Imagine an island on which magic trees grow. These trees, as it turns out, are exactly like the trees everywhere else, except for three things. First, these trees never die. Second, the trees always grow to exactly 100 feet tall eventually. And third, to pass time on this boring island the villagers place bets on which specific trees in a given acre of land (on which all trees were planted at the same time) will grow the fastest over the next ten years.
Right after an acre is planted, there is much activity that can only be termed purely speculative. Without any obvious difference in the first shoots, the villagers place their bets based on which of the tree-market brokers tells the best story about a particular tree. These brokers do tend to change their minds frequently, however, so it turns out that there is rapid trading.
After a few years, some trees have clearly started to grow faster than other trees. Villagers tend to invest more on these trees that have “momentum.” And this trend continues, because the further in the lead a given tree is over its rivals, the more momentum it clearly has. There is, however, a class of investors who like to invest in the smaller trees, since the bet is on the rate of growth over time, and these investors think that the smaller trees are likely to revert to the mean (indeed, because all of these magic trees end up at the same height, they are correct on average).
The villagers who “own” the taller trees are generally happy, since their trees are “in the lead.” They don’t much care for the villagers who “own” the smaller trees, because they think these folk are just negative ninnies. The value-villagers are fairly confident, though, because they understand the math; and many of them are dismissive of the momentum-villagers and call them “lemmings.”
The odd thing is that both of these “investors” have their time in the sun. Early on in a tree’s growth pattern, the ones quickly out of the gate do tend to grow more rapidly. Consequently, momentum is a viable strategy. But the bigger the lead gets for these trees, the worse the bet becomes that the rate of growth will continue. Once the tree reaches 99 feet, for example, there are not many ways that it can beat a 20-foot tree going forward (remember – all of these magic trees always grow to be exactly 100 feet in time). And yet, the momentum-villagers remain true to their investment style, saying “the 20-foot tree must just be sick. And it can’t get as much sun because the 99-foot tree is shading it. The 99-foot tree may only grow 1 foot over the next ten years, but the 20-foot tree might not grow at all.” And, after all, it is fun to have your bet on the biggest tree in the forest. However, the value-villagers almost always win that bet.
This allegory isn’t really about growth versus value in equity investing. It is about asset class performance and, more specifically, the performance of equities versus commodities. There is a significant amount of history to suggest that over long periods of time, the average growth rate of equities and the average growth rate of commodity indices is approximately equal. This happens because the basic sources of both asset classes are fairly steady: aggregate economic growth, in the case of equities, and collateral return plus rebalancing effect, plus some other smaller sources of return, in commodities. So regardless of what you think about equities or commodities, in general when equities are dramatically outperforming commodities, you should be selling them to buy commodities, and vice-versa. But that isn’t how most investors bet. Most investors make up a story about why the tree is stunted, and will never grow, will never catch up, and then turn to bet on the tall tree.
It is a mistake.
It is a mistake, though, that the Street actively encourages because where the broker makes his money is on frenzy. Rallying markets tend to produce more volume and excitement, and that means more money for the broker. This is especially true when the market is equities, since there isn’t much underwriting of commodities to be done but there is quite a lot of underwriting of new equity issues.
Frankly, this over-exuberant cheerleading sometimes results in lies being disseminated to investors. Consider the following snapshot of a Bloomberg page describing the characteristics, including the P/E ratio, of the Russell 2000 index. You will see it says the Price/Earnings ratio is about 18.41. We all know that means that if you pay $18.41, you will get a set of stocks that will have $1 in earnings, collectively. Right?
Well, the following chart is also from Bloomberg, and you get it if you type RTY<Index>FA<GO>. What it says is that the Price/Earnings Ratio is actually 54.86, which means that your $18.41 actually only gets you $0.33 of earnings! What’s going on here? Well, the next line shows you that what Bloomberg considers the “real” P/E ratio – important enough to have on the front page – is really the Price/Earnings ratio if we only count the positive earnings.
So, that $18.41 does in fact get us $1 in earnings. Wall Street doesn’t want us to focus on the fact that it also gets us $0.67 in losses, so that the net is only $0.33. Because surely, those losses were one-time events, and obviously all 2000 companies will make money next year, right?
It may be that stocks are a great bargain here, and that multiples will expand further, the economy will surge in a way we haven’t seen in a decade or two, in an environment of tame inflation but ample liquidity. If that is the case, then equity investors will win over the next five years because they’re betting on the trees that have grown the most in the last two years. But in all other cases, commodity indices should grow faster than stocks as both revert to their long-term growth rates.
With little economic data on the calendar, and the Fed speakers back-loaded at the Chicago Fed conference later in the week, there is time to reflect on other questions (unless, of course, the Israel/Syria back-and-forth turns into something more than the last couple of jabs have produced).
It is interesting to me that analysts and journalists truly enjoy finding comparisons between present situations and actors, except when the comparisons suggest unpleasant conclusions. This is at a time when there are really no comparable periods in history to compare to, at least with respect to major global policy initiatives!
