$40 trillion and counting

The market cap of global equity markets has risen over $40 trillion since the early March, 2009 low, and now stands at a record $66.1 trillion. That's a handsome gain of 158% plus dividends in just over five years.

Pessimists argue that this was all fabricated by easy money (e.g., the Fed's multi-trillion dollar expansion of its balance sheet). Optimists like myself argue that these gains were fully justified: At their lows early 2009, equity markets were priced to five years of depression and deflation that would make the Great Depression pale in comparison. As I wrote in November, 2008, corporate credit spreads were priced to the expectation that 24% of all corporate bonds outstanding at the time and 70% of junk bonds would be in default by now. Instead, we've seen a sub-par recovery with growth averaging just over 2% per year for the past five years, record corporate profits, and collapsing corporate default rates. In short, the stock market is way up because the economy has performed far better than expectations.

In investing, what matters is how things stack up relative to expectations.

Expectations currently are far from exuberant. As I noted yesterday, there are still plenty of signs of risk aversion in the market. Investors are willing to pay a significant premium for the safety to be found in T-bills, TIPS, and gold. Businesses are still very reluctant to invest. The bond market is priced to the expectation that the U.S. economy is likely to slow, and to register growth of only 0-1% in coming years. Since PE ratios currently are only modestly above their long-term average, but corporate profits are at record highs and discount rates are near record lows, the market is (arguably) priced to the expectation that profits will decline meaningfully in coming years.

As long as we avoid a recession, it would seem, there is still room on the upside for the equity market.

Car sales continue to exceed expectations

August light vehicle sales beat expectations by 5% (17.45 mil. vs. 16.6 mil), and were 9% higher than a year ago. Vehicle sales have registered annualized gains of almost 13% since the recession bottom, which occurred 5 ½ years ago, and have now staged a complete recovery, nearly doubling in the process, as the graph above suggests. On a sustained basis, vehicle sales have never been stronger.

There's still plenty of room on the upside. Because sales fell so much during the Great Recession and took over 5 years to recover, the average age of the U.S. auto fleet soared. It might take several years of sales as high as 20 million cars per year to get things back in balance. In the meantime, this represents a very positive change on the margin—much stronger than expected—which has ripple effects throughout the economy.

In related news, according to the folks at Manheim Consulting, used vehicle prices have been relatively flat for the past few years, and have fallen by 26% in real terms since their 1999 highs. The only time in recent decades that used cars were this cheap was during the depths of the Great Recession. Despite the relative "cheapness" of used cars, new cars continue to sell at a healthy pace.

Why are yields so low if manufacturing is doing so well?

The manufacturing outlook for the U.S. doesn't get much better than it is now. In the past 35 years, the ISM manufacturing index has only exceeded its most recent level (59) about 5% of the time. We're in one of those relatively rare periods when the outlook for manufacturing appears to be robust. So why is the Fed still treating the economy as if it were in intensive care? That's a question that must be disturbing the sleep of at least a few FOMC members these days. 

As the graph above shows, the ISM manufacturing index has a strong tendency to track the health of the overall economy. The August reading (which exceeded expectations, 59 vs. 57) suggests it is very likely that GDP growth in the current quarter will be at least 3-4%. That would be a distinct and welcome improvement relative to the average quarterly annualized growth rate of 2.2% that we have seen since the current recovery started just over five years ago. On the margin, economic conditions appear to be improving, and that should be showing up in higher bond yields. Yet Treasury yields remain depressed. That can hardly be the result of the Fed's QE purchases, which because of the "taper" of QE3 that started early this year, are now relatively small and scheduled to go to zero within the next month or two. It's not a lack of growth that is keeping yields low, I think it's a lack of confidence.

The employment index of the ISM report was strong too, suggesting that firms are increasingly confident in the future and are planning to staff up accordingly. As the second graph above shows, consumer confidence is also on the rise. Things could be and have been a lot better, but on the margin things are getting better, and that is what's most important from the market's perspective. 

