggests that the market is still willing to "pay up" for the relative safety of bonds.

The prices of gold and 5-yr TIPS have been declining for the past two years, as shown in the chart above. (Here again I use the inverse of the real yield on TIPS as a proxy for their price.) Yet both are still high from an historical perspective. The demand for these two unique assets has weakened as the market has regained some confidence in the future, but they are still relatively expensive. The inflation-adjusted price of gold over the past century has averaged almost $600/oz., which is half of today's price. The average real yield on 5-yr TIPS since 1997 is about 1.4%, which is substantially higher than their current real yield of -0.2%.

As the chart above suggests, the real yield on TIPS should tend to track the real growth potential of the U.S. economy. GDP growth has picked up over the past year or so, and real yields have moved higher, both of which are good signs. But real yields remain quite low relative to the almost 3% rate of real growth over the past two years. That's a sign that the market is dominated more by worries than by exuberance.


Anonymous said...

The FED seems to want to raise rates in order to normalize them. I can understand that because everyone without exception says extended low rates cause dislocation, misallocation, imbalance, disequilibrium, or something like that.

But it seems so theoretical if not ideological. The economy is not hot. Inflation is not hot. I don't see any head room to raise rates before hitting historical down trends. So are we now entering a new era where credit expansion is not paramount?

It reminds me of a 1950s song by the Shangri-Las, "I can never go home anymore"

Benjamin Cole said...

Joseph Constable: you have asked the $64,000 question---the one central bankers need to ask.

Scott Grannis said...

Prudent central bankers shouldn't wait until the economy is "hot" or inflation is "hot" to raise rates. Monetary policy acts with long and variable lags. Waiting too long can let an as-yet-invisible problem gather momentum, thus making it harder to address.

Whether central bankers are smart enough to raise and lower rates at just the right time and by just the right amount is the real question.

William said...

One GOOD REASON to raise rates is so that SAVERS get at least some return!!!! It would in fact be great news for SAVERS if they had a return greater than the annual inflation rate!! NO???
GOOD REASONS not to keep rates so low is that the MAJOR effect of the historically low rates has been to create too much supply of EVERYTHING! In theory, extremely low rates would create demand - perhaps too much demand and inflation.

BUT what has actually happened over the past 5 years is that many major, multi-billion dollar corporate projects have been undertaken because of the extremely low rates which NEVER would have gone forward if rates had been "normal". Like many mine expansions or new developments in Australia, Africa and South America; Petrobras sub-salt oilfields in the Atlantic Ocean; Nigerian offshore oil fields; the extensive oil fracking in North America; and the many factories throughout Asia.

The low interest rates have brought over-capacity and over-production everywhere. THUS the LOW prices - and soon to be witnessed LOW PROFIT MARGINS.


Benjamin Cole said...

To my right-wing friends, and tight-money enthusiasts:

Scott Sumner, the don of the Market Monetarism movement, has taken a chair at the Mercatus Center, the very pinnacle of the George Mason University right-wing redoubt.

Here is the Wiki definition of the Mercatus Center.

"The Mercatus Center at George Mason University in the United States is a non-profit American market-oriented research, education, and outreach think tank. It works with policy experts, lobbyists, and government officials to connect academic learning and real-world practice. Taking its name from the Latin word for "markets", the Center advocates free-market approaches to public policy. Washington Post columnist Al Kamen has described Mercatus as a "staunchly anti-regulatory center funded largely by Koch Industries Inc."

Okay, I hope this give right-wingers "cover" to adopt Market Monetarism, which is less obsessed with exalting deflation or microscopic rates of inflation than with obtaining real economic growth.

I encourage Scott Grannis and others to join the new right-wing of Market Monetarism (which is really just an adoption of the best of Milton Friedman's ideas, but don't tell anyone).

Prosperity should be the goal!

Andrew said...

I'm struggling with the concept of "normal". Of course, there is also the new normal to consider as well.

Anyhow, 5 year tips are currently yielding -0.3%. In other words, risk adverse savers are not able to protect themselves from inflation. Instead, they must endure a slow erosion of their savings. There are no locked boxes, not truly safe banks; but there are small loses.

This actually makes sense to me. So, I'll call the current financial environment "normal".

Equity is not as safe, a rightfully so with earnings surprises and scandals always a possibility. So, equities ought to yield more. A 4% equity premium appears normal from a historical perspective.

Of course, laws and liabilities for lying about earnings have changed over the years and it's possible that a 4% equity premium may no longer be necessary. Could it be maybe only 3%?

Anonymous said...

Benjamin has revealed himself quite openly. The right just wants to stop with the spike in rates>avalanche in rates>spike in rates all over again cycle. The right want markets to determine interest rates instead of central planners. It isn’t about the level of rates.