I read comparisons between Shinzo Abe’s pressure on the Bank of Japan and Fed Chairman Bernanke’s campaign to resurrect the American economy with ever-greater monetary policy shocks. Somewhere, I saw an analyst ask “isn’t Abe taking note of the failure of U.S. monetary policy to goose the economy?” But the comparison is not apt because the two men, and the two economies, face very different challenges. Abe doesn’t need to increase consumer spending and reinvigorate the economy with monetary policy. While that might be nice, the main goal of Japanese monetary policy now is to raise the price level and the rate of inflation. They are using exactly the right tool to do so: lots of monetary easing. On the other hand, Bernanke is trying to kick-start the real economy with a monetary tool, while at least in principle avoiding an inflationary outcome. That’s like trying to hammer a nail with a fish. It might work, but it’s the wrong tool for the job. So the comparison doesn’t work: one man knows how to use his tools, the other does not.
Here is another useless comparison: “Bond Buyers See No 1994 as Bernanke Clarity Tops Greenspan.” The myth that transparency really helps markets in the long run is sort of silly: is there any sign that the crises caused by monetary policy have become less frequent since the Greenspan glasnost than they were before? I know that’s the belief, because the Fed has told us that’s the way it is. But my scorecard tells a sorry tale of bubbles and crashes since the early 1990s. It isn’t a lack of transparency that causes routs. It’s leverage, and negative gamma. Mortgage hedgers are more active now than they were in 1994, and they have larger books. Hedge funds are orders of magnitude larger. And Wall Street is smaller, and is able to provide less liquidity – partly because they are more levered (which they think is okay because of “Fed transparency”), and partly because the government doesn’t want them to take bets with the leverage they have (which, since they’re paying for failures under the current system, isn’t wholly absurd).
So will the next bond selloff not be as bad as in 1994, because the Fed will give more warning? Remember that no matter how transparent the Fed is, there is still a transition point. Somehow, the market goes from a state of thinking there will be no tightening of policy, to a state of thinking that there will be a tightening of policy. That requires a re-pricing, whether it occurs because the Fed signaled it in a speech or a statement, or because they signaled it by doing Matched Sales for the SOMA account with Fed funds already trading above target (as was the old way of telling us something had changed). There is no way to go from “not knowing” to “knowing” without a moment of realization. And when that phase change ultimately occurs, the greater leverage inherent in the market and the diminished role of market makers will cause the selloff (in my view) to very likely be more dramatic than in 1994.
One place where we cannot prevent comparisons – nor should we want to – is in the asset markets. Stocks are doing well, despite absurd valuations, because most other markets are either more-absurdly valued (e.g., Treasury bonds) or have horrible momentum that means they’re not popular right now (e.g., commodities). I have no doubt that equity performance over the next 10 years will be very uninspiring, because equity markets that start from this level of valuation never produce inspiring returns. But when people ask me what the trigger will be for a selloff, I have to shrug. There have been plenty of “reasons” for that to happen. But I think the ultimate reason is probably this: equities are perceived as the “only game in town.” I have read several articles recently that echo this one: “Bond Fund Managers are Loading Up on Stocks.” When there is some other asset class, or some other world market, that starts doing appreciably better, perhaps investors will decide to allocate away. Unfortunately, the candidates for that market are pretty few, given the general level of valuations. Could it be commodities, which is one of the few genuinely cheap markets? Or perhaps real estate, which is still only fair value but has some pretty striking momentum? I don’t know – but I am also not sitting around waiting for a “trigger event.” There may well be a selloff without such a trigger.
Housekeeping note: in case you missed it, here is a link to Tuesday’s article, which was not picked up through all of the “usual” syndication channels. Note that, in addition to doggerel, it contains an announcement regarding the free ‘office hours’ I am making available to readers who wish to sign up. (On the basis of the first “round,” I’ve decided to lengthen the sessions to 20 minutes but only offer three of them per week, but this may evolve further as I learn more.)
When we look back on this period of financial history, I wonder if it will not be called the “era of unintended consequences.” I can think of lots more names for the era, some of them unprintable, but this one certainly applies.
I tend to think of unregulated markets as chaotic, but fundamentally structured. They tend to be efficient, although research has demonstrated that even completely free markets can produce bubbles and negative bubbles. But I really do believe in something like Adam Smith’s ‘invisible hand,’ that leads the baker to make just enough bread without being told how many loaves to make. A farmer’s market or third-world bazaar, although seemingly chaotic, still often manages to arrange itself so that most purveyors of similar goods end up in one general area. However, when someone intervenes to organize the chaos, there is often an unintended consequence. A recent example is the Fed’s low-rate policy in the mid-2000s, which was meant to respond to the equity bubble burst and the recession of the early 2000s; it also helped produce the housing bubble. Certainly, the housing bubble was not intended by the Fed, but it clearly followed partly from the easy money policies. As another example, Cyprus needed a bailout partly because their banks had been involved in helping Greece by buying Greek debt. Surely countless other examples suggest themselves.
Another example came to my attention today. As part of a presentation I am giving in a week and a half, I will be talking about the “portfolio balance channel” and how it is pushing investors to take more risk than they should, based on the absolute return expectations, because of the configuration of relative return expectations. (I wrote about this in “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”, back in January). But a friend pointed out that it isn’t merely retail and professional investors who are being forced to take risky assets at bad prices because the safe assets have even worse prices: central banks are as well, according to this article in the Financial Times, entitled “Central banks move into riskier assets.” Who knew?
