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Signs of a Top, OR that I am a Grumpy Old Man

June 20, 2018 4 comments

I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

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My Ridiculously Specific Expectation for 10-year Interest Rates

I try to stay away from making predictions. I don’t see the upside. If I am right, then yay! But after the fact, predictions often look obvious (hindsight bias) and it is hard to get much credit for them. By the same token, if I am wrong then the ex post facto viewer shakes his head sadly at my obtuseness. Sure, I can make a prediction with a very high likelihood of being true – I predict that the team name of the 2019 Super Bowl winner will end in ‘s’ – but there’s no point in that. This is one of the reasons I think analysts should in general shy away from making correct predictions and instead focus on asking the correct questions.

But on occasion, I feel chippy and want to make predictions. So now I am going to make a ridiculously specific prediction. This prediction is certain to be incorrect; therefore, I just want to observe that it would be churlish of you to criticize me for its inaccuracy either before or after the fact.

Ten-year Treasury rates will break through 3% for good on May 10, and proceed over the next six weeks to 3.53%. As of this Thursday, year/year core CPI inflation is going to be 2.2% or 2.3%, and median CPI over 2.5% and nearing 9-year highs. At that level of current inflation, 3% nominal yields simply make no sense, especially with the economy – for now – growing above trend. Two percent growth with 2.5% inflation is 4.5%, isn’t it? There is also no reason for 10-year real yields to be below 1%, so when we get to that 3.53% target it will be 1.08% real and 2.45% expected inflation (breakevens).

As I said, inflation is going up, at least through the summer (and I think quite a bit beyond), and summer is traditionally a difficult time for the bond market (although less so in recent years). So I think the selloff will end by June 28th and we will chop around in a 16bp range – roughly the average range from the last two chop periods – until September 6th. Then we will have a nice little rally to 3.18% as economic reports start to show some softness and the Q3 GDP trackers start to point to a 1-handle report. Also, Democrats will continue to lead in the generic ballot polling, prompting fears that impeachment proceedings for the President will begin once the party takes Congress in the midterm elections. Stocks will do badly for the second half of the year, partly on growth concerns, partly on interest rate concerns and the inflation outlook, and partly on fear that impeachment could damage the Trump business-friendly environment. But stocks will not do so badly so quickly as to trigger a flight-to-quality flow into bonds. Price deterioration will be steady with the S&P 500 dropping to 2329 by November 6th, when 10-year yields will be at 3.23%.

On Election Day, returns will show that voters booted out a lot of Republicans, but a surprising number of old guard Democrats also lose their seats. The House flips to the Democrats, while Republicans retain a slim edge in the Senate. The Democrats surprise everyone by not selecting Nancy Pelosi to be the Speaker of the House, signaling that they have no desire to pursue impeachment against a President whose leadership and behavior they question but against whom no actual crime is alleged. (Moreover, Democrats realize that they would rather contest for the White House in 2020 against The Donald than against some other, less lampoonable Republican). Stocks rally into year-end, but bonds begin the next leg down. By early 2019, although the economy is recording its first quarter of the as-yet-unidentified recession, the Fed continues to tighten, core inflation exceeds 3%, 10-year bonds surpass 4.25%, and stocks resume a downtrend that lasts for much of that year and takes the S&P 500 to 1908.75. The curve never inverts as the Fed keeps chasing inflation higher.

Now, if I nail even 20% of that prediction you’ll be justifiably impressed. But the point of the exercise is less about laying markers on particular outcomes and more about imagining how the bond bear market – because that is what I believe we are now in – will unfold. While I don’t know if my conjecture about how the election and the run-up thereto will hold, I do think it is likely that the midterms will cause more than the usual amount of market turbulence. And this is in the context of markets that have already rediscovered their turbulence somewhat. Now, I may also be completely wrong about inflation, but the number of signposts we are seeing these days about capacity constraints in labor markets and some product markets (and even some commodity markets) indicate to me that this inflation scare is less jump-scare and more Gothic horror novel.

We will turn the next page on that novel this Thursday when the CPI is reported. To ‘listen’ to me read a few pages about inflation, be sure to sign up for my private Twitter feed at https://premosocial.com/inflation_guypv and follow my CPI tweets live (I am also starting to put more chart packages and other content on that feed, so sign up! Only $10 per month!)

