Monday, March 2, 2015

10 charts to watch

The news and the economic fundamentals haven't changed much in recent months, but on the margin there has been some modest improvement. The following charts highlight some of the more interesting developments that bear watching.

Rising profits have been the source of most of the gains in equity prices in recent years. Since the post-recession low in PE ratios (13.9 in August 2010), ratios have increased by 35% to almost 19 today. Over the same period, earnings have increased almost 50%. However, profits growth has declined in the past year, with S&P 500 trailing earnings up only 4.4% in the past 12 months, thanks in part to falling oil prices. Fortunately, that's not exactly a bad thing for everyone. PE ratios are above average, but not by a significant amount.

I remain fascinated by the chart above, which I've been following for the past few years. It shows a decent correlation between the earnings yield on equities and the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). When earnings yields are high and real yields are very low, that is a sign of a market that is very risk-averse: investors don't trust earnings, and are willing to pay very high prices for the safety of TIPS. Risk aversion has been declining for the past few years, however, as confidence slowly improves. This is a significant trend that is likely to continue. Expect higher PEs and higher real yields over time. 

Equity risk premiums (defined here as the difference between the earnings yield on stocks and the yield on 10-yr Treasuries) have come down sharply from their October 2009 highs, but remain relatively high by historical standards. The earnings yield on stocks today is still substantially higher than the yield on safe Treasuries. That's another sign of risk aversion: in a strong, growing economy like we had in the 1980s, investors are typically willing to give up yield (i.e., accept a lower earnings yield on risky stocks than the yield on safe Treasuries) in order to benefit from a rising equity market. Today, investors still demand a higher yield on risky equities because they are still somewhat risk averse. Today's relatively high equity risk premium is reminiscent of the high equity risk premiums that prevailed in the late 1970s, when investors were reeling from the shock of double-digit inflation, a weak dollar, and soaring Treasury yields. Today's investors are still reeling from the shock of the Great Recession.

Earnings yields on stocks are still higher than the yield on BAA corporate bonds. This is relatively rare, since corporate bonds are higher in the capital structure. In a "normal" world, equities should have lower yields than corporate bonds, since equity investors are willing to give up yield in order to benefit from the expected growth of earnings. Bond investors, on the other hand, are willing to give up price appreciation in exchange for a higher and safer yield. Today, however, investors are unwilling to pay up for equities, in a sign that risk aversion that still prevails. I wouldn't be surprised to see equity yields continue to decline (i.e., rising PE ratios) even as bond yields flatten or begin to rise.

Equity prices continue their slow upward march, climbing a major wall of worry that is fading away (e.g., Greek defaults, collapsing oil prices, Ukraine tensions, Fed tightening).

The February ISM manufacturing index was about as expected. Although it's off quite a bit from its recent highs, it is still consistent with overall economic growth of 2-3%. The economy has been doing a bit better over the past year, but it's nothing to get excited about. The outlook for growth remains moderate; not great, but not bad either, with some modest improvement on the margin. Significant improvement will come when and if fiscal policy becomes more growth-friendly (e.g., lower and flatter tax rates, especially for corporations, and reduced regulatory burdens).

One of the more encouraging developments in the past year is the pickup in C&I Loans. This reflects increased confidence on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow. Bank lending to small and medium-sized businesses is growing at a solid 12% annual rate these days. The increased confidence this reflects lends solid support to a forecast of continued economic growth.

Money supply growth has averaged just over 6% per year for the past 20 years. No sign here of the Fed "printing money" in any unusual way. However, nominal GDP growth has averaged 4.4% over this same period. When money growth exceeds nominal GDP growth, we can infer that the world's demand for "money" has increased; people want to increase their money balances relative to their incomes, usually out of a desire to reduce risk.

Demand for money (i.e., the ratio of M2 to nominal GDP) has risen strongly over the past 20 or so years, especially since the Great Recession. But the rate of increase in money demand is slowing, as risk aversion declines. Rising money demand was the major impetus for the Fed's Quantitative Easing, whose major purpose was to "transmogrify" notes and bonds into T-bill equivalents (bank reserves). The world wanted a lot more safe assets, and QE generated over $3 trillion of safe assets to meet that demand. As risk aversion declines, QE is no longer necessary.

