Serendipity often plays a role when I am considering a blog post. In this case, I wasn’t even planning a post but was updating old spreadsheets for current data to see how things have developed. In the past, I have documented how NYSE Composite volume has been falling fairly steadily since at least 2006. It is difficult to tell whether this is important or not, since some of this is due to the fact that more trading occurs off of the NYSE these days. Still, there was a significant drop-off in 2010 and 2011 and 2012 which seemed more than coincidental (2012 total volume was about half of the volume traded in 2008, in terms of shares, and probably lower than that in terms of volume).
In 2013, volume fell a small amount further. But I was interested to see that in 2014, NYSE volumes look to be just about exactly the same as they were in 2013 – for the first time in a long while, volumes have not declined.
But what was even more interesting to me was the pattern of volume over the course of the year. I put together the following chart to compare the rolling-20-trading-day volume for last year and this year.
You can easily see the increase in volume in the “taper tantrum” of May/June 2013, and the summer lull in both years. You can also see how volumes recovered in September and then fade into year end. But what stands out is how the summer was significantly quieter than in 2013, but since the end of September volumes have been quite high.
For fun, I decided to look at the data for 2006-2013 in its entirety (that’s all the data that I have). For each day, I computed the share of the year’s total volume and then averaged that across all eight years. By taking percentage of the total, I removed any tendency to overweight 2006’s much higher volume compared to 2013…it was the pattern I was looking for. Then, I computed a rolling-20-day sum. The line in blue below is the percentage of the year’s volume represented by any 20-day window ending on the day in question (since there are roughly 12.5 such windows in a year, we would expect 8% = 1/12.5 in a steady line if there was no seasonality). I then did the same thing for 2014 (but adjusting for the fact that we don’t know the year’s total volume yet).
Several things jump out as interesting. First is that there seems to be a general pattern that volumes generally decline after June. The summer volume swoon is mainly in August, there is a flurry of trading in September and early October, and then volume ebbs from there. Second, and more interesting at the moment, is that volumes in 2014 haven’t picked up just compared to 2013, but are quite a bit higher than the norm, and even quite a bit higher than for most of the rest of this year! By contrast, in 2013 the pattern was fairly normal except for the spike around the taper tantrum.
What causes me to scratch my head is the implication. There is no clear cause I can think of that would trigger a rise in equity trading volumes since mid-September. The end of the Fed’s taper was becoming clear, but I don’t know why that would trigger higher equity volumes. There haven’t been any unusual geopolitical events (at least, no more unusual than in any other year).
I am reluctant to declare this as yet another sign of a frothy and overbought equity market, with swelling participation at the highs. But I am open to the possibility.
The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.
Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.
However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.
In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.
Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.
So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).
As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility, when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.
I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.
 This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.
I guess it’s something about strong growth numbers and a tightening central bank that bonds just don’t like so much. Ten-year Treasury yields rose about 9bps today, under pressure from the realization that higher growth and higher inflation, which is historically a pretty bad cocktail for bonds, is being offset less and less by extraordinary Federal Reserve bond buying. Yields recently had fallen as the Q1 numbers doused the idea that the economic recovery will continue without incident, and as the global political and security situation deteriorated (maybe we will just say it became “less tranquil”). Nominal 10 year yields had dipped below 2.50%, and TIPS yields had reached 0.20% again. It didn’t hurt that so many were leaning on the bear case for bonds and were tortured the further bonds rallied.
Stocks, evidently, didn’t get the message that higher interest rates are more likely, going forward, than lower interest rates. They didn’t get the message that the Fed is going to be less accommodative. They didn’t even get the message that the Fed sees the “likelihood of inflation running persistently below 2 percent has diminished somewhat.” The equity markets ended flat. Sure, it has not been another banner month for the stock jockeys, but with earnings up a tepid 6% or so year/year the market is up nearly 17% so…yes, you did the math right: P/E multiples keep expanding!
My personal theory is that stocks are doing so well because Greenspan thinks they’re expensive. In an interview today on Bloomberg Television, Greenspan said that “somewhere along the line we will get a significant correction.” Historically speaking, the former Chairman’s ability to call a top has been something less than spectacular. After he questioned whether the market might be under the influence of ‘irrational exuberance,’ the market continued to rally for quite some time. Now, he wasn’t alone in being surprised by that, but he also threw in the towel on that view and was full-throatedly bullish through the latter stages of the 1990s equity bubble. So, perhaps, investors are just fading his view. Although to be fair, he did say that he didn’t think equities are “grossly overpriced,” lest anyone think that the guy who could never see a bubble might have actually seen one.