This is not a bad idea seeing how rates and recessions and inter-recessionary periods are related to rates driven by people disadvantaged by having all gone to the same college or two.

1leone said...

"...Confidence is returning, however, and demand for safe assets is declining"

Could you pls elaborate on this as I can't get my head around it with bonds hitting record low yields almost on a daily basis. Just look at what TLT is doing today...

Scott Grannis said...

Nominal bond yields are very low, but real yields on 5-yr TIPS have increased (meaning their prices have fallen) by almost 150 bps since March 2013.

In other words, the price of gold and the price of 5-yr TIPS have fallen significantly in the past two years, a time during which consumer confidence has increased.

There is a meaningful difference between the behavior of real and nominal yields these days, mainly because the big decline in energy prices has driven down inflation expectations.

Grechster said...

Scott Sumner maintains a blog: The paper on nominal GDP targeting (scroll down on the home page, bottom right) is a terrific read.

Roy said...

"The market is still climbing walls of worry, and that's a good sign."

Pardon, could you clarify on the "climbing" part? How to see it in the graphs?

I"m not disagreeing with you or anything, just that it looks different than 2013 and 2014.


Scott Grannis said...

Roy: the "walls of worry" are the spikes in the Vix/10-yr ratio. The market starts to worry, the ratio moves up, and stocks sell off. But with the passage of time, stocks recover and worries subside. Every spike in the ratio coincides with a low in stock prices. When the ratio is low, stocks continue their gradual ascent. It's more a figure of speech than anything else. What makes it work is that the market's fears are never realized; the fundamentals don't deteriorate. That won't go on forever, of course.

steve said...

with all due respect, any attempt to "time" the stock market is a fools game. in over thirty years in the business I have NEVER seen anyone remotely consistently successful. I repeat a point I've made before: you're either in it all the time or none of the time.

Benjamin Cole said...

Side note to those who contend "savers" are getting hurt by the Fed.

Well...depends on how you look at it.

A saver invested in the ZROZ ETF (PIMCO 25+ Year Zero Coupon U.S. Trs ETF) is up 52% in last 52 week.

In short, if you have been invested )saved in the from of) in high-quality bonds or US Treasuries, you have made a killing in last year.

If you have been saving in a bank account, yes you have treaded water.

Last word: There is a misunderstanding that savers are "entitled" to returns. This misunderstanding probably goes back to FFIC insurance on bank accounts, and the old Reg Q regulated rates.

In a free market, you are entitled to gains on your savings, and also losses.

The world right now is awash in capital, what Bain & Co, predicts is a long cycle of "superabundant" capital. Your passive savings are not scarce. It is not a pleasant situation.

Indeed, as there may be more capital than can be profitably invested, that may mean a lot of people are going to have to take losses, if the free market works correctly.

He who has the gold rules, except when everybody has gold. Then he who has the best business plan rules.

We may be there now. Certainly, we saw that no good idea in the energy sector in the last 10 years went unfunded. If you own commercial real estate at all well-placed, you can command a premium for it.

The globe and the US is still lacking strong total aggregate demand, and central banks are loath to let inflation rise above 1%. Some central bankers are extolling the virtues of deflation.

Thus, investing capital successfully going forward may be very iffy.

Grechster said...

Benjamin: Excellent point. This is an issue I've had in the back of my head for a good long while now. The idea that the world is awash in capital looking for a home... A real estate friend of mine observes that buyers of big real estate assets - frequently foreigners - don't give a whit about returns. Rather, they're looking for a place to park big money where they won't lose too much. It's all very interesting and a bit warped if I may say...

William said...

@ Benjamin wrote "In a free market, you are entitled to gains on your savings, and also losses."

But I thought it was understood that the short end of the money curve is set / controlled by the central bank, presently at 0 to 0.25% per annum. The short end has never been a "free market" rate since the FED was founded.

What's more the US FED has bought about $ 3.0 trillion of bonds of various types and maturities. The longer bonds also have not been in a "free market" since QE was undertaken.

Surely you do understand this.

Benjamin Cole said...

Matt: Sophisticated institutional investors are paying very low cap rates on trophy assets....ouch.

Benjamin Cole said...

William: good points. So you think yields on Treasuries would have fallen even more without Fed intervention?

Of course that means Fed actions are raising T-bill yields...resulting in higher returns for savers...t

William said...

@ Benjamin

I understand that the FED Funds rate was lowered to almost ZERO to aid the distressed banks and to enable them to improve their balance sheets and to raise capital. But the FED has done incalculable harm to savers who (including corporate cash) have $12 - $13 billion in money market funds, passbook savings accounts with limited saving and T-bills.

I have never understood the big deal about raising the Funds Rate a 1/4 point a couple times by now. I suspect that in the future this will be seen as a big mistake much as Greenspan is now viewed as having kept interest rates too low for too long.