The important thing to watch for is a decline in money demand. It's been a long time coming, but sooner or later we are likely to see nominal GDP growth exceed M2 growth. That time will most likely coincide with rising confidence, a stronger economy, and a tendency for rising inflation. This will test the Fed's ability to keep the supply and demand for money in balance by increasing short-term interest rates.

The main source of M2 growth since the Great Recession has been bank savings deposits. Note the slowing in the growth rate of savings deposits that began about two years ago. Savings deposits were growing about 12% per year, but have only grown at about 6% over the past year. This growth slowdown is likely to continue, as households become less interested in accumulating savings deposits that pay almost nothing in a world in world in which stocks rise 1% a month, earnings remain at record levels, and inflation is at least 1-1.5% a year and rising.


Benjamin Cole said...

Yes, the Fed credited the commercial bank accounts of the 22 primary dealers with $3 trillion in deposits when the Fed bought $3 trillion in T-bonds from the primary dealers. This is the source of the increase in reserves, as can be verified at NY Fed website.
But there was another step in this process: the primary dealers bought $3 trillion in Treasuries from their clients or others in the private sector--essentially using $3 trillion of freshly minted Fed cash.
We see commercial bank deposits are weak.
The bond sellers probably re-invested their proceeds in other assets, or spent the fresh cash.
Pre-QE, the Fed attempted stimulus by increasing bank reserves, given that banks would usually lend out based upon their reserves. That no longer worked in 2008 as banks were not lending out to anybody. Before QE, Fed open market operations were in the billions or tens of billions of dollars. In QE, we see Fed open market operations move into the trillions of dollars, and all in one direction---buying. That is because the Fed was no longer raising bank reserves to obtain stimulus, but rather injecting trillions of dollars into the pockets of people who sold bonds.

Benjamin Cole said...

Fascinating, from AEI-Pethokoukis, from WSJ:

"We have a difference of opinion, or at least a difference of forecasts. The WSJ’s Jon Hilsenrath notes, “Central-bank policy makers on average see rates going nearly twice as high as futures markets indicate in coming years, for a variety of reasons. The median Fed policymaker forecast puts the fed funds rate at 2.5% for the end of 2016 and 3.63% for the end of 2017. But futures markets put the expected fed funds rate at “0.50% on average in December 2015, 1.35% in December 2016 and 1.84% in December 2017.” Built into those expectations is the investor calculation “that there is some probability rates will return to near-zero after a few increases and stay there.”


When you think about it, the futures market is saying the Fed will be tight, and possibly drive rates back down to zero. And the Fed says rates will go they want to make rates go higher, which of course will ultimately lead back to zero, as a central bank cannot tighten it way to higher interest rates for long. Tight money leads back to zero, as noted by Milton Friedman.

BTW, the (headline) PCE price index out, it was 0.2% up for last year.

Have to say, the Japan scenario is very possible here. The U.S. is not Japan, so our future does not have to play out exactly the same. But we could see interest rates near zero for a long, long time, and sloggy growth.

Anonymous said...

Standard and Poors with 95% reporting for 2014 have the 500 GAAP earnings $102.77, and projects 2015 $111.27, and 2016 $124.20. That makes increases over the previous year of 2.6%, 8.3%, and 11.6% respectively.

With the S&P 500 at 2100 that gives a PE of 20.4 now, 18.8, and 16.9 in the future.

So the market is cheap. Right? I mean if earnings in 2016 are at a present PE of 16.9 why wouldn’t one just buy and hold and just go away and wait for 2016?

I guess people might be skeptical of the projections. They might think Standard and Poors falls somewhere between being nice guys that could be a bit over optimistic and wall street hacks.

If earnings grow 5% in 2015 and 5% in 2016 the earnings are $107.91 and $113.30 giving PEs of 19.5 and 18.5 at a price of 2100. Which means stocks are priced at about earnings growth of a bit less than 5%.

That shouldn’t be so hard with growth in productivity, buybacks, M&A, a stable or declining dollar, a recovering price of oil. And there is always QE.