Make no mistake, there is no question that stocks are overvalued by every meaningful metric that has historical support for its predictive power. That does not mean (as we have all learned over the past few years) that the market will decline tomorrow, but it does ensure that future real returns will be punk over a reasonably-long investment horizon.
It will certainly be interesting to see how long markets can remain levitated when the Fed’s buying ceases completely. Frankly, I am a bit surprised that these valuation levels have persisted even this long, especially in the face of rising global tensions and rising inflation. I am a little less surprised that commodities have corrected so much this month after what was a steady but uninspiring move higher over the first 1-2 quarters of 2014. Commodities are simply a reviled asset class at the moment (which makes me love them all the more).
Do not mistake the Fed’s statement (that at the margin the chance of inflation less than 2% is slightly less likely) for hawkishness. And don’t read hawkishness into the mild dissent by Plosser, who merely wanted to remove the reference to time in the description of when raising rates will be appropriate. Chicago Fed President Evans was the guy who originally wanted to “parameterize” the decision to tighten by putting numbers on the unemployment rate and inflation levels that would be tolerable to the Fed (the “Evans Rule”)…levels which the economy subsequently blasted through without any indication that the Fed cared. But Evans himself recently said that “it’s not a catastrophe to overshoot inflation by some amount.” Fed officials are walking back the standards for what constitutes worrisome inflation, in the same way that they walked back the standards for what constitutes too-low an unemployment rate.
This is a good point at which to recall the “Wesbury Map,” which laid out the excuses the Fed can be expected to make when inflation starts being problematic. Wesbury had this list:
- Higher inflation is due to commodities, and core inflation remains tame.
- Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that’s temporary.
- It’s not actual inflation that matters, but what the Fed projects it to be.
- It’s okay for inflation to run a little above 2% for a while because it was under that level for so long.
- Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
- Well, 3-4% inflation isn’t that bad for the economy, anyway.
I think the order of these excuses can change, but they’re all excuses we can expect to hear trotted out. Charles Evans should have just shouted “FOUR!” Instead, what he actually said was
“Even a 2.4 percent inflation rate, if it’s reasonably well controlled, and the rest of the economy is doing ok, and then policy is being adjusted in order to keep that within a, under a 2.5 percent range — I think that can work out.”
That makes sense. 2.4% is okay, as long as they limit it to 2.5%. That’s awfully fine control, considering that they don’t normally even have the direction right.
Now, although the Evans speech was a couple of weeks ago I want to point out something else that he said, because it is a dangerous error in the making. He argued that inflation isn’t worrisome unless it is tied to wage inflation. I have pointed out before that wages don’t lead inflation; this is a pernicious myth. It is difficult to demonstrate that with econometrics because the data is very noisy, but it is easy to demonstrate another way. If wages led inflation, then we would surely all love inflation, because our buying power would be expanding when inflation increased (since our wages would have already increased prior to inflation increasing). We know, viscerally, that this is not true.
But economists, evidently, do not. The question below is from a great paper by Bob Shiller called “Why Do People Dislike Inflation” (Shiller, Robert, “Why Do People Dislike Inflation?”, NBER Working Paper #5539, April 1996. ©1996 by Robert J. Shiller. Available at http://www.nber.org/papers/w5539). This is a survey question and response, with the economist-given answer separated out from the answer given by real people.
Economists go with the classic answer that inflation is bad mainly because of “menu costs” and other frictions. But almost everyone else knows that inflation makes us poorer, and that very fact implies that wages follow inflation rather than lead.
Put another way: if Evans is going to be calm about inflation until wage inflation is above 3.5%, then we can expect CPI inflation to be streaking towards 4% before he gets antsy about tightening. Maybe this is why the stock market is so exuberant: although the Fed has tightened by removing the extra QE3, a further tightening is evidently a very long way off.
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).
After fairly boring trading through the first half of the month, the equity market has shot to new highs over the last few sessions. Could it be mere boredom on the part of investors, who are seeking more excitement?
Stocks have been expensive for a while, with Shiller P/Es near 25, yet the battle cry among bulls has been “but look, the trailing P/E is still low.” Although the trailing P/E recently has incorporated earnings that represented unusually high margins (see chart, source Bloomberg), the “see no evil” crowd brushed that complaint aside. But now, the trailing P/E ratio of the S&P 500 is at 17.6, and at 18.7 before the write-off of “extraordinary items” (which, while extraordinary for any given company in a given year, are not extraordinary for the index of a whole, which always has some of these write-offs).
