Posts tagged ‘interest rates’
Draghi Provides Markets QE Beer Goggles
While the financial market party has been gaining momentum in the U.S., Europe has been busy attending an economic funeral. Mario Draghi, the European Central Bank President is trying to reverse the somber deflationary mood, and therefore has sent out $1.1 trillion euros worth of quantitative easing (QE) invitations to investors with the hope of getting the eurozone party started.
Draghi and the stubborn party-poopers sitting on the sidelines have continually been skeptical of the creative monetary punch-spiking policies initially implemented by U.S. Federal Reserve Chairman Ben Bernanke (and continued by his fellow dovish successor Janet Yellen). With the sluggish deflationary European pity party (see FT chart below) persisting for the last six years, investors are in dire need for a new tool to lighten up the dead party and Draghi has obliged with the solution…“QE beer goggles.” For those not familiar with the term “beer goggles,” these are the vision devices that people put on to make a party more enjoyable with the help of excessive consumption of beer, alcohol, or in this case, QE.
Source: The Financial Times
Although here in the U.S. “QE beer goggles” have been removed via QE expiration last year, nevertheless the party has endured for six consecutive years. Even an economy posting such figures as an 11-year high in GDP growth (+5.0%); declining unemployment (5.6% from a cycle peak of 10.0%); and stimulative effects from declining oil/commodity prices have not resulted in the cops coming to break up the party. It’s difficult for a U.S. investor to admit an accelerating economy; improving job additions; recovering housing market; with stronger consumer balance sheet would cause U.S. 10-Year Treasury Note yields to plummet from 3.04% at the beginning of 2014 to 1.82% today. But in reality, this is exactly what happened.
To confound views on traditional modern economics, we are seeing negative 10-year rates on Swiss Treasury Bonds (see chart below). In other words, investors are paying -1% to the Swiss government to park their money. A similar strategy could be replicated with $100 by simply burning a $1 bill and putting the remaining $99 under a mattress. Better yet, why not just pay me to hold your money, I will place your money under my guarded mattress and only charge you half price!
Does QE Work?
Debate will likely persist forever as it relates to the effectiveness of QE in the U.S. On the half glass empty side of the ledger, GDP growth has only averaged 2-3% during the recovery; the improvement in the jobs upturn is arguably the slowest since World War II; and real wages have declined significantly. On the half glass full side, however, the economy has improved substantially (e.g., GDP, unemployment, consumer balance sheets, housing, etc.), and stocks have more than doubled in value since the start of QE1 at the end of 2008. Is it possible that the series of QE policies added no value, or we could have had a stronger recovery without QE? Sure, anyone can make that case, but the fact remains, the QE training wheels have officially come off the economy and Armageddon has still yet to materialize.
I expect the same results from the implementation of QE in Europe. QE is by no means an elixir or panacea. I anticipate minimal direct and tangible economic benefits from Draghi’s $1+ trillion euro QE bazooka, however the psychological confidence building impacts and currency depreciating effects are likely to have a modest indirect value to the eurozone and global financial markets overall. The downside for these unsustainable ultra-low rates is potential excessive leverage from easy credit, asset bubbles, and long-term inflation. Certainly, there may be small pockets of these excesses, however the scars and regulations associated with the 2008-2009 financial crisis have delayed the “hangover” arrival of these risk possibilities on a broader basis. Therefore, until the party ends or the cops come to break up the fun, you may want to enjoy the gift provided by Mario Draghi to global investors…and strap on the “QE beer goggles.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Supply & Demand: The Lesson of a Lifetime
Between all the sporting events, road trips, and parties, I had a difficult time balancing my academic responsibilities just like any other college student. Nonetheless, after a few jobs and a few decades post my graduation, it is refreshing to see my economics college degree was able to teach me one valuable lesson…”supply & demand” actually works.
Emotions and animal spirits can separate fact from fiction in the short-run, but over the long-run, the economic forces of “supply & demand” will ultimately determine the direction of asset prices. If you can think of any bubble market, ranging from tulips and tech stocks (see Bubbles and Naps) to commodities and houses, sooner or later new supply will enter the market, and/or some other factor, which will prick the demand side of the bubble equation.
The same economic rules apply to currencies. Gut-based, day-traders may be skeptical, but economics’ longest enduring axiom shined last week when we saw the Swiss franc spike +20% against the euro in a single day. On the heels of a weakening euro currency and heightened demand for the franc, the Swiss National Bank (SNB) decided to remove its artificial peg to the euro. Effectively, the SNB has been selling francs and buying $490 billion in reserves (the majority of which is in euros and U.S. dollars). As a result, exports of Swiss army knives, watches, and industrial equipment will be more expensive now, which could potentially crimp demand for the country’s goods and services. The SNB, however, could no longer afford to buy euros and dollars to artificially depress the franc. Swiss bankers were very worried about the possible amplified costs of a currency war in the face of this week’s expected European Central Bank (ECB) announcements on quantitative easing (QE) monetary stimulus, so they decided to allow the franc to free-float versus global currencies.