One thing stands out like a sore thumb, however: this year's growing gap between manufacturing conditions in the U.S. and the Eurozone. The Eurozone is really struggling, while the U.S. is doing noticeably better. Eurozone weakness, lingering fears of a Japanese-style stag-deflation, and mounting geopolitical risks in Ukraine and the Middle East are likely all factors keeping U.S. yields depressed. Confidence may be on the rise, but it is still relatively low and there are still plenty of reasons for the market to be nervous about the future.

Not surprisingly, there has been a huge relative underperformance of Eurozone equities in recent years. Since August of 2010, the S&P 500 has beaten the Euro Stoxx index by over 60%. Over the same period, the Nikkei 225 has beaten the Euro Stoxx index by over 40%. If the long-struggling Japanese economy is now beating the Eurozone economy, why are 10-yr Japanese bond yields a mere 0.5%? Even though the Nikkei is doing pretty well, it is still quite low from an historical perspective and the yen is weakening (today falling to 105, down from a high two years ago of 78). Although a weaker yen appears to be good for stocks, as I argued last year, it does not inspire a lot of confidence per se.

Treasury yields have been falling since 1980, resulting in the greatest bond bull market of the century.  Falling inflation was the main driver of falling yields, but that ceased to be the case about five years ago. I think the decline in yields in recent years owes more to a flight to quality and safety than it does to deflation. The market is still willing to pay a substantial premium for things, like Treasuries, TIPS, and gold, that offer protection from risk.

The above graph suggests that the reason yields are unusually low today is that the bond market and the Fed are very worried about the risk of a slowdown in U.S. economic growth. The market figures that U.S. growth is capped on the upside at 2% a year due to a combination of demographics (the aging of the baby boomers) and weak productivity, which in turn is the predictable result of today's weak business investment climate. U.S. growth could easily be derailed, the thinking goes. The chart above suggests that 5-yr TIPS are priced to the assumption that U.S. economic growth averages 0-1% over the next few years. The market is willing to pay a significant premium for TIPS in exchange for their inflation hedging properties and their guaranteed, risk-free real yield.

The graph above compares the inverse of 5-yr TIPS real yields to the earnings yield on the S&P 500. The correlation over time looks reasonably good. When real yields were high in the late 1990s, earnings yields on stocks were very low, because the market was very confident that economic growth and profits would remain strong. (That turned out to be wrong, of course.) Today, with real yields in negative territory and earnings yields relatively strong, the market is worrying that economic growth will be weak and profits will fall. No one is willing to pay much of a premium to own stocks these days, whereas they are willing to pay a significant premium to enjoy the safety of TIPS.

The graph above compares the inverse of the real yield on 5-yr TIPS (a proxy for their price) to the price of gold. TIPS and gold prices have tracked each other amazingly well for the past 7-8 years. Why? Because they are both assets that have intrinsic hedging and risk-reducing properties. Demand for the safety and inflation protection of TIPS has been strong, and demand for the inflation protection and end-of-the-world-as-we-know-it protection of gold has also been strong. Demand for both has weakened in the past 18 months. Why? Because confidence, which was extremely depressed for years following the Great Recession, is slowly reviving. 

 

If the nominal and real yields on Treasuries appear to be unusually low, and the prices of TIPS and gold appear to still be unusually high, it is because the world is still willing to pay a premium for safe assets. That willingness appears to be weakening on the margin, however, and more news like today's ISM manufacturing support will likely serve to further boost confidence and weaken the demand for safe assets going forward. This would likely manifest itself in a significant rise in real and nominal Treasury yields, and a decline in the price of gold. Equity investors needn't worry, however, since yields will only move higher as the economic outlook brightens.

 

As this last chart shows, gold prices overshot commodity prices beginning in 2009, and appear to have been correcting that overshoot in recent years. In a sense, gold at $1900 was pricing in a colossal inflation mistake on the part of the Fed that has failed to materialize. I won't be surprised if gold declines to $900 or so within a few years. Full disclosure: at the time of this writing I have no position in gold.