So it isn’t as if the equity market is now rising because earnings have been rising and prices are just catching up. The trailing P/E is now at a level slightly higher than it was prior to the 2007 top, and on par with the levels of the Go-Go Sixties prior to the malaise of the 1970s (see chart, source Bloomberg). Let us not forget that earnings quality isn’t what it once was, either. And again: I am not a fan of a 1-year trailing P/E; I am merely pointing out that even this bullish argument is going away.
To be sure, trailing P/Es aren’t at the pre-crash levels of 1987 or 1999 – but, again, let us recall that margins are at cyclical highs, so that if we look at the S&P price/sales ratio, we again get a disturbing view that has equity valuations higher than at any time other than the 1999 bubble run-up. (See chart, source Bloomberg – note that Bloomberg history for this series only goes back to 1990.)
Now, some observers will draw exaggerated offense to the notion that stocks might be priced for somewhat poor forward returns, and insist that the recent rally in bonds means that the ratio of the “Earnings yield” to bond yields is merely being maintained. Aside from the fact that this “Fed model” is explanatory rather than predictive (that is, it helps explain why prices are high, while not suggesting they will remain high…and indeed, rather suggesting the opposite as future returns are inversely correlated with the P/E of the starting point of the holding period), we also can’t give credit for the equity rally to the bond market rally this year from 3% 10-year yields to 2.50% yields without simultaneously asking why investors didn’t sell stocks when yields rose from 1.70% to 3% last year.
Admittedly, I was probably saying roughly the same thing at this point last year. Sour grapes? No, it just concerns the question of investing rules versus trading rules. In other words: I’m not telling you how to vote; I’m telling you how to weigh. Nothing has changed valuation-wise since last year, other than the fact that the market as a whole is growing more expensive.
On the “good news” front, corporate credit growth has been re-accelerating again. This is somewhat of a sine qua non for faster economic growth. We had seen decent credit growth in 2011 and into 2012, but when QE3 kicked off loan activity had ebbed. But now quarterly growth in commercial credit is nearing a 10% annual rate (see chart, source Board of Governors), something that hasn’t happened since the beginning of 2008 – other than for a brief spike around the crisis itself.
While this is good news, it is not unmitigated good news considering that the Federal Reserve as yet has no viable plan for exiting QE before all of those horses leave the barn. One of the biggest concerns, in terms of a risk of unpleasant surprise, is that few seem to be giving the inflation risk much thought, either in markets where 10-year inflation swaps float in the middle of the 2.40%-2.60% range they have occupied for the last twelve months, or in policymaker circles. This is on my mind today because I was reading an article published on the BLS website entitled “One hundred years of price change: the Consumer Price Index and the American inflation experience” and ran across this passage:
“Why the return of inflation when it seemed to be guarded against and feared? One possibility is a change in the perspective of policymakers. Some have argued that inflation was tempered in the 1950s by a Federal Reserve that, believing that inflation would reduce unemployment in the short term but increase it in the long term, was willing to contract the economy to prevent inflation from growing. By the 1960s, however, the notion of the Phillips curve, a straightforward tradeoff between inflation and unemployment, ruled the day. Citing the curve, policymakers believed that unemployment could be permanently reduced by accepting higher inflation. This view led to expansionary monetary and fiscal policies that in turn led to booming growth, but also inflationary pressures. However much policymakers professed to fear inflation, the policies they pursued seemed to reflect other priorities. The federal government ran deficits throughout the 1960s, with steadily increasing deficits starting in 1966.
Aside from the dates, it strikes me that this paragraph could have been written today. The Phillips Curve, now “augmented,” is still a key tool in the Fed economist’s toolkit even as responsible control of the money supply is deemed passé. As for accepting higher inflation the FOMC changed its inflation target a couple of years ago to be 2% on the PCE, which was implicitly a bump higher from the previous 2% CPI target since PCE is normally 0.3% or so below CPI, and various officials have mooted the idea of letting price increases exceed that rate “for a time” since expectations are well-grounded. And then, of course, you have economists like Krugman arguing for a higher inflation target. Not that we ought to pay any attention to Krugman, but somebody invited him to speak at that conference and that suggests he still has credibility somewhere.
I must say that I don’t believe in an end to history, in which a permanent and pleasant equilibrium exists in capital markets and economies, which both can continue to expand at a reasonable pace with low and fairly stable inflation and interest rates and generous profit margins. If I did believe in such a thing, then I might think that we had arrived; and then perhaps I would see equity multiples and bond yields as reasonable and sustainable. But I do not, because I have already lived through three periods where the VIX was in the 10-12 range: in the 1990s, in 2005-2007, and in 2013-2014. The first two periods produced very exciting finishes. The boredom always ends, and usually abruptly.