Another asset class heavily impacted by volatile supply-demand dynamics has been the oil market. Weaker demand from Europe/Russia combined with the higher supply from U.S. shale has created a recipe for a crude price collapse (> -50% declines over the last year). Thus far, OPEC (Organization of Petroleum Exporting Countries) has remained committed to maintaining its supply/production levels.
Interest Rates and Supply-Demand
Not every asset price is affected by direct supply-demand factors. Take for example the stock market. I have been writing and commentating about the fascinating persistence and accelerated decline in global interest rates recently (see Why 0% Rates?). Near-0% rates are important because interest rates are just another name for the “cost of money” (or “opportunity cost of money”). When the Prime Rate was 20% in the early 1980s, the cost of money was high and a 16% CD at the bank looked pretty attractive relative to rolling the dice on volatile/risky stocks. Any economics, finance, or accounting student knows through their studies of the “time value of money” that interest rates have a tight inverse correlation to asset values (i.e., lower interest rates = higher asset values, and vice versa).
More practically speaking, we see stock prices supported by the lower borrowing costs tied to low interest rates. Just look at the $500,000,000,000+ conducted in share buybacks over the past 12 months (chart below). Economics works quite effectively when you can borrow at 3% and then purchase your own stock yielding 6% (the inverse percentage of the current 16x P/E ratio). What makes this mathematical equation even more accretive for corporate CFOs is the 6% rate earned today should double to 12% in 10 years, if a company resembles an average S&P 500 company. In other words, S&P 500 earnings have historically grown at a 7% annual clip, therefore the 6% earnings yield should double to 12% in about a decade, based on current prices. This basic arbitrage strategy is a no-brainer for corporate execs because it provides instantaneous EPS (earnings per share) growth with minimal risk, given the current bullet proof status of many blue-chip company balance sheets.
Source: Financial Times
I have provided a few basic examples of how straightforward supply-demand dynamics can be used to analyze market relationships and trends. Although supply-demand analysis is a great rudimentary framework at looking at markets and various asset classes, unanticipated exogenous factors such regulation, terrorism, politics, weather, and a whole host of other influences can throw a wrench into your valuation conclusions. Until rates normalize, the near-0% interest rates we are experiencing now will continue to be a significant tailwind for stock prices. As interest rates have been declining for the last three and a half decades, it appears I still have time before I will need to apply the other important concept I learned in college…mean reversion.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Stretching the High Yield Rubber Band
The 10-Year Treasury note recently pierced below the all-important psychological 2% level (1.97%), which has confounded many investors, especially if you consider these same rates were around 4% before the latest mega-financial crisis hit the globe. Some of the rate plunge can be explained by sluggish global growth, but the U.S. just logged a respectable +5.0% GDP growth quarter; corporate profits are effectively at all-time record highs; and the economy has added about 11 million private sector jobs over the last five years (unemployment rate of 10.0% has dropped to 5.6%). So what gives…why such low interest rates? Well, as I noted in a recent article (Why 0% Rates?), there is a whole host of countries with lower rates, which acts like an anchor dragging down our rates with them. Scott Grannis encapsulates this multi-decade, worldwide rate decline in the chart below:
It should come as no surprise to many that these abnormally low rates have had a massive ripple effect on other asset classes… including of course high-yield bonds (aka “junk bonds”). It doesn’t take a genius or rocket scientist to discern the effects of an ultra-low interest rate environment. Quite simply, investors are forced to hunt for yield. When a Bank of America (BAC) customer is forced into earning less than 1/10th of 1 cent for every dollar invested in a CD, you can easily understand why the smile in their CD advertisement looks more like a grimace. Rather than accept $8 in annual interest on a $10,000 investment, post-crisis investors frightened by the stock market have piled into junk bonds. If you don’t believe me, check out the analysis provided by the Financial Times (data from Dealogic) in the chart below, which shows about $1 trillion in U.S. high-yield debt issuance over the last three years. Europe has experienced an even more dramatic growth rate in junk issuance compared to the U.S.
Stretching High-Yield Band
A rubber band can only stretch so far before the elasticity forces it too snap. We are getting closer to the snapping point, as more complacent investors lend money to riskier borrowers and also accept more lenient terms from issuers (e.g., cov-lite loans). Although default rates on high yield bonds remain near decade lows (1.1% through November 2014), high-yield investors keep on inching towards an ultimate day of reckoning. Thanks to a continually improving economy, Fitch Ratings is still projecting a benign default rate environment for high-yield bonds in 2015 – somewhere in the 1.5% – 2.0% range (see chart below). However, high-yield credit spreads did widen in 2014 with the help of crude oil prices getting chopped by more than -50% over the last year. Given the energy sector accounts for about 17% of the high-yield market (Barron’s), it would be natural to expect a larger number of energy company defaults to occur over the next 12-18 months, especially if crude oil prices remain depressed.
