A very common refrain among stock market bulls these days – and an objection some made to my remarks yesterday that markets are still not making sense – is that the low level of interest rates warrants a high multiple, since future earnings are being discounted at a lower interest rate.
My usual response, and the response from far more educated people than me, like Cliff Asness who published “Fight the Fed Model” back in 2003, is that low interest rates explain high multiples, but they do not justify high multiples. High multiples have always historically been followed – whether explained by low interest rates or not – by poor returns, so it does no good to say “multiples are high because rates are low.” Either way, when multiples are high you are supposed to disinvest.
But I thought it would also be useful, for people who are not as familiar with the argument and only familiar with the sound bite, to see the actual data behind the proposition. So, below, I have a chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year nominal interest rates.
Note that it is generally true that lower nominal interest rates are associated with higher multiples, although it is far more clear that higher nominal interest rates are associated with lower multiples, whether we are talking about the long tail to the right (obviously from the early 1980s) or the smaller tail in the middle that dates from around 1920 (when 5% was thought to be a pretty high interest rate). But, either way, the current multiples represent high valuations whether you compare them to high-rate periods or low-rate periods. The exception is clearly from the late 1990s, when the long downtrend in interest rates helped spark a bubble, and incidentally spurred the first widespread discussion/excuse of the so-called “Fed model.” If you take out that bubble, and you take out the 1980s high-rates tail, then there is left just a cloud of points although there does seem to be some mild slope to it from lower-right to upper-left.
But in short, the data is hardly crystal clear in suggesting that low interest rates can explain these multiples, never mind justify them.
More interesting is what you get if you compare P/E ratios to real rates. Because equities are real assets, you should technically use a real discount rate. Since real economic growth in earnings should be reflected in higher real interest rates generally, only the incremental real growth in earnings should be discounted into higher values today. This eliminates, in other words, some of the ‘money illusion’ aspect of the behavior of equity multiples.
I haven’t seen a chart like this before, probably because the history of real interest rates in the U.S. only dates to 1997. However, using a model developed by Enduring Investments (and used as part of one of our investment strategies), we can translate those historical nominal rates into the real rates we would have expected to see, and that allows us to produce this chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year real interest rates – using Enduring’s model until 1997, and actual 10-year real interest rates thereafter.
I find this picture much more interesting, because there seems to be almost no directionality to it at all. The ‘tail’ at upper right comes from the late 1990s, when again we had the equity bubble but we also had real rates that were higher than at equilibrium since the Treasury’s TIPS program was still new and TIPS were very cheap. But other than that tail, there is simply no trend. The r-squared is 0.02 and the slope of the regression line is not statistically different from zero.
And, in that context, we can again see more clearly that the current point is simply at the high end of the cloud of historical points. The low level of real interest rates – actually quite a bit higher than they were last year – is of no help whatsoever.
None of that should be particularly surprising, except for the buy-and-hope crowd. But I thought it constructive to show the charts for your amusement and/or edification.
Suddenly, there is a bunch of talk about inflation. From analysts like Grant Williams to media outlets like MarketWatch and the Wall Street Journal (to be sure, the financial media still tell us not to worry about inflation and keep on buying ‘dem stocks, such as Barron’s argues here), and even Wall Street economists like those from Soc Gen and Deutsche Bank…just two name two of many Johnny-come-latelys.
It is a little surprising how rapidly the articles about possibly higher inflation started showing up in the media after we had a bottoming in the core measures. Sure, it was easy to project the bottoming in those core measures if you were paying attention to the base effects and noticing that the measures of central tendency that are more immune to those base effects never decelerated much (see median CPI), but still somehow a lot of people were taken by surprise if the uptick in media stories is any indication.
I actually have an offbeat read of that phenomenon, though. I think that many of these analysts, media outlets, and economists just want to have some record of being on the inflation story at a time they consider early. Interestingly enough, while there is no doubt that the volume of inflation coverage is up in the days since the CPI report, there is still no general alarm. The chart below from Google Trends shows the relative trend in the search term “rising inflation.” It has shown absolutely nothing since the early days of extraordinary central bank intervention.