Central bankers are not supposed to really care about portfolio returns. They’re supposed to care mainly about return of capital rather than return on capital. That’s theory, but the reality is that central bankers want to be heroes just like anyone else, and their jobs are definitely made politically easier if they are revenue generators and not cost-centers. And that in turn made me think of the article in this month’s Financial Analysts Journal by Robert C. Merton et. al., in which they argue that “monetary and fiscal policies designed to deal with things like stimulus or consumption demand can actually have unintended consequences of some magnitude for financial stability and markets.” More interestingly, they graphically illustrate how much more connected financial institutions are now than they were prior to 2008.
And one important unintended consequence of the Fed’s efforts on the portfolio balance channel is that the connectedness is increasing, and the nonlinear exposures of central banks are increasing as well. That, in turn, suggests that rather than being meaningfully safer than we were five years ago, we may well be less safe. You could already make such an argument by pointing out that sovereign states have less room to fiscally ease in response to crisis, but add to that the fact that central banks themselves could be caught up in a crisis and be losing capital at just the moment when it is most needed. Of course, at some level a central bank that has control over its own currency – unlike those in, say, Portugal or Italy – can always print a solution. The increasing risk posture of central banks, I believe, increases the possibility of a blatant printing outcome (as opposed to the circumspect printing currently being pursued) in response to a renewed crisis.
Never before have so many fingers been crossed for the global economy. And never before has it been so necessary to cross our fingers!
For a change, fixed-income is where all of the excitement is. For more than a month (since March 5th, the S&P has closed no lower than 1540 and no higher than 1570, plus or minus a couple of nickels: a month-long range of less than 2%. What’s really amazing about that is that on seven of those twenty-three trading days, the range of the day was more than half of the month’s entire closing range. In two of the last four trading days, the intraday range was two-thirds of that for the entire month!
Meanwhile, the 10-year Treasury rate has gone from 1.90% to 2.06%, down to 1.71%, and ending today at 1.75%. The closing range in point terms of the current 10-year note was 99-16 to 102-19, or a bit more than 3% (and it was obviously more than that for the long bond). It has been a long time since bonds were more volatile than stocks over a period as long as a month.
Most of that volatility in nominal rates has been on the real interest rate side. The range in closing 10-year TIPS yields is -0.52% to -0.76%, or 24bps, compared to 35bps for the nominal yield. That’s more volatility than the real yield should be displaying at this level of rates, and it has moved TIPS from being slightly cheap a month ago to somewhat rich. Our Fisher yield decomposition model, which had been neutral on TIPS and breakevens since mid-February, is now modestly short TIPS (and still flat breakevens). Moreover, the leverage applied by our long-inflation-biased “smart beta” model is only 2/3 of the neutral leverage, so conservatism is the watchword at the moment.
The rally in TIPS and nominal yields owes much, I am sure, to the somewhat feeble data we have seen over the last week. The Employment data, in particular, were very disappointing, especially to that group of people who expected profligate monetary policy easing to create economic growth. It will surprise no regular reader of this column that I am not shocked to see a lack of growth response to aggressive monetary policy easing – as I take pains to remind readers, monetary policy is not supposed to affect growth, except in the presence of money illusion. It is therefore something less than a news flash that growth is responding more to tiny changes in government spending (albeit temporarily) than to massive changes in monetary aggregates.
To be sure, even monetary aggregates have been drooping lately…at least, the ones that matter. M2 has been lurching along in the mid-6% growth rate year-on-year, and flat over the last quarter (see chart, source Federal Reserve). That’s only slightly above the average growth rate in M2 since 1981 – although, to be fair, the average core inflation over the same time period has been about 3.1%, so core inflation is still well below where we would expect it to get to if this rate of monetary growth continues.
Growth in commercial bank credit growth, also, has retreated to only 4.1% year-over-year after spending most of the past year above 5%. It too is still right around the long-term average real growth in commercial bank credit (see chart, source Federal Reserve, Enduring Investments), but last year it had been edging towards the mid-2000s standard.
So these are positive developments from the standpoint of future inflation, but it is far too early to call victory on that front. I expect the rise in M2 to re-accelerate in fairly short order; but in any event it is important to remember that the Fed is not the only game in town and not the only central bank that is pursuing easy-money policies. Indeed, last week the biggest news was that the Bank of Japan pledged to double its monetary base, its holdings of JGBs, and its holdings of ETFs and JREITs over a period of only two years.
This policy will almost surely produce the result the Japanese policymakers have been shamelessly vocal about seeking: higher inflation, in a short period of time. At the end of the day, the inflation that Japan gets in the near-term will depend on what their domestic money velocities and multipliers do, but they will surely get higher inflation eventually just as the Fed’s policies have produced inflation even with declining multipliers and velocity. To my mind, the Japanese inflation swaps market – which according to Bloomberg is at 1.26% for 5 years and 1.01% for 10 years – seems to be cheap!
But the Japanese policy will certainly not stop at the water’s edge. Around 2/3 of our domestic inflation is sourced from global factors, and the monetary policy of a major trading partner is a significant global factor. The behavior of the Yen and industry response to changing competitive pressures from Japan will determine how much of the BOJ’s inflation remains domestic and how much is exported, but it would be surprising indeed if the result was entirely contained within the borders of Japan. The Yen has responded sharply to the policy changes at the BOJ (see chart, source Bloomberg), but in my opinion it has very much further to go. In fact, the only reason we may not get back to mid-1980s levels is that the Fed’s policy is similarly aggressive – the only difference at the moment is that the Fed is giving lip service to the notion that they intend to hold down inflation in the long run. (I don’t believe them.)