Source: Fitch Ratings
While it makes sense for you to hold a portion of your portfolio in high-yield bonds, especially for diversification purposes, don’t forget the power of mean reversion. The uncharacteristically low default rates will eventually revert towards historical averages. Stated differently, the increased risk profile of the high-yield bond market continues to stretch, so make sure you are not overly exposed to the sector because this segment will eventually snap.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions (JNK, HYG), and BAC, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Why 0% Rates? Tech, Globalization & EM (Not QE)
Recently I have written about the head-scratching, never-ending, multi-decade decline in long-term interest rates (see chart below). Who should care? Well, just about anybody, if you bear in mind the structure of interests rates impacts the cost of borrowing on mortgages, credit cards, automobiles, corporate bonds, savings accounts, and practically every other financial instrument you can possibly think of. Simplistic conventional thinking explains the race to 0% global interest rates by the loose monetary Quantitative Easing (QE) policies of the Federal Reserve. But validating that line of thinking becomes more challenging once you consider QE ended months ago. What’s more, contrary to common belief, rates declined further rather than climb higher after QE’s completion.
Source: Calafia Beach Pundit
More specifically, if you look at rates during this same time last year, the yield on the 10-Year Treasury Note had more than doubled in the preceding 18 months to a level above 3.0%. The consensus view then was that the eventual wind-down of QE would only add gasoline to the fire, causing bond prices to decline and rates to extend an indefinite upwards march. Outside of bond guru Jeff Gundlach, and a small minority of prognosticators, the herd was largely wrong – as is usually the case. As we sit here today, the 10-Year Note currently yields a paltry 2.26%, which has led to the long-bond iShares 20-Year Treasury ETF (TLT) jumping +22% year-to-date (contrary to most expectations).
The American Ostrich
Like an ostrich sticking its head in the sand, us egocentric Americans tend to ignore details relating to others, especially if the analyzed data is occurring outside the borders of our own soil. Unbeknownst to many, here are some key country interest rates below U.S. yields:
- Switzerland: 0.33%
- Japan: 0.34%
- Germany: 0.60%
- Finland: 0.70%
- Austria: 0.75%
- France: 0.88%
- Denmark: 0.89%
- Sweden: 0.98%
- Ireland: 1.29%
- Spain: 1.69%
- Canada 1.80%
- U.K: 1.85%
- Italy: 1.93%
- U.S.: 2.26% (are our rates really that low?)
Outside of Japan, these listed countries are not implementing QE (i.e., “Quantitative Easing”) as did the United States. Rather than QE being the main driver behind the multi-decade secular decline in interest rates, there are other more important disinflationary forces at work driving interest rates lower.
Technology, Globalization, and Emerging Market Competition (T.G.E.M.)
While tracking the endless monthly inflation statistics is a useful exercise to understand the tangible underlying pricing components of various industry segments (e.g., see 20 pages of CPI statistics), the larger and more important factors can be attributed to the somewhat more invisible elements of technology, globalization, and emerging market competition (T.G.E.M).
Starting with technology, to put these dynamics into perspective, consider the number of transistors, or the effective horsepower, on a semiconductor (a.k.a. computer “chip”) today. The overall impact on global standards of living is nothing short of astounding. Take an Intel chip for example – it had approximately 2,000 transistors in 1971. Today, semiconductors can cram over 10,000,000,000 (yes billions – 5 million times more) transistors onto a single semiconductor. Any individual can look no further than their smartphone to understand the profound implications this has not only on pricing in general, but society overall. To illustrate this point, I would direct you to a post highlighted by Professor Mark J. Perry, who observed the cost to duplicate an iPhone during 1991 would have been more than $3,500,000!
There are an infinite number of examples depicting how technology has accelerated the adoption of globalization. More recently, events such as the Arab Spring point out how Twitter (TWTR) displaced costly military engagement alternatives. The latest mega-Chinese IPO of Alibaba (BABA) was also emblematic of the hunger experienced in emerging markets to join the highly effective economic system of global capitalism.
I think New York Times journalist Tom Friedman said it best in his book, The World is Flat, when he made the following observations about the dynamics occurring in emerging markets:
“My mom told me to eat my dinner because there are starving children in China and India – I tell my kids to do their homework because Chinese and Indians are starving for their jobs”.
“France wants a 35 hour work week, India wants a 35 hour work day.”
There may be a widening gap between rich and poor in the United States, but technology and globalization is narrowing the gap across the rest of the world. Consider nearly half of the world’s population (3 billion+ people) live in poverty, earning less than $2.50 a day (see chart below). Technology and globalization is allowing this emerging middle class climb the global economic ladder.
These impoverished individuals may not be imminently stealing our current jobs and driving general prices lower, but their children, and the countless educated millions in other international markets are striving for the same economic security and prosperity we have. The educated individuals in the emerging markets that have tasted capitalism are giving new meaning to the word “urgency”, which is only accelerating competition and global pricing pressures. It comes as no surprise to me that this generational migration from the poor to the middle class is putting a lid on inflation and interest rates around the world.
Declining costs of human labor from emerging markets however is not the only issue putting a ceiling on general prices. Robotics, an area in which Sidoxia holds significant investments, continues to be an area of fascination for me. With human labor accounting for the majority of business costs, it’s no wonder the C-suite is devoting more investment dollars towards automation. Rather than hire and train expensive workers, why not just buy a robot? This is not just happening in the U.S. – in fact the Chinese purchased more robots than Americans last year. And why not? An employer does not have to pay a robot overtime compensation; a robot never shows up late; robots never sue for discrimination or harassment; robots receive no healthcare or retirement benefits; and robots work 24 hours/day, 7 days/week, and 365 days/year.