Inflation and Corporate Margins

On Monday I was on the TD Ameritrade Network with OJ Renick to talk about the recent inflation data (you can see the clip here), money velocity, the ‘oh darn’ inflation strike, etcetera. But Oliver, as is his wont, asked me a question that I realized I hadn’t previously addressed before in this blog, and that was about inflation pressure on corporate profit margins.

On the program I said, as I have before in this space, that inflation has a strong tendency to compress the price multiples attached to profits (the P/E), so that even if margins are sustained in inflationary times it doesn’t mean equity prices will be. As an owner of a private business who expects to make most of the return via dividends, you care mostly about margins; as an owner of a share of stock you also care about the price other people will pay for that share. And the evidence is fairly unambiguous that inflation inside of a 1%-3% range (approximately) tends to produce the highest multiples – implying of course that, outside of that range, multiples are lower and therefore stock prices tend to adjust when the economy moves to a new inflation regime.

But is inflation good or bad for margins? The answer is much more complex than you would think. Higher inflation might be good for margins, since wage inputs are sticky and therefore producers of consumer goods can likely raise prices for their products before their input prices rise. On the other hand, higher inflation might be bad for margins if a highly-competitive product market keeps sellers from adjusting consumer prices to fully keep up with inflation in commodities inputs.

Of course, business are very heterogeneous. For some businesses, inflation is good; for some, inflation is bad. (I find that few businesses really know all of the ways they might benefit or be hurt by inflation, since it has been so long since they had to worry about inflation high enough to affect financial ratios on the balance sheet and income statement, for example). But as a first pass:

You may be exposed to inflation if… You may benefit from inflation if…
You have large OPEB liabilities You own significant intellectual property
You have a current (open) pension plan with employees still earning benefits, You own significant amounts of real estate
…especially if the workforce is large relative to the retiree population, and young You possess large ‘in the ground’ commodity reserves, especially precious or industrial metals
…especially if there is a COLA among plan benefits You own long-dated fixed-price concessions
…especially if the pension fund assets are primarily invested in nominal investments such as stocks and bonds You have a unionized workforce that operates under collectively-bargained fixed-price contracts with a certain term
You have fixed-price contracts with suppliers that have shorter terms than your fixed-price contracts with customers.
You have significant “nominal” balance sheet assets, like cash or long-term receivables
You have large liability reserves, e.g. for product liability

So obviously there is some differentiation between companies in terms of which do better or worse with inflation, but what about the market in general? This is pretty messy to disentangle, and the following chart hints at why. It shows the Russell 1000 profit margin, in blue, versus core CPI, in red.

Focus on just the period since the crisis, and it appears that profit margins tighten when core inflation increases and vice-versa. But there are two recessions in this data where profits fell, and then core inflation fell afterwards, along with one expansion where margins rose along with inflation. But the causality here is hard to ferret out. How would lower margins lead to lower inflation? How would higher margins lead to higher inflation? What is really happening is that the recessions are causing both the decline in margins and the central bank response to lower interest rates in response to the recession is causing the decline in inflation. Moreover, the general level of inflation has been so low that it is hard to extract signal from the noise. A slightly longer series on profit margins for the S&P 500 companies, since it incorporates a higher-inflation period in the early 1990s, is somewhat more suggestive in that the general rise in margins (blue trend) seems to be coincident with the general decline in inflation (red line), but this is a long way from conclusive.

Bloomberg doesn’t have margin information for equity indices going back any further, but we can calculate a similar series from the NIPA accounts. The chart below shows corporate after-tax profits as a percentage of GDP, which is something like aggregate corporate profit margins.

And this chart shows…well, it doesn’t seem to show much of anything that would permit us to make a strong statement about profit margins. Over time, companies adapt to inflation regime at hand. The high inflation of the 1970s was very damaging for some companies and extremely bad for multiples, but businesses in aggregate managed to keep making money. There does seem to be a pretty clear trend since the mid-1980s towards higher profit margins and lower inflation, but these could both be the result of deregulation, followed by globalization trends. To drive the overall point home, here is a scatterplot showing the same data.

So the verdict is that inflation might be bad for profits as it transitions from lower inflation to higher inflation (we have one such episode, in 1965-1970, and arguably the opposite in 1990-1995), but that after the transition businesses successfully adapt to the new regime.