None of the above has much, if anything, to do with North Korea, or Cyprus, or Slovenia, or Portugal. All of those countries still are potential wild cards, and all of them (it needs hardly be said) constitute downside risk. The White House is seemingly satisfied to wait to see if North Korea really will launch a nuclear-tipped missile; this means that the entire distribution of potential outcomes is compressed so that there is a very high likelihood of nothing bad happening, and a very small chance of something really, really bad happening. How do you trade that? The answer is that you use options. Implied volatilities are under pressure again because the recent tight range makes it difficult to eat the time decay of long-vol positions. But as for me, I’m delighted to pay insurance premiums for insurance that turns out to be unnecessary, especially when that premium is low. I don’t have any long equity positions, but if I did then I’d be protecting them with cheap put options.
Markets have been surprisingly quiet over the last few days. Some of that, no doubt, is due to the NCAA basketball tournament, to the Good Friday/Easter Monday holiday in the U.S. and in Europe, and to baseball’s Opening Day.
We also had Japanese year-end and the end of Q1 in the U.S., and to the extent that the last week has brought any market moves of interest at least a portion of that can be put on the account of the calendar. On Thursday, the S&P set a record month-end close, although a higher intraday print was established in October of 2007. But while news accounts attributed the almost-record to an “easing of Cyprus fears,” it is much more likely that it was due to the normal (and well-known) quarter-end “mark ‘em up” machinations of less-scrupulous fund managers in illiquid market conditions.
In a similar vein, the quirk of having the quarter end on a Thursday three days before the calendar turns helped exaggerate a massive move in grains, especially corn, on a mildly bearish crop report. Those who are invested in commodities for tactical reasons are being flushed because they’re tired of waiting, as an article in today’s Wall Street Journal made clear. The investors who are leaving do not have comfort in the asset class because they don’t understand the drivers of the asset class; the result is that they become performance chasers. So, when crop reports suggest that the real price of corn should fall a little bit, investors slash nominal prices 10% in ‘get me out’ orders.
But as I said, these investors don’t understand the fundamental drivers of the asset class. The article cited above regarded the breakdown of the correlation between commodity indices and equity indices as something sinister, saying that the correlation is at its lowest level since 2008 and suggesting that this means that one of the two markets is wrong. As it turns out, though, the correlation of stocks and commodities is a relatively new phenomenon. Over the last 5 years, the correlation of monthly changes in the DJ-UBS index and the S&P is 0.61. However, for the 17 years prior to that, the correlation was 0.04 (see chart, source Bloomberg).
For the GSCI commodity index, the last-5-years correlation is 0.65, but for the 38 years prior to that (the GSCI has a longer history) the correlation was -0.02. In short, there is no reason to read a whole lot into the recent decoupling of stocks and commodities, except that it may suggest the hot money is finally leaving commodities. The correlation breakdown is also a good thing for anyone who believes – as I do – that stocks are overvalued. And, since a good portion of commodities’ long-run return comes from a rebalancing effect that is larger when the inter-commodity correlations are lower, this is more good news.
The choppy melt-up in stocks on Thursday was partially reversed by the new-quarter blues today, but all of this is mere detail. Over the last week, while authorities in Europe have encouraged investors to put the Cyprus issue to bed additional details have emerged that deserve mentioning. For example, it turns out that the larger depositors (over €100,000) investors in one of the Cypriot banks will not get a 10% haircut, or a 20% haircut, but something close to a 100% haircut – 37.5% of the deposit balance in excess of 100k will be converted to equity in the bankrupt bank. There are some reports that certain deposits belonging to “EU funds” will be exempt from the haircut. There are of course the stories that capital controls implemented in Cyprus were ignored in non-Cyprus branches of Cypriot banks, and one Cypriot newspaper is claiming that relatives of the president withdrew substantial funds from Laiki bank just before the bank was shut down.
While the worst of the immediate crisis has surely passed, it seems madness to me to pretend that it never happened or that it will have no knock-on effects. For that matter, it seems madness to conclude that since the knock-on effects were not immediate, that no such effects exist. On the other hand, when events are no longer going bang-bang-bang in rapid succession, it is reasonable to ask “whose move is it?” Will bank deposits begin to flee from periphery countries, or wait to see what assurances European officials give? Are central bankers already injecting liquidity into shaky banks, or are they waiting for the invitation from the banks in-country? Are investors reducing risk and diversifying away from European assets, or are they waiting to see if other investors do so first? All of these actions entail costs, and so there is a natural desire of every party to delay action…but to not delay action so long as to cause those costs to rise substantially.
As a trader, my inclination is to hit a bid and get out, and not worry about the bid/offer spread or those other costs. But I am not dealing with billions of Euros when I do that. Still, the insight is that when bad things might happen, the here-and-now transactions costs are usually a poor reason not to seek protection. This is why T-Bills over the last couple of years have occasionally had negative nominal yields (see the chart of 3-month T-bill yields below, source Bloomberg). Yes, it’s clearly dumb to pay $1.01 now to receive $1 in the future. But is it dumber than the alternatives?
I just finished a paper called “Managing Laurels: Liability-Driven Investment for Professional Athletes,” and I thought that one or two of the charts might be interesting for readers in this space.