While newspapers, bloggers, and talking heads like to point to the simplistic explanation of loose, irresponsible monetary policies of global central banks as the reason behind a four decade drop in interest rates that is only a small part of the story. Investors and policy makers alike should be paying closer attention to the factors of technology, globalization, and emerging market competition as the more impactful dynamics systematically driving down long term interest rates and inflation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including long positions in certain exchange traded fund positions and INTC (short position in TLT), but at the time of publishing SCM had no direct position in BABA, TWTR or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Santa and the Rate-Hike Boogeyman
Boo! … Rates are about to go up. Or are they? We’re in the fourth decade of a declining interest rate environment (see Don’t be a Fool), but every time the Federal Reserve Chairman speaks or monetary policies are discussed, investors nervously look over their shoulder or under their bed for the “Rate Hike Boogeyman.” While this nail-biting mentality has resulted in lost sleep for many, this mindset has also unfortunately led to a horrible forecasting batting average for economists. Santa and many equity investors have ignored the rate noise and have been singing Ho Ho Ho as stock prices hover near record highs.
A recent Deutsche Bank report describes the prognostication challenges here:
i.) For the last 10 years, professional forecasters have consistently been wrong on their predictions of rising interest rates.
Source: Deutsche Bank via Vox
ii.) For the last five years, investors haven’t fared any better. As you can see, they too have been continually wrong about their expectations for rising interest rates.
Source: Deutsche Bank via Vox
I’m the first to admit that rates have remained “lower for longer” than I guessed, but unlike many, I do not pretend to predict the exact timing of future rate increases. I strongly believe inevitable interest rate rises are not a matter of “if” but rather “when”. However, trying to forecast the timing of a rate increase can be a fool’s errand. Japan is a great case in point. If you take a look at the country’s interest rates on their long-term 10-year government bonds (see chart below), the yields have also been declining over the last quarter century. While the yield on the 10-Year U.S. Treasury Note is near all-time historic lows at 2.18%, that rate pales in comparison to the current 10-Year Japanese Bond which is yielding a minuscule 0.36%. While here in the states our long-term rates only briefly pierced below the 2% threshold, as you can see, Japanese rates have remained below 2% for a jaw-dropping duration of about 15 years.
Source: TradingEconomics.com
There are plenty of reasons to explain the differences in the economic situation of the U.S. and Japan (see Japan Lost Decades), but despite the loose monetary policies of global central banks, history has proven that interest rates and inflation can remain stubbornly low for longer than expected.
The current pundit thinking has Federal Reserve Chairwoman Yellen leading the brigade towards a rate hike during mid-calendar 2015. Even if the forecasters finally get the interest rate right for once, the end-outcome is not going to be catastrophic for equity markets. One need look no further than 1994 when Federal Reserve Chairman Greenspan increased the benchmark federal funds rate by a hefty +2.5%. (see 1994 Bond Repeat?). Rather than widespread financial carnage in the equity markets, the S&P 500 finished roughly flat in 1994 and resumed the decade-long bull market run in the following year.
Currently 15 of the 17 Fed policy makers see 2015 median short-term rates settling at 1.125% from the current level of 0-0.25%. This hardly qualifies as interest rate Armageddon. With a highly transparent and dovish Janet Yellen at the helm, I feel perfectly comfortable the markets can digest the inevitable Fed rate hikes. Will (could) there be volatility around changes in Fed monetary policy during 2015? Certainly – no different than we experienced during the “taper tantrum” response to Chairman Ben Bernanke’s rate rise threats in 2013 (see Fed Fatigue).
As 2014 comes to an end, Santa has wrapped investor portfolios with a generous bow of returns in the fifth year of this historic bull market. Not everyone, however, has been on Santa’s “nice” list. Regrettably, many sideliners have received no presents because they incorrectly assessed the elimination impact of Quantitative Easing (QE). If you prefer presents over a lump of coal in your stocking, it will be in your best interest to ignore the Rate Hike Boogeyman and jump on Santa’s sleigh.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including certain exchange traded fund positions, but at the time of publishing SCM had no direct position in DB or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Don’t Be a Fool, Follow the Stool
It’s the holiday season and with another year coming to an end, it’s also time for a wide range of religious celebrations to take place. Investing is a lot like religion too. Just like there are a countless number of religions, there are also a countless number of investing styles, whether you are talking about Value investing, Growth, Quantitative, Technical, Momentum, Merger-Arbitrage, GARP (Growth At a Reasonable Price), or a multitude of other derivative types. But regardless of the style followed, most professional managers believe their style is the sole answer to lead followers to financial nirvana. While I may not share the same view (I believe there are many ways to skin the stock market cat), each investing discipline (or religion) will have its own unique core tenets that drive expectations for future returns (outcomes).