Now, I don’t really care very much when the fear of inflation broadens. It is the phenomenon of inflation, not the fear of it, which causes the most damage to society. However, there is no doubt that the fear of inflation definitely could cause damage to markets much sooner than inflation itself can. The concern has been rising in narrow pockets of the markets where inflation itself is actually traded, but because we trade headline inflation the information has been obscured. The chart below (source: Enduring Investments) shows the 1-year headline inflation swap, in black, which has risen from about 1.4% to 2.2% since November. But the green line shows the implied core inflation extracted from those swap quotes, and that line has risen from 1.2% in December to 2.6% or so now. That is far more significant – 2.6% core inflation over the next year would mean core PCE would exceed 2% by next spring. This is a very reasonable expectation, but as I said it is still only a narrow part of the market that is willing to bet that way.
If I was long equities – which I am not, as our four-asset-class model currently has only a 7.4% weight in stocks – then I would keep an eye on the search terms and for other anecdotal evidence that inflation fears are starting to actually rise among investors, rather than just being the probably-cynical musings of people who don’t want to be seen as having missed the signs (even if they don’t really believe it).
The recent, aggressive ECB ease, combined with some mild Fed growls about increasing rates “at some point,” ought to be good news for the dollar against the Euro. And so it has been, although as you see in this weekly chart (source: Bloomberg) the weakening of the Euro has been (a) mild and (b) started more than a month before the ECB actually took action. (Note that the units here are dollars per Euro).
Even though the ECB did considerably more than expected, much of that was in the form of a promise; until the body takes concrete steps towards implementing some of the new QE forms, the decline in the Euro is likely to be relatively slow and steady. Similarly, although the Yen has stopped weakening in 2014, I expect that trend has further to go as long as the Bank of Japan doesn’t lose its nerve with easing. In any event, both of those central banks seem at the moment to be more dovish than the Fed, which augurs for dollar strength.
Is that bad for commodities? The conventional wisdom is that since many commodities trade in dollars, a strong dollar implies weak commodities and vice versa.
There is some support for this view. The chart below (source: Bloomberg) shows weekly levels of the dollar index versus the DJ-UBS index, going back to 1996 or so. The correlation is okay, at -0.725.
Note, though, that this is a correlation of levels. If you look at a correlation of changes, which is what you would need to use dollar movements as a trading model for commodities, it is effectively zero. (These two series aren’t lovers, moving together always, but just friends coming together to the same place from time to time). Moreover, the regression of levels says that commodities are currently 15% or so cheap – the red smudge on the chart shows the current levels (yet another way that commodities appear to be cheap). Finally, the beta is quite low: if the dollar index rose 20%, it would correlate with roughly a 20% decline in commodities…if commodities preserved the same level of cheapness. To be sure, that is a sizeable drop but a 20% rise in the dollar would put it at levels not seen in more than a decade.
In any event, be careful not to confuse the nominal dollar price of commodities with the real price (I’ve made this argument from time to time in many contexts – see for example here, here, and here). Although changing the value of the dollar will diminish the price of commodities in dollars relative to what they would otherwise would be, if the global price level rises then the price of commodities will rise with it – they just may rise less than they otherwise would. And, since commodities typically experience their highest inflation “beta” at the beginning of an increase in inflation, it is reasonable to expect that commodities’ rise will be enough to cause any dollar-inspired softness to be completely obscured.
You still want to be long commodities if we are in an inflationary upswing, regardless of what the Fed does. And, needless to say, I am somewhat skeptical that the Fed will do anything particularly aggressive on the tightening side!
I think it’s really interesting that suddenly, we are hearing from both hawks and doves on the Federal Reserve that the Fed is starting to worry whether some “complacency” has snuck into the market.
It is sort of a strange claim, since a really important part of QE and about how it was supposed to work was through the “portfolio balance channel.” In a nutshell, the idea of the portfolio balance channel is that if the Fed removes sufficient of the “safe” securities from the market, then people will be forced to buy riskier securities. Thus, the Fed was intentionally trying to substitute for animal spirits. And they were successful at it, which I illustrated in this post more than a year ago. So now, the Fed is surprised that the riskier asset classes are getting very expensive?