An athlete’s investing challenge is actually much more like that of a pension fund than it is of a typical retiree, because of the extremely long planning horizon he or she faces. While a typical retiree at the age of 65 faces the need to plan for two or three decades, an athlete who finishes a career at 30 or 35 years of age may have to harvest investments for fifty or sixty years! This is, in some ways, closer to the endowment’s model of a perpetual life than it is to a normal retiree’s challenge, and it follows that by making investing decisions in the same way that a pension fund or endowment makes them (optimally, anyway) an athlete may be better served than by following the routine “withdrawal rules” approach.
In the paper, I demonstrate that an athlete can have both good downside protection and preserve upside tail performance if he or she follows certain LDI (liability-driven investing) principles. This is true to some extent for every investor, but what I really want to do here is to look at those “withdrawal rules” and where they break down. A withdrawal policy describes how the investor will draw on the portfolio over time. It is usually phrased as a proportion of the original portfolio value, and may be considered either a level nominal dollar amount or adjusted for inflation (a real amount).
For many years, the “four percent rule” said that an investor can take 4% of his original portfolio value, adjusted for inflation every year, and almost surely not run out of money. This analysis, based on a study by Bengen (1994) and treated more thoroughly by Cooley, Hubbard, and Walz in the famous “Trinity Study” in 1998, was to use historical sampling methods to determine the range of outcomes that would historically have resulted from a particular combination of asset allocation and withdrawal policies. For example, Cooley et. al. established that given a portfolio mix of 75% stocks and 25% bonds and a withdrawal rate of 6% of the initial portfolio value, for a thirty-year holding period (over the historical interval covered by the study) the portfolio would have failed 32% of the time for, conversely, a 68% success rate.
The Trinity Study produced a nice chart that is replicated below, showing the success rates for various investment allocations for various investing periods and various withdrawal rates.
Now, the problem with this method is that the period studied by the authors ended in 1995, and started in 1926, meaning that it started from a period of low valuations and ended in a period of high valuations. The simple, uncompounded average nominal return to equities over that period was 12.5%, or roughly 9% over inflation for the same period. Guess what: that’s far above any sustainable return for a developed economy’s stock market, and is an artifact of the measurement period.
I replicated the Trinity Study’s success rates (roughly) using a Monte Carlo simulation, but then replaced the return estimates with something more rational: a 4.5% long-term real return for equities (but see yesterday’s article for whether the market is currently priced for that), and 2% real for nominal bonds (later I added 2% for inflation-indexed bonds…again, these are long-term, in equilibrium numbers, not what’s available now which is a different investing question). I re-ran the simulations, and took the horizons out to 50 years, and the chart below is the result.
Especially with respect to equity-heavy portfolios, the realistic portfolio success rates are dramatically lower than those based on the “historical record” (when that historical record happened to be during a very cheerful investing environment). It is all very well and good to be optimistic, but the consequences of assuming a 7.2% real return sustained over 50 years when only a 4.5% return is realistic may be incredibly damaging to our clients’ long-term well-being and increase the chances of financial ruin to an unacceptably-high figure.
Notice that a 4% (real) withdrawal rate produces only a 68% success rate at the 30 year horizon for the all-equity portfolio! But the reality is worse than that, because a “success rate” doesn’t distinguish between the portfolios that failed at 30 years and those that failed spectacularly early on. It turns out that fully 10% of the all-equity portfolios in this simulation have been exhausted by year 19. Conversely, 90% of the portfolios of 80% TIPS and 20% equities made it at least as far as year 30 (this isn’t shown on the chart above, which doesn’t include TIPS). True, those portfolios had only a fraction of the upside an equity-heavy portfolio would have in the “lucky” case, but two further observations can be made:
- Shuffling off the mortal coil thirty years from now with an extra million bucks in the bank isn’t nearly as rewarding as it sounds like, while running out of money when you have ten years left to lift truly sucks; and
- By applying LDI concepts, some investors (depending on initial endowment) can preserve many of the features of “safe” portfolios while capturing a significant part of the upside of “risky” portfolios.
The chart below shows two “cones” that correspond to two different strategies. For each cone, the upper line corresponds to the 90th percentile Monte Carlo outcome for that strategy and portfolio, at each point in time; the lower line corresponds to the 10th percentile outcome; the dashed line represents the median. Put another way, the cones represent a trimmed-range of outcomes for the two strategies, over a 50-year time period (the x-axis is time). The blue lines represent an investor who maintains 80% in TIPS, 20% in stocks, over the investing horizon with a withdrawal rate of 2.5%. The red lines represent the same investor, with the same withdrawal rates, using “LDI” concepts.
While this paper concerned investors such as athletes who have very long investing lives and don’t have ongoing wages that are large in proportion to their investment portfolios (most 35-year-old investors do, which tends to decrease their inflation risk), the basic concepts can be applied to many types of investors in many situations.
And it should be.
We have one month in the books in 2013 already; my, how time flies when you’re having fun! But the fun may not last much longer.
I have spent lots of time, over the last year, answering the question “why hasn’t inflation responded to QE?” My response has been that it has: core inflation rose from 0.6% to 2.3% from October 2010 to January 2012, rising for a record-tying fifteen consecutive months – a feat that last happened in 1973-74, as official prices adjusted to catch up for being frozen during wage and price controls. By a bunch of measures, that was an acceleration of core inflation that was unprecedented in modern U.S. economic history. As I wrote at the time (in “Inflation: As ‘Contained’ As An Arrow From A Bow“), the only reason to defer panic was that Housing inflation was overdue to level out and decelerate. Fortunately, it did.