As it relates to my firm, Sidoxia Capital Management, our investment process is premised on four key tenets. Much like the four legs of a stool, the following principles provide the foundation for our beliefs and outlook on the mid-to-long-term direction of the stock market:
- Profits
- Interest Rates
- Sentiment
- Valuations
Why are these the key components that drive stock market returns? Let’s dig a little deeper to clarify the importance of these factors:
Profits: Over the long-run there is a very significant correlation between stock prices and profits (see also It’s the Earnings, Stupid). I’m not the only one preaching this religious belief, investment legends Peter Lynch and William O’Neil think the same. In answer to a question by Dell Computer’s CEO Michael Dell about its stock price, Lynch famously responded , “If your earnings are higher in five years, your stock will be higher.” The same idea works with the overall stock market. As I recently wrote (see Why Buy at Record Highs? Ask the Fat Turkey), with corporate profits at all-time record highs, it should come as no surprise that stock prices are near all-time record highs. Regardless of the absolute level of profits, it’s also very important to have a feel for whether earnings are accelerating or decelerating, because investors will pay a different price based on this dynamic.
Interest Rates: When embarrassingly low CD interest rates of 0.08% are being offered on $10,000 deposits at Bank of America, do you think stocks look more or less attractive? It’s obviously a rhetorical question, because I can earn 20x more just by collecting the dividends from the S&P 500 index. Now in 1980 when the Federal Funds rate was set at 20.0% and investors could earn 16.0% on CDs, guess what? Stocks were logging their lowest valuation levels in decades (approximately 8x P/E ratio vs 17x today). The interest rate chart from Scott Grannis below highlights the near generational low interest rates we are currently experiencing.
Source: Calafia Beach Pundit
Sentiment: As I wrote in my Sentiment Indicators: Reading the Tea Leaves article, there are plenty of sentiment indicators (e.g., AAII Surveys, VIX Fear Gauge, Breadth Indicators, NYSE Bulls %, Put-Call Ratio, Volume), which traditionally are good contrarian indicators for the future direction of stock prices. When sentiment is too bullish (optimistic), it is often a good time to sell or trim, and when sentiment is too bearish (pessimistic), it is often good to buy. With that said, in addition to many of these short-term sentiment indicators, I realize that actions speak louder than words, therefore I like to also see the flows of funds into and out of stocks/bonds to gauge sentiment (see also Market Champagne Sits on Ice).
Valuations: As Fred Hickey, the lead editor of the High Tech Strategist noted, “Valuations do matter in the stock market, just as good pitching matters in baseball.” The most often quoted valuation metric is the Price/Earnings multiple or PE ratio. In other words, this ratio compares the price you would pay for an annual stream of profits. This can be tricky to determine because there are virtually an infinite number of factors that can impact the numerator and denominator. Currently P/E valuations are near historical averages (see below) – not nearly as cheap as 1980 and not nearly as expensive as 2000. If I only had one metric to choose, this would be a good place to start because the previous three legs of the stool feed into valuation calculations. In addition to P/E, at Sidoxia one of our other favorite metrics is Free-Cash-Flow Yield (annual cash generation after all expenses and expenditures divided by a company’s value). Earnings can be manipulated much easier than cold hard cash in our view.
Source: Calafia Beach Pundit
Nobody, myself and Warren Buffett included, can consistently predict what the stock market will do in the short-run. Buffett freely admits it. However, investing is a game of probabilities, and if you use the four tenets of profits, interest rates, sentiment, and valuations to drive your long-term investing decisions, your chances for future financial success will increase dramatically. This framework is just as relevant today as it is when studying the 1929 Crash, the 1989 Japan Bubble, or the 2008-2009 Financial Crisis. If your goal is to not become an investing fool, I highly encourage you to follow the legs of the Sidoxia stool.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including BAC and certain exchange traded fund positions, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Sector Weightings: Another Financial Toolbox Gizmo
The ever-elusive $64,000 question of “Where does the stock market go from here?” is as popular a question today as it was a century ago. All you have to do is turn on CNBC to find an endless number of analysts, strategists, journalists, economists, and other talking heads guessing on the direction of stock prices. So many people are looking to make a quick buck or get a hot tip, but unfortunately investing is like dieting…it takes hard work and there are no simple solutions. As much as the pundits would like to make this investment game sound like a scientific certainty, in reality there is a lot of subjective art, experience, and luck that goes into successful investment outcomes. Consistent followers of Investing Caffeine understand there are a number of tools I use to guide me on the direction and level of stock prices, and three of my toolbox gizmos include the following:
- Earnings (Stock prices positively correlated)
- Interest Rates (Stock prices inversely correlated)
- Sentiment (Stock prices inversely correlated)
While these and other devices (see SHGR Holy Grail) are great for guesstimating the direction of longer-term stock prices, sector weightings are also great tools for identifying both overheated and unloved segments of the market. Take an extreme example, such as the S&P 500 Technology historical sector weighting in the year 2000. As you can see from the Bespoke Investment charts, the Technology sector went from about a 5% weighting of the overall market in the early 1990s to around 36% at the 2000 peak before dropping back down to 15% after the Tech Bubble burst. If you fast forward to the 2008-2009 Financial Crisis, we saw a similar “bubblicious” phenomenon rupture in the Financial sector. During 1980 the Financial segment accounted for approximately 5% of the total S&P 500 Index market capitalization in 1980 and skyrocketed to a peak of 23% in 2007, thanks in large part to a three decade bull-run in declining interest rates coupled with financial regulators asleep at the oversight switch.