It is sometimes hard to keep track of all of the Fed’s arguments, since they seem to shift as frequently as necessary to make them appear to be on the right side of the data. Honestly, it’s a little bit like the way politicians work the “spin” cycle. The portfolio balance channel was good, and a goal of policy; now it’s surprising. You need to take good notes to keep this stuff straight.
That being said, it is not usually a coincidence when three Fed officials use nearly the same words in consecutive speeches, particularly when those three Fed officials include both hawks (Fisher, George) and doves (Dudley). The difference here is that Fisher and George are probably making this argument because they’d like to see the Fed pull back on the reins a bit, while Dudley probably doesn’t intend to do anything about the fear of complacency other than talk about it.
What does this mean?
- I am not the only person who is worried about not being worried (see my article from Monday).
- At least some people at the Fed are concerned that they have gone too far. This isn’t really news; the only news would be if that’s starting to be a majority opinion.
- At least some people at the Fed think that policymakers should be trying to ‘talk down’ markets.
Why do I include the third point? Because, if the Fed really was planning to do anything about it, they would just do it. Talking about complacency might cause some people to decrease their risky-market bets, but putting Treasuries back on the street and taking in cash would force the de-risking to happen. Call it the portfolio “rebalance” channel. No doubt, there is plenty of fear at the Fed about the possibility that the complacency might break suddenly in a sloppy, discontinuous way, but there are a couple of decades of experience with the lack of success of FOMC “open mouth policy.” Does the phrase “irrational exuberance” mean anything to you? Did Greenspan’s utterance of that phrase in December 1996 affect in any way the trajectory of the over-complacent equity market? Nope.
Ironically, I think what really galls the Fed is that market measures of policy rate expectations over the next few years imply a lower trajectory than the Fed feels they have laid out as their road map. The Committee, it seems doesn’t mind surprising the market on the dovish side but is wary of surprising them on the hawkish side. I predict that, if the short end of the rates curve steepens just a little bit, Fed officials will stop worrying so much about “complacency” even if stocks continue to ramp up.
In any case, it is worth listening when the Fed starts talking with one voice. There are lots of other reasons to be the first person to shed complacency, but here is a new one: whether it’s a bona fide signal or just central banker bluster, there is a new tone coming from Fed speakers. Beware of dogs that growl; sometimes they bite.
I am beginning to worry about my own complacency. As a person who has been a participant in the fixed-income markets for a long time, I have become quite naturally a very cautious investor. Such caution is a quintessentially fixed-income mindset (although you might not guess that from the way bond people behaved in the run-up to the global financial crisis) – as a bond investor, you are essentially in the position of someone who is short options: taking in small amounts on a regular basis, with an occasional large loss when the credit defaults. A bond investor can greatly improve his performance in the long run relative to an index by merely avoiding the blow-ups. Miss the Enron moment, and you pick up a lot of relative performance. (The same is true of equities, but there is much more upside to being an optimist. The stock market selects for optimists, the bond market for pessimists.)
This is a lesson that many high-yield investors today, chasing near-term carry, seem to have forgotten. But my purpose here isn’t to bash those involved in the global reach for yield. I am merely pointing out that this is how I tend to think. I am always looking for the next disaster that hangs a portfolio with a big negative number. As Prince Humperdinck said in The Princess Bride, “I always think everything could be a trap – which is why I’m still alive.”
And I am starting to worry about my own complacency. I don’t get the feeling that we’re gearing up for Round 2 of the global financial crisis. Something bad, perhaps, but not catastrophic.
To be sure, there are a large number of potential pitfalls facing investors today, and I think market volatilities underestimate their probabilities substantially. We are facing an inflection in policy from the ECB this week, with analysts expecting a substantial additional easing action (and it is overdue, with money growth in Europe down to a feeble 1.9% y/y, near the worst levels of the post-crisis period – see chart, source Bloomberg). Absent a major change in policy, liquidity on the continent is going to become increasingly dear with possible ramifications for the real economy as well as the asset economy.