But, as I’ve written extensively recently, that blessing has been rescinded and the question of “why hasn’t inflation responded to QE” will shortly be moot. In the next couple of months, core inflation will begin to re-accelerate, driven by the pass-through of rising home prices into rents. In our view, the best we can hope for is that core inflation only reaches 2.6% this year. Absent a change from the historical relationship between home prices and rents, some 40% of the core consumption basket is going to be rising at 3.5% or better by late this year.
So, when will markets get a whiff of this?
We are primarily motivated by valuations, and we are patient investors. Moreover, we think it makes more sense to focus effort on valuation work, because if your valuation work isn’t pretty good then timing isn’t going to matter much. But nevertheless, it is helpful to look for signs and signals that indicate time may be drawing short. So I’d like to go all ‘techie’ for a few minutes and show three charts that suggest markets are preparing for a new, higher-inflation reality.
The first one is the dollar index (see chart, source Bloomberg). This one is interesting, because I am not convinced that U.S. QE will cause a uniquely American inflation. After all, everybody’s doing it. This chart is technically of a head-and-shoulders pattern, but I’m just pointing to that trendline that keeps bringing in buyers.
A break below the current level (and as a trader, I’d be tentative until the September lows broke as well) projects to a test of the bottom end of a much bigger consolidation pattern that has been forming since the beginning of the crisis in 2008 (see next chart, source Bloomberg – the green oval is the area of detail in the prior chart). Below there be dragons.
Now, at the same time we have inflation breakevens (the compensation, in nominal bonds, for expected inflation – represented as the raw spread between the Treasury yield and the TIPS real yield). I’ve shown this uptrend in breakevens and/or inflation swaps in a number of ways recently, but the chart below (source: Bloomberg) shows a long-term view. In the last three months, the 5-year breakeven has risen about 35bps (and you get a similar picture from inflation swaps, but the data isn’t as clean that far back). Right now, bond investors are demanding a fairly high level of expected inflation compensation over TIPS and their guaranteed return of actual inflation. We’ve got a ways to go before we hit all-time highs on the 5y BEI, but the 10-year BEI is only about 22bps away from all-time highs.
Those prior charts haven’t yet broken out, and so while the timer is buzzing the alarm might ultimately not be set off. But in commodities, there are some interesting signs that the lows may be in even though sentiment remains very negative. The chart below (source: Bloomberg) illustrates that in January, the DJ-UBS commodity index gapped through trendline resistance not once, but twice.
In my experience, technical analysis of commodity indices is a fraught exercise, but commodities have quietly been doing quite well lately. Although the S&P rose 5% in January to only 2.4% for the DJ-UBS, that’s mostly due to the first trading day of the year. Since January 9th, the DJ-UBS is +3.7% while the total return of the S&P is only +2.6%. Surprised?
Now, the conventional wisdom is that stocks are a great place to hide if there is inflation. That conventional wisdom is wrong. Stocks may do okay if starting from modest valuations, but a rise of inflationary concerns (especially if accompanied by rising interest rates) while stocks are at high valuations would likely be less than generous to equity investors.
So, of course, retail investors have been breaking their piggy banks open to rush into stocks, in a rush not seen for many years. It is tragic, but it is the natural result of the Fed’s misguided crusade to stimulate the economy via the portfolio balance channel (see my discussion and illustration of this topic here). Where does the retail investor turn, when he sees rising gasoline prices, rising home prices, and a shrinking paycheck due to higher withholding rates? The television is telling him that it’s time to jump aboard the equity train. Although he has been prudently suspicious of equity markets for much of the last decade, he is also aware that the cash he has in the bank is evaporating in real value.
And perhaps that’s why total savings deposits at all depository institutions (the main component of non-M1 M2) has fallen more in the last two weeks than in any two-week period…ever. About $115bln has fled from savings accounts in the last fortnight. Now, that’s a volatile series, and it might mean nothing unless we happened to see it show up somewhere.
Like, perhaps, here?
The chart above (source: ICI, via Bloomberg) shows the net new cash flows into equity funds, which just happen to be at the highest level over the past three weeks (about $30bln) of any time during the period of data available on Bloomberg.
Again, it isn’t because the future suddenly looks bright. Initial Claims today was 368k, above expectations and unfortunately putting a big dent in the notion that the ‘Claims data over the last few weeks was signaling a meaningful shift in the rate of new claims. The number is probably still going to go lower, but it is likely to be a drift, not a break. And we will see a similar story tomorrow, probably, when the Payrolls figure (Consensus: 165k) and Unemployment Rate (Consensus: 7.8%, but I think it might tick up to 7.9%) will paint the same sort of picture. No, people are not reaching for their wallets to invest in stocks because they are suddenly flush. More likely, it’s because they’re frustrated and confused; they feel they’re being left behind. Perhaps there is a bit of desperation, if retirement is getting further away as the cost of retirement rises and take-home pay stagnates.