Source: Bespoke Investment
While some segment weightings are currently above and below historical averages, the chart shows there is a tendency for mean reversion to occur over time. As I’ve written in the past, while I believe the broader market can be objectively be interpreted as reasonably priced in light of record earnings, record low interest rates, and a broader skeptical investing public ( see Markets Soar and Investors Snore), I’m still finding expensive, frothy sub-sectors in areas like money losing biotech and social media companies. The reverse can be said if you examined the 2000 period – the overall stock market was overpriced at its 3/24/00 peak (P/E ratio of about ~31x), but within the S&P 500 stocks there were bargains of a lifetime if you looked outside the Tech sector. Consider many of the unloved “Old Economy” stocks that got left behind in the 1990s. Had you invested in these forgotten stocks at the peak of the 2000 market (March 24, 2000), you would have earned an equal-weighted average return of +430% (and significantly higher than that if you included dividends):
Caterpillar Inc (CAT): +416%
Deere & Co (DE): +367%
FedEx Corp (FDX): +341%
Ingersoll-Rand Co (IR): +260%
Lockheed Martin Corp (LMT): +811%
Three M Company (MMM): +254%
Schlumberger Ltd (SLB): +158%
Union Pacific Corp (UNP): +1,114%
Exxon Mobil Corp (XOM): +148%
Average +430%
That +430% compares to a much more modest +36% return for the S&P 500 over the same period. What this data underscores are the perils of pure index investing and highlights the room for active investment managers like Sidoxia Capital Management to generate alpha.
There are many ways of analyzing “Where does the stock market go from here?,” but whatever methods you use, the power of examining sector weightings and mean reversion gizmos should be readily accessible in your investment toolbox.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own FDX; non-discretionary positions in DE, LMT, MMM, SLB, XOM, and a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in CAT, IR, UNP, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Mathematics 101: The Cheap Money Printing Machine
Like many other bloggers and pundits, I have amply pontificated on the relative attractiveness of the stock market. For years, cash and gold hoarding bears have clung to the distorted, money-losing Shiller CAPE P/E ratio (see CAPE Smells Like B.S.), which has incorrectly signaled investors to stay out of stocks and miss trillions of dollars in price appreciation. Apparently, the ironclad Shiller CAPE device has been temporarily neutralized by the Federal Reserve’s artificially cheapening money printing press policies, just like Superman’s strength being stripped by the nullifying powers of kryptonite. The money printing logic seems so elegantly sound, I felt compelled to encapsulate this powerful relationship in an equation:
Interests Rate Cuts + Printing Press On = Stocks Go Higher
Wow, amazing…this is arithmetic any investor (or 3rd grader) could appreciate! Fortunately for me, I have a child in elementary school, so I became emboldened to share my new found silver bullet equation. I initially received a few raised eyebrows from my child when I introduced the phrase “Quantitative Easing” but it didn’t take long before she realized Rate Cuts + QE = Fat Piggy Bank.
After the intensive tutorial, I felt so very proud. With a smile on my face, I gave myself a big pat on the back, until I heard my child say, “Daddy, after looking at this squiggly S&P 500 line from 2007-2014, can you help my brain understand because I have some questions.”
Here is the subsequent conversation:
Me: “Sure kiddo, go ahead shoot…what can I answer for you?”
Child: “Daddy, if the Federal Reserve is so powerful and you should “not fight the Fed,” how come stock prices went down by -58% from 2007 – 2009, even though the Fed cut rates from 5.25% to 0%?”
Me: “Uhhhh….”
Child: “Daddy, if stock prices went down so much after massive rate cuts, does that mean stock prices will go up when the Fed increases rates?”
Me: “Uhhhh….”
Child: “Daddy, if Quantitative Easing is good for stock prices, how come after the QE1 announcement in November 2008, stock prices continued to go down -25%?”
Me: “Uhhhh….”
Child: “Daddy, if QE makes stocks go up, how come stock prices are at all-time record highs after the Fed has cut QE by -$70 billion per month and is completely stopping QE by 100% next month?”
Me: “Uhhhh….”
Child: “Daddy, everyone is scared of rate increases but when the Fed increased interest rates by 250 basis points in 1994, didn’t stock prices stay flat for the year?”
Me: “Uhhhh….” (See also 1994 Bond Repeat)
What started as a confident conversation about my bullet-proof mathematical equation ended up with me sweating bullets.
Math 101A: Low Interest Rates = Higher Asset Prices
As my previous conversation highlights, the relationship between rate cuts and monetary policy may not be as clear cut as skeptics would like you to believe. Although I enjoy the widely covered Shiller CAPE discussions on market valuations, somehow the media outlets fail to make the all-important connection between interest rates and P/E ratios.
One way of framing the situation is by asking a simple question:
Would you rather have $100 today or $110 a year from now?
The short answer is…”it depends.” All else equal, the level of interest rates will ultimately determine your decision. If interest rates are offering 20%, a rational person would select the $100 today, invest the money at 20%, and then have $120 a year from now. On the other hand, if interest rates were 0.5%, a rational person would instead select the option of receiving $110 a year from now because collecting a $100 today and investing at 0.5% would only produce $100.50 a year from now.