The Federal Reserve is facing a more-serious policy inflection point, with no agreement amongst FOMC members (as far as I can tell) about how to transition from the end of QE to the eventual tightening. I’ve pointed out before – while many Fed officials were whistling Dixie about how easy it would be to reverse policy – that there is no proven method for raising interest rates with the vast quantity of excess reserves sitting inert on bank balance sheets. Moreover, raising interest rates isn’t the key…restraining money growth is. The key point for markets is simply that there is no plan in place that removes these reserves, which means that interest rates are not likely to respond to Fed desires to see them rise. And, if the Fed uses a brute-force method of raising the interest paid on excess reserves, then rates may rise but we don’t know what will happen to the relative quantities of required and excess reserves (and it is the level of required reserves that actually matter for inflation). It is a thorny problem, and one which the markets aren’t giving enough credit regarding the difficulty thereof.
Valuation levels are high across the board (with the exception of commodity indices). They’re doubly high in stocks, with high multiples on earnings that are themselves high with respect to revenues. And yes, this concerns me. I expect more volatility ahead, and perhaps serious volatility. But the fact that I am just saying “perhaps,” when all of my experience and models say “there is no escape without some bad stuff happening,” means that I am being infected – relative to my usual caution – by the general complacency.
In other words, I am worried that I am not worried enough.
The interesting thing is that equity bulls said during the entire march higher that “it doesn’t matter what the fundamentals are, the Fed is pushing the market higher and spreads tighter.” I still don’t believe that was an inevitable outcome to the Fed’s QE, but the fact is that people believed it and they were correct: that was enough to keep the market going higher. I can’t be comfortable going along with the crowd in that circumstance, but in retrospect it would have been better to abandon the models, throw caution to the wind, and ride along with the fun. And perhaps this regret is one reason for my developing complacency.
But that way lies madness, since the problem is not the ride but the getting out when the ride is over. The Fed is no longer providing QE (or, in any event, QE will shortly end altogether). So what’s the excuse now? It seems to me that everyone is still riding on the fun train, and just watching carefully to see if anyone jumps off. I think the market rally is on very tenuous footing, because if faith in the market’s liquidity goes away, the value anchor is very far from these levels. Yet, part of me is skeptical that a market which hasn’t corrected in more than two years can actually return to those value anchors. I should know better, because the bond-market mindset reminds me that market gains are generally linear while market losses are discontinuous, sloppy, and non-linear. Especially, I ought to be thinking, when market liquidity is so poor thanks to the government’s assault on market makers over the last few years.
I keep wondering if there is one more pulse higher in stocks coming, one more decline in commodities before they begin to catch up with money growth and inflation, one more rally in bonds before they begin to discount a higher inflation path. And this is very possible, because while I worry about my own developing complacency most investors are not concerned about their own.
Complacency or no, insurance is cheap. The low current level of implied volatilities in almost every asset class makes portfolio protection worthwhile, even if it costs a bit of performance to acquire that protection.
Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.
To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.
The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.
Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.
Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.
Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.
Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.
Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…
It might seem crazy what I’m ’bout to say
Sunshine she’s here, you can take a break
I’m a hot air balloon that could go to space
With the air, like I don’t care baby by the way
- From “Happy” by Pharrell Williams
Cliff Asness and John Liew have an article that is in the latest issue of Institutional Investor, discussing the development, strengths, and shortfalls of the Efficient Market Hypothesis, which underlies the Nobel award for both Fama (as a proponent) and Shiller (as a skeptic) this year.One of the interesting points that Asness and Liew make is that examinations of market efficiency depend on the “joint hypothesis” that (a) prices move efficiently to represent correct values, and (b) the model of values that they move to is correct. They point out that if prices seem to deviate from fair value (as expressed by a model), that could mean that either markets are inefficient/irrational, or that the model is wrong (or both). And they suggest strengthening the EMH to include a limitation on such models that they make some kind of sense – since a model that incorporates irrational behavior might well-describe all sorts of crazy market action but not be “efficient” in any sense that makes sense to us.