Trouble is, I just made a scenario for S&P 500 at 2100 over the next year if earnings only grow at 5% over the next two year each. It all depends on earnings growth. A high growth in earnings will engender a high PE. And vice versa.

Just sayin’ 5% earnings growth isn’t so good with prices this high. That 8.3% projected growth is important to achieve. Or at least the expectations of it being achieved is important.

See, Mr. Grannis is right. This is a perfect example of being risk adverse.

Anonymous said...

I prefer to use the more broad MZM measurement of money supply than the less broad M2 measurement. When doing so money velocity is a steadily declining trend since the great expansion since 1980. Such a trend makes sense to me with the ever decreasing federal funds rate over the same period.

“…but sooner or later we are likely to see nominal GDP growth exceed M2 growth.”

You never heard of credit velocity. I made it up. It already has bottomed out and is slightly increasing. Go to FRED, chart GDP and divide it by TCMDO – total credit market debt outstanding. This is perhaps most encouraging.

Benjamin Cole said...


Yes, I wonder if earnings of US corporations can rise by 20% in next two years.

Earnings are now, of course, at all-time records, and far far above 1980s and 1990s levels, by any metric. Corporate America has never had it so good---and I think that is great. Bring on more profits, I say.

But...I wonder how? These guys (corporate managers) are batting .400 right now. They can bat .435?

Ted Williams....

steve said...

always bet with the MARKETS-especially over feds opinion of where rates will be. their track record, dismal speaks for itself.

Benjamin Cole said...

OT: the Federal Reserve says that has a balance sheet of $4.5 trillion dollars, and says it has purchased $4 trillion in securities. Commercial banks say they have excess reserves of 2.5 trillion. If QE equals excess reserves, what happened to the $1.5 trillion to $2 trillion?

Scott Grannis said...

The non-excess reserves can be found in required reserves and as collateral for currency in circulation, currently about $1.3 trillion. A dollar of bank reserves can be exchanged for a dollar of currency.

Benjamin Cole said...

Required reserves are tiny; $80 bil or so.
Cash in circulation is a fascinating topic. There is about $4000 in cash in circulation for every US resident. If cash in circulation has truly increased by a trillion dollars since QE, then I suggest it is very stimulative on our cash economy.
I'll check the numbers later---something does not add up. The math does not jive.

Scott Grannis said...

Currency in circulation has increased by a little less than $500 billion since late 2008. Required reserves are about $160 billion. Trust me, the numbers add up.

Benjamin Cole said...


Well, maybe I am missing something.

I see the Fed buying $4 trillion in bonds since 2008.

I see bank reserves now at $2.5 trillion.

I see required reserves at about $77 billion, I don't know why we mismatch on that number.

Cash in circulation is up $500 billion since 2008, now at $1.34 trillion.

Still about $1 trillion in QE did not become reserves or cash.

Add on: $500 billion in added cash in circulation must be stimulative. Sure, some of the $500 billion it is inert mattress-suitcase money, but not all of it.

The $4 trillion in bonds:

The $2.5 trillion in reserves:

The cash:

Well, $2.5 trillion in reserves and $500 billion in cash adds to $3 trillion; the Fed bought $4 trillion.

Ergo, people who sold bonds to the Fed did not bank all of it. You had a $1 trillion in stimulus; I would say $1.5 trillion, as $500 billion in circulating cash is something.

David Landy said...

I'm trying to align the p/e chart that Blodget presents here, with your version, in the first graph of this post. Any help appreciated.

Scott Grannis said...

My chart is fundamentally different from Blodget's chart, so the two will never align. My chart is based on the standard P/E ratio: price divided by the last 12 months' worth of earnings. I use Bloomberg's calculation of this ratio, and Bloomberg in turn uses "adjusted" earnings.

Blodget's chart uses Shiller's P/E ratio: price divided by the average of the last 10 years' worth of earnings.

Shiller's P/E ratio is commonly referred to as CAPE, or Cyclically Adjusted Price Earnings.

I suggest you read a prior post of mine which discusses the relative merits of various measures of P/E ratios:

David Landy said...

Thank you.