The same time-value-of-money principle applies to any asset, whether you are referring to gold, cars, houses, private businesses, stocks, or other assets. The mathematical fact is, all else equal, a rational person will always pay more for an asset when interest rates are low, and pay less when interest rates are high. As the 200-year interest chart below shows, current long-term interest rates are near all-time lows.
Source: The Big Picture
The peak in interest rates during the early 1980s correlated with a single digit P/E ratio (~8x). The current P/E ratio is deservedly higher (~16x), but it is dramatically lower than the 30x+ P/E ratio realized in the 2000 year timeframe. If none of this discussion makes sense, consider the simple Rule of 20 (see also The Rule of 20 Can Make You Plenty), which states as a simple rule-of-thumb, the average market P/E ratio should be equal to 20 minus the level inflation. With inflation currently averaging about 2%, the Rule of 20 implies an equilibrium of ~18x. If you assume this P/E multiple and factor in a 7-8% earnings growth rate, you could legitimately argue for 20% appreciation in the market to S&P 2,400 over a 12-month period. It’s true, a spike in interest rates, combined with a deceleration in earnings would justify a contraction in stock prices, but even under this scenario, current index values are nowhere near the bubble levels of 2000.
After six long years, the QE train is finally grinding to a halt, and a return towards Fed policy normalcy could be rapidly approaching. Many investors and skeptical bears have tried to rationalize the tripling in the market from early 2009 as solely due to the cheap Fed money printing machine. Unfortunately, history and mathematics don’t support that assertion. If you don’t believe me, perhaps a child may be able to explain it to you better.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Buy in May and Tap Dance Away
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (May 1, 2014). Subscribe on the right side of the page for the complete text.
The proverbial Wall Street adage that urges investors to “Sell in May, and go away” in order to avoid a seasonally volatile period from May to October has driven speculative trading strategies for generations. The basic premise behind the plan revolves around the idea that people have better things to do during the spring and summer months, so they sell stocks. Once the weather cools off, the thought process reverses as investors renew their interest in stocks during November. If investing was as easy as selling stocks on May 1 st and then buying them back on November 1st, then we could all caravan in yachts to our private islands while drinking from umbrella-filled coconut drinks. Regrettably, successful investing is not that simple and following naïve strategies like these generally don’t work over the long-run.
Even if you believe in market timing and seasonal investing (see Getting Off the Market Timing Treadmill ), the prohibitive transaction costs and tax implications often strip away any potential statistical advantage.
Unfortunately for the bears, who often react to this type of voodoo investing, betting against the stock market from May – October during the last two years has been a money-losing strategy. Rather than going away, investors have been better served to “Buy in May, and tap dance away.” More specifically, the S&P 500 index has increased in each of the last two years, including a +10% surge during the May-October period last year.
Nervous? Why Invest Now?
With the weak recent economic GDP figures and stock prices off by less than 1% from their all-time record highs, why in the world would investors consider investing now? Well, for starters, one must ask themselves, “What options do I have for my savings…cash?” Cash has been and will continue to be a poor place to hoard funds, especially when interest rates are near historic lows and inflation is eating away the value of your nest-egg like a hungry sumo wrestler. Anyone who has completed their income taxes last month knows how pathetic bank rates have been, and if you have pumped gas recently, you can appreciate the gnawing impact of escalating gasoline prices.
While there are selective opportunities to garner attractive yields in the bond market, as exploited in Sidoxia Fusion strategies, strategist and economist Dr. Ed Yardeni points out that equities have approximately +50% higher yields than corporate bonds. As you can see from the chart below, stocks (blue line) are yielding profits of about +6.6% vs +4.2% for corporate bonds (red line). In other words, for every $100 invested in stocks, companies are earning $6.60 in profits on average, which are then either paid out to investors as growing dividends and/or reinvested back into their companies for future growth.
Source: Dr. Ed’s Blog
Hefty profit streams have resulted in healthy corporate balance sheets, which have served as ammunition for the improving jobs picture. At best, the economic recovery has moved from a snail’s pace to a tortoise’s pace, but nevertheless, the unemployment rate has returned to a more respectable 6.7% rate. The mended economy has virtually recovered all of the approximately 9 million private jobs lost during the financial crisis (see chart below) and expectations for Friday’s jobs report is for another +220,000 jobs added during the month of April.
Source: Bespoke
Wondrous Wing Woman
Investing can be scary for some individuals, but having an accommodative Fed Chair like Janet Yellen on your side makes the challenge more manageable. As I’ve pointed out in the past (with the help of Scott Grannis), the Fed’s stimulative ‘Quantitative Easing’ program counter intuitively raised interest rates during its implementation. What’s more, Yellen’s spearheading of the unprecedented $40 billion bond buying reduction program (a.k.a., ‘Taper’) has unexpectedly led to declining interest rates in recent months. If all goes well, Yellen will have completed the $85 billion monthly tapering by the end of this year, assuming the economy continues to expand.
In the meantime, investors and the broader financial markets have begun to digest the unwinding of the largest, most unprecedented monetary intervention in financial history. How can we tell this is the case? CEO confidence has improved to the point that $1 trillion of deals have been announced this year, including offers by Pfizer Inc. – PFE ($100 billion), Facebook Inc. – FB ($19 billion), and Comcast Corp. – CMCSA ($45 billion).