In any event, what you do not want to see, four years and 125% above the S&P lows, is people taking money out of savings to put into stocks. If you are not one of the people putting money in, then consider being one of the people taking your profits out – and looking to those markets that actually do tend to keep up or outperform inflation. I hasten to remind readers that they don’t ring a bell at the top of the market, and so one ought to be careful to rely too much on the “signs” and “timing signals” suggested above. But the sharp-pencil work suggests that core inflation is going to head back up in the next 2-3 months; in my opinion, you don’t necessarily need signs to position for that – you need excuses.
 One is tempted to say ‘evil,’ but I don’t believe the Fed actually is anticipating the pain they are likely to cause to the little guy. Indeed, they may believe that the impact of their actions may fall disproportionally on the rich: an economist at the Federal Reserve Bank of St. Louis recently co-published a paper entitled “Understanding the Distributional Impact of Long-Run Inflation,” which concludes in part that “When money is the only asset, a faster rate of monetary expansion acts as a progressive tax that lowers wealth inequality; when bonds can be traded, wealth inequality is less affected by inflation because the rich hold more illiquid portfolios than the poor.” [emphasis added]
According to Bloomberg, investors are the most optimistic on stocks they have been in 3½ years. As is normal, investors mistake a sense of optimism about the economy for a sense of optimism on equities. As is normal, investors are reaching this peak of optimism as the stock market achieves its highest nominal level in five years, and among the highest valuation multiples in … hey!…about five years. What a coincidence! (Incidentally, while we calculate our long-term valuation metrics ourselves this page is a pretty good source for a quick-and-dirty view of valuations. I don’t have any relationship to the company and this is the only page on the site that I’ve used so I am not endorsing any other page!)
Now, while I am probably as optimistic on the economy as I have been in the past few years, I’m still less-optimistic than the crowd since I think the crowd hasn’t yet assimilated the fact that the little growth spurt at the end of Q4 owes quite a lot to the movement of dividends and incomes into Q4 from Q1, and thus the first quarter of this year will probably look rather poor.
In fact, while I am clearly negative long-term on the prospects for nominal Treasury bonds, that’s my investment view. My trading view is that at 1.84%, Treasury bond yields are probably going to go lower before they go higher. That’s partly because the present yields incorporate a lot of enthusiasm about growth – enthusiasm I think will be dashed once the January numbers begin to be reported in earnest. But the trading view is also because the Fed is buying virtually all of the net supply the Treasury is supplying to the market, with no sign that project is ending. I have no illusions that buying 10-year Treasuries at 1.84% and holding to maturity will be an awful investment. But if I was a short-term swing trader, I’d play for the next 20bps to be lower, not higher, in yield.
With respect to January data, incidentally, here is what we have so far (outside of Initial Claims, which as I have pointed out previously are all over the map at this time of year):
|Release for January||
|NAHB Housing Mkt Index||
|Philadelphia Fed Index||
|Richmond Fed Mfg Index||
For the most part, these are not just misses but big misses. I wonder how long it will take for investors to notice? Initial Claims on Thursday could get attention as the numbers start to converge on the actual condition of the underlying economy, but the first big January datum is the January 29th release of Consumer Confidence, which is currently expected to rise slightly from December. That is followed by ADP on January 30th (but any weakness there will likely be tempered by the advance release of Q4 GDP on the same day), the Chicago PMI on the 31st, and the ISM PMI and Unemployment on February 1st. Regardless of what happens over the next few days, I don’t want to be short bonds headed into that gauntlet next week.
I said the January data were big misses “for the most part,” because the NAHB miss wasn’t really a big miss. Housing is even strong enough now to resist downside surprises. As an aside, although it is a December number, the median price of existing home sales rose 10.89% year-on-year. Adjusted for the level of core inflation (so that we’re looking at the real rise in existing home prices), this is the fastest rise in history except for several months in 2005 – see the chart, (source Enduring Investments).
As for stocks, the fact that investors are as bullish as they have been in a third of a decade is sad but not terribly surprising (although this is a survey of Bloomberg users, which supposedly are much more astute since they have to come up with the 1700 clams per month for the service). On a related note, I was recently reading an article, called “I Saw The Movie,” in the January issue of Financial Advisor Magazine. In the article, the author compares the fear that some investors have of the stock market to the (irrational) fear of going into the water after watching Jaws. The author notes that “If your balance in 2011 resembled your balance in early 2008, you lost three years – but you didn’t lose any money, unless you sold out of panic…the vast majority of big losers were those who sold at the ebb of fall of ’08 to the spring of ’09 and parked their boats in the shallows of rock-bottom savings accounts.”
This, it occurs to me, is the real toll that the Fed’s QE has had on the investor class. It taught the wrong lesson. The lesson that has been taught is that you should hold on through all things, good and bad, and things will be okay. It is true that with hindsight, those who sold with the market finally at fair value (but no cheaper) in March of ’09 missed a rollicking rally all the way back to similar levels of overvaluation. But the real lesson should have been that most investors shouldn’t have been overweight in equities in 2008 or in 2007, based on market valuations. In the absence of manipulation of asset prices through the “portfolio balance channel” (see my discussion of this phenomenon in my recent article “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”), those who sold in March of 2009 would have missed an average market return rather than the 21% per annum the market actually delivered since then. So the problem isn’t that they got out in 2009, but that they got in (or stayed in) in 2007 and 2008, and then got out in 2009. Investors who heeded the overvaluation of the market at, say, year-end 1998 and never got back in have earned a compounded return of 2.54% in T-Bills, 7.39% in TIPS, 5.64% in commodities, or 5.77% in the Lehman/Barclays Agg (nominal bonds) compared with 2.94% in stocks.