This may not be an irrelevant reflection, given the price events of today. Stocks more than rebounded from yesterday’s Ukraine-induced selloff, implying that not only are stocks just as valuable today as they were yesterday, but that they are even more valuable than they were before we found out about escalating tensions in the Crimean. This seems to border on the “unusual model” side of things – especially since nothing particularly soothing happened today.
Earlier today, Reuters reported that one of the Russian threats made in response to the vague declarations of the U.S. that “all options are on the table, from diplomatic to economic” (pointedly leaving out “military,” as Obama did yesterday, because gosh knows we don’t want the Russians to think that’s even a possibility) was that Russians might not repay loans due to U.S. banks (or, presumably, European banks if they joined any sanctions). This is a clever threat, in the old vein of “if you owe $100, it’s your problem; if you owe $1 billion, it’s the bank’s problem.” Everyone who thinks that economic sanctions are a no-brainer are correct, in the sense that it would imply no brain.
Russia also tested an intercontinental ballistic missile. This was “viewed as non-threatening and is not connected to what is going on in Crimea,” which is of course absurd: regardless of how long the test has been scheduled, someone who was trying to “de-escalate” tensions would surely defer the test for a week. The fact that the test happened is one of many signs today that Putin’s soothing words were hollow. All of the actions today, from additional warships steaming towards the Crimean peninsula to ICBM launches and confrontations between Ukrainian and Russian troops, were consistent with an escalating crisis even as Putin said there was no “immediate” need to invade eastern Ukraine.
Stocks loved the idea that the conflict may be over, with the west simply conceding the Crimea and Russia deciding that she is sated for the time being, as ridiculously unlikely as that outcome actually is. And, as I fully expected, we heard over and over today the Rothschildian admonition to “buy on the sound of cannons.” And indeed, they bought. Oh, how they bought. The S&P rose 1.53% and most European bourses were up 2%-3%. The expected comparisons were made, to the performance of equities during and following the Cuban Missile Crisis, the first Gulf War, and the invasion of the Sudetenland.
These comparisons are all nonsense. Here’s why.
|Event||Date||CAPE prior to|
This is what happens when people learn the “whats” of history, but don’t learn the “whys.” The Rothschildian point isn’t simply to buy on the sound of cannons. It’s to buy when markets are cheap because of the sound of cannons. And that is most assuredly not the case presently. If stocks had dropped 50% because of the Russian invasion, I would have been at the front of the line telling people to buy. It is reckless and feckless to buy when the market is expensive, and there are cannons that suggest a higher risk premium is warranted at least for a time.
Really, what is the risk here, today? Is the risk really that an investor might miss the next 25%, because the world becomes not only safe, but safer than it was a week ago, and a super-cheap market simply takes off? Or is there some risk that an investor might participate in the next -25%? Good heavens, surely the latter is a far greater risk right now. And, after all, Rothschild also said “sell on the sound of trumpets” (it’s always interesting how the bearish parts get forgotten), so that if the crisis is over and the west is victorious then you’re supposed to be selling! Here I guess is my point: this is not Rothschild’s market.
And, as Asness and Liew might put it, the model that implies stocks are more valuable after such an episode…might not be a rational model. But today, Pharrell wins: clap along if you feel like that’s what you want to do!
In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.
Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.
But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).
There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).
Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.
It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.
Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.
But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.
It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?
Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.
To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.
Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.
Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.
(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).
So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.
On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.
And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.
However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). What is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).
Investors have learned the same wrong lessons over the last couple of years that they learned in the run-up to 2000, evidently. I remember that in the latter part of 1999, every mild equity market setback was met immediately with buying – the thought was that you had to jump quickly on the train before it left the station again. There was no thought about whether the bounce was real, or whether it “made sense”; for quite a number of them in a row, the bounce was absolutely real and the train really did leave the station.