Source: Entrepreneur
Banks are feeling more confident too, and this is evident by the acceleration seen in bank loans. After the financial crisis, gun-shy bank CEOs fortified their balance sheets, but with five years of economic expansion under their belts, the banks are beginning to loosen their loan purse strings further (see chart below).
The coast is never completely clear. As always, there are plenty of things to worry about. If it’s not Ukraine, it can be slowing growth in China, mid-term elections in the fall, and/or rising tensions in the Middle East. However, for the vast majority of investors, relying on calendar adages (i.e., selling in May) is a complete waste of time. You will be much better off investing in attractively priced, long-term opportunities, and then tap dance your way to financial prosperity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in PFE, CMCSA, and certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in FB or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Treadmill Market – Jogging in Place
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (April 1, 2014). Subscribe on the right side of the page for the complete text.
After the stock market raced ahead to about a +30% gain last year, it became clear this meteoric trend was not sustainable into perpetuity. Correct investing should be treated more like a marathon than a sprint. After dashing ahead by more than +100% over the last handful of years, 2014 stock prices took a breather by spending the first quarter jogging in place. Like a runner on the treadmill, year-to-date returns equated to a -0.7% for the Dow Jones Industrial Average index, and +1.3% for the S&P index. Digesting the large gains from previous years, despite making no discernable forward progress this quarter, is a healthy exercise that builds long-term portfolio endurance. As far as I’m concerned, nothing in life worthwhile comes easy, and the first three months of the year have demonstrated this principle.
As I’ve written in the past (see Series of Unfortunate Events), there is never a shortage of issues to worry about. The first few months of 2014 have been no exception. Vladimir Putin’s strong armed military backed takeover of Crimea, coupled with the Federal Reserve’s unwinding $30 billion of the $85 billion of its “Quantitative Easing” bond buying program (i.e. tapering) have contributed to investors’ nervousness. When the “Fairy Godmother of the Bull Market,” Federal Reserve Chair Janet Yellen, hinted at potentially raising interest rates in about 12 months, the mood soured further.
The unseasonably cold winter back east (a.k.a., Polar Vortex) has caused some additional jitters due to the dampening effects on economic conditions. More specifically, economic growth as measured by GDP (Gross Domestic Product) is expected to come in around a meager +2.0% rate during the first quarter of 2014, before picking up later in the year.
And if that isn’t enough, best-selling author Michael Lewis, whose books include Money Ball, The Blind Side, and Liar’s Poker, just came out on national television and sparked a debate with his controversial statement that the “stock market is rigged.” (read and listen more here)
Runners High
But as always, not everything is gloom and doom. Offsetting the temporary price fatigue, resilient record corporate profits have supported the surprising market stamina. Like a runner’s high, corporations are feeling elated about historically elevated profit margins. As you can see from the chart below, the reason it’s prudent for most to have some U.S. equity exposure is due to the clear, upward multi-decade trend of U.S. corporate earnings.
Source: Calafia Beach Plundit (gray areas are recessions)
While the skeptics wait for these game-ending dynamics to take root, core economic fundamentals in areas like these remain strong:I didn’t invent the idea of profits impacting the stock market, but the concept is simple: stock prices generally follow earnings over long periods of time (see It’s the Earnings, Stupid). In other words, as profits accelerate, so do stock prices – and the opposite holds true (decelerating earnings leads to price declines). This direct relationship normally holds over the long-run as long as the following conditions are not in place: 1) valuations are stretched; 2) a recession is imminent; and/or 3) interest rates are spiking. Fortunately for long-term investors, there is no compelling evidence of these factors currently in place.
Employment Adrenaline
The employment outlook received a boost of adrenaline last month. Despite the slight upward nudge in the unemployment rate to 6.7%, total nonfarm payroll jobs increased by +175,000 in February versus a +129,000 gain in January and an +84,000 gain in December. Not only was last month’s increase better than expectations, but the net figures calculated over the previous two months were also revised higher by +25,000 jobs. As you can see below, the improvement since 2009 has been fairly steady, but as the current rate flirts with the Fed’s 6.5% target, Chair Yellen has decided to remove the quantitative objective. The rising number of discouraged workers (i.e., voluntarily opt-out of job searching) and part-timers has distorted the numbers, rendering arbitrary numeric targets less useful.
Source: Barron’s Online
Housing Holding Strong
In the face of the severe winter weather, the feisty housing market remains near multi-year highs as shown in the 5-month moving average housing start figure below. With the spring selling season upon us, we should be able to better gauge the impact of cold weather and higher mortgage rates on the housing market.
Source: Barron’s Online
Even though stock market investors found themselves jogging in place during the first quarter of the year, long-term investors are building up endurance as corporate profits and the economy continue to consistently grow in the background. Successful investors must realize stock prices cannot sustainably sprint for long periods of time without eventually hitting a wall and collapsing. Those who recognize investing as a marathon sport, rather than a mad dash, will be able to jump off the treadmill and ultimately reach their financial finish line.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
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