And that return is based on the pumped-up valuations that still exist in stocks today.
Investors, and their advisors for the most part, haven’t learned the right lessons yet, which is why patient investors are still having to wait to get back into equities even though the Federal Reserve is working very hard to force them back into the market via the portfolio balance channel.
The right lesson is this: investing for the long term is mostly about valuations, and very little about the economic cycle, the news cycle, or the lunar cycle. And two of those three we can’t predict, anyway. Yes, there is a tactical element of trading, but most investors should be (a) rebalancing on a regular basis, (b) paying attention to basic rudiments of asset valuation so as to adjust – mainly at the margin – their basic asset mix, and (c) turning off the television.
Desperation is unattractive, and desperate greed – needing to have a big return, quickly – is dangerous when it comes to investing. But investors appear to be getting increasingly desperate to swing for home runs rather than to try for singles and doubles, if the increased stampeding of retail investors’ monies into equities is any indication. Again today, stocks rallied steadily for most of the day. As the S&P reaches a new 5-year high with every advance, and is not terribly far away from an all-time (not inflation-adjusted) high, investors are increasingly throwing caution to the wind and plunging back in to stocks. Blackrock’s CEO, Larry Fink, observed today that “…the move back into equities is one of the mega trends we witnessed in the fourth quarter, and that has continued into the first 15, 16 days of the year.”
According to Fink, investors are doing this because of disdain for bond returns, not because of a desire to go “risk on.” And yet, risk-on they are going. They are going risk-on with corporate margins at post-WWII highs and following a Q4 that will be exaggerated by the tax-related movement of income from Q1 into Q4 (for example, via the payment of special dividends), and a Q1 that will end up looking weaker than the underlying fundamentals really are. Are these desperate investors ready to see a few months of weak data when they’re buying in at the highs?
Today’s data offered both the good and the bad. The good was the December Housing Starts number, which achieved the highest level since 2008 (see chart, source Bloomberg). To be sure, building activity is nowhere near the levels that were common in the 1980s, 90s, and 00s, but it is recovering. This should continue, as the inventory of new homes is at a very low level. The bad was the January Philly Fed index, which was expected to rise but which instead declined. The index of current conditions (at -5.8%) is the worst for a January since 2009.
Much was made of the sharp decline in the Initial Claims figure, which was expected at 369k but instead came in at 335k. My advice is to ignore any Claims figure in the second half of December until late January, as the seasonal adjustment factors are actually much larger than the net number – that is, the report should have a huge error bar around the weekly number, which is a seasonally-adjusted figure. If this is why stocks rocketed higher, then the desperation is even more disturbing. No one ought to ever invest on the basis of a weekly economic number.
After yesterday’s CPI report, I expected to see a number of denunciations of “inflation-phobes,” and I was not disappointed. David Wessel’s column in the Wall Street Journal was one example. Although Wessel came to the wrong conclusion (he agreed with Bernanke that there isn’t “much evidence” that the monetary policy of the last several years is going to be inflationary), at least he did undertake to “weigh…arguments on the other side.”
But he almost lost me straightaway, when he said that “the link between the money supply and the inflation rate is hard to discern in data…” Take a look at the chart below (source: Enduring Investments) and tell me if it’s really hard to discern the link in the data.
Oh, and on a longer-term basis there is this, which I wrote about in this great article.
What is hard to discern in the data is any link between inflation and growth, other than the spurious one that comes from the fact that the 2008 crisis was caused by an implosion of housing prices, which then impacted core inflation with a lag. (See chart, source Bloomberg)
Or, more consonant with the NAIRU theory, any link between the unemployment rate and core inflation (see chart, source Bloomberg).
This last chart is fun. If you run core CPI as a function of the unemployment rate from 2000-2012, you get a good correlation that looks like the right thing. But again, it’s spurious: if you look at the same relationship from 1990-2000, you also get a good correlation…but exactly the opposite slope to the relationship (that is, implying that lower unemployment causes lower inflation). Showing them both together makes the point that…you can’t see much in this data.
These latter two relationships are absolutely accepted without question in large swaths of the economics profession, such as when Wessel argues that “it would be difficult to spark and sustain inflation with so many unemployed workers, empty stores and offices and underused factories.” Where does he see that in the data?
I shouldn’t be so hard on Mr. Wessel, because he does make a reasonable effort to give some arguments about why people fear that the Fed will either intentionally or unintentionally make a mistake. But I think his best argument is one that he doesn’t make on purpose: policymakers and many economists just don’t understand what inflation is and how it works, and that creates a very high likelihood of error in the future. Moreover, they not only don’t understand, but they greatly overestimate their degree of understanding. I recognize, as an investor, trader, and economist, that there is some chance that my forecasts are wrong. Furthermore, since I understand that overconfidence is a very common cognitive error, I even recognize that I am most likely underestimating the chances that I am wrong. As a consequence, I am very conservative with my approach to investment when the consequences of an error are very high. Most good investors are very wary of overconfidence.
No such wariness afflicts the economic profession, unfortunately, especially at one particular address on Constitution Avenue Northwest in Washington, DC.