Then, the train reached the end of the line and rolled backwards down the mountain, gathering speed and making it very difficult to jump off. I remember getting a call from my broker at the time, recommending Lucent at around $45 – quite the discount from the $64 high. I noted that I was a value investor and I didn’t see value in that stock, and to not call me again until he had a decent value idea. He next called with a recommendation later that year, with a stock that had just hit $30…a real bargain! And, as it turned out, that stock was also Lucent. The lesson he had learned was that any stock at a discount from the highs was a “value” stock. (Lucent ended up bottoming at about $0.55 in late 2002 and was eventually acquired by Alcatel in 2006).
This lesson appears to have been learned as well. On Thursday and Friday a furious rally took stocks up, erasing a week and a half of decline. This happened despite the fact that Friday’s Employment number was just about the worst possible number for equities: weak enough to indicate that the December figure was not just about seasonal adjustment, but represented real weakness, but nowhere near weak enough to influence the Federal Reserve to consider pausing the recent taper. We will confirm this fact tomorrow, before the market open, when new Fed Chairman Janet Yellen delivers the Monetary Policy Report (neé Humphrey-Hawkins) testimony to the House Financial Services Committee (her comments to be released at 8:30ET). While I believe that Yellen will be very reluctant to raise rates any time soon, and likely will seize on signs of recession to stop the taper in its tracks, she will be reluctant to be a dove right out of the gate.
And that might upset the apple cart tomorrow, if I’m right.
I have been fairly clear recently that I see a fairly significant risk of market volatility to come, both on the fixed-income side but especially on the equity side. I think stocks are substantially overvalued and could fall markedly even without any important change in the underlying economic dynamics. But there is actually good news which should be considered along with that fact: when markets were last egregiously overpriced, financial institutions were also substantially more-levered than they are today. The chart below (source: Federal Reserve) shows that as a percentage of GDP, domestic financial institutions are about one third less levered than they were at the 2008 peak.
Now, this exaggerates the deleveraging to some extent – households, for example, appear to have deleveraged by about 20% on this chart, but the actual nominal amount of debt outstanding has only declined from about $14 trillion to about $13.1 trillion. Corporate entities have actually put on more debt (which made sense for a while but probably doesn’t now that equity is so highly valued relative to earnings), but in terms of a percentage of GDP they are at least not any more levered than they were in 2008.
The implication of this fact is some rare good news: since the banking system has led the deleveraging, the systemic risk that could follow on the heels of a significant market decline is likely to be much less, at least among U.S. domestic financial institutions. So, in principal, while it was clear that a decline in equity and real estate prices in 2007-2008 would eventually cause damage to the real economy as the financial damage was amplified through the financial system, this is less true today. We can, in other words, have some reasonable market movements without having that automatically lead to recession. The direct wealth effect of equity price movements is very small, on the order of a couple of percent. It’s the indirect effects that we have to worry about, and the good news is that those indirect effects are smaller now – although I wouldn’t say those risks are absent.
Now for the bad news. The bad news is that significant market volatility – say, a 50% decline in stock prices – would likely be met with “help” from the federal government and monetary authorities. It is that help which likely would hurt the economy by increasing business uncertainty further. It is probably not a coincidence that the last couple of months, which correspond to the implementation of the Affordable Care Act, have led to some weaker growth figures. Whether change is perceived as positive or negative, it’s the constant changing of the rules – and especially now that these rules are increasingly changed by executive fiat without the moderating influence of Congress (I never thought I would write that) – that damages business confidence.
In other words, I wouldn’t be concerned about the direct economic effect of a 50% decline in equity prices; but I would be concerned if such a decline led to meddling from the Fed, the Congress, or the White House.
While investors learned the hard lessons after 2000 and 2008 about the wisdom of automatically buying dips, they eventually forgot those lessons. But that makes them almost infinitely smarter than policymakers, who have refused to learn the obvious lesson of the last few years: your ministrations do little to help, and most likely hurt. So, maybe it really is true that there are two types of people: those who listen to everybody, and those who listen to nobody. The former become investors, and the latter enter government service!