That’s good news if you’re bullish on stocks in this rising-inflation environment. You only get tattooed once by rising inflation, and that’s via the equity multiple. Inflation will still create winners and losers – not always easy to spot in advance – but business will find a way.

You Haven’t Missed It

April 26, 2018 2 comments

A question I always enjoy hearing in the context of markets is, “Have I missed it?” That simple question betrays everything about the questioner’s assumptions and about the balance of fear and greed. It is a question which, normally, can be answered “no” almost without any thought to the situation, if the questioner is a ‘normal’ investor (that is, not a natural contrarian, of which there are few).

That is because if you are asking the question, it means you are far more concerned with missing the bus than you are concerned about the bus missing you.

It usually means you are chasing returns and are not terribly concerned about the risks; that, in turn – keeping in mind our assumption that you are not naturally contrary to the market’s animal spirits, so we can reasonably aggregate your impulses – means that the market move or correction is probably underappreciated and you are likely to have more “chances” before the greed/fear balance is restored.

Lately I have heard this question arise in two contexts. The first was related to the stock market “correction,” and on at least two separate occasions (you can probably find them on the chart) I have heard folks alarmed that they missed getting in on the correction. It’s possible, but if you’re worried about it…probably not. The volume on the bounces has diminished as the market moves away from the low points, which suggests that people concerned about missing the “bottom” are getting in but rather quickly are assuming they’ve “missed it.” I’d expect to see more volume, and another wave of concern, if stocks exceed the recent consolidation highs; otherwise, I expect we will chop around until earnings season is over and then, without a further bullish catalyst, the market will proceed to give people another opportunity to “buy the dip.”

The other time I have heard the angst over missing the market is in the context of inflation. In this, normal investors fall into two categories. They’re either watching 10-year inflation breakevens now 100bps off the 2016 lows and 50bps off the 2017 lows and at 4-year highs (see chart, source Bloomberg) and thinking ‘the market is no longer cheap’, or they just noticed the well-telegraphed rise in core inflation from 1.7% to 2.1% over the last several months and figuring that the rise in inflation is mostly over, now that the figure is around the Fed’s target and back at the top of the 9-year range.

Here again, the rule is “you didn’t miss it.” Yes, you may have missed buying TIPS 100bps cheap to fair (which they were, and we pointed it out in our 2015Q3 Quarterly Inflation Outlook to clients), but breakevens at 2.17% with median inflation at 2.48% and rising (see chart, source Bloomberg), and still 25bps below where breakevens averaged in the 5 years leading up to the Global Financial Crisis, says you aren’t buying expensive levels. Vis a vis commodities: I’ve written about this recently but the expectations for future real returns are still quite good. More to the point, inflation is one of those circumstances where the bus really can hit you, and concern should be less about whether you’ve missed the gain and more about whether you need the protection (people don’t usually lament that they missed buying fire insurance cheaper, if they need fire insurance!).

(In one way, these two ‘did I miss it’ moments are also opposites. People are afraid of missing the pullback in stocks because ‘the economy still looks pretty strong,’ but they’re afraid they missed the inflation rally because ‘the economy is going to slow soon and the Fed is tightening and will keep inflation under control.’ Ironically, those are both wrong.)

My market view is this:

  • For some time, TIPS have been very cheap to nominal bonds, but rich on an absolute Negative real yields do not a bargain make, even if they look better than other alternatives when lots of asset classes are even more expensive. But as real yields now approach 1% (70bps in 5y TIPS, 80bps in 10y TIPS), and with TIPS still about 35bps cheap to nominal bonds, they are beginning to be palatable to hold on their own right. And that’s without my macro view, which is that over the next decade, one way or the other, inflation protection will become an investment theme that people tout as a ‘new focus’ even though it’s really just an old focus that everyone has forgotten. But the days of <1% inflation are over, and we aren’t going to see very much <2% either. We may not see 4% often, or for long, but at 3% inflation is something that people need to take into account in optimizing a portfolio. I think we’re at that inflection point, but if not then we will be in a year or two. And TIPS are a key, and liquid, component of smart real assets portfolios.
  • Stocks have been outrageously expensive with very poor forward return expectations for a long time. However, these value issues have been overwhelmed by strong momentum (that, honestly, I never gave enough credit to) and the currently in-vogue view that momentum is somehow better than value. But perennially strong momentum is no longer a foregone conclusion. Momentum has stalled in the stock market – the S&P has broken the 50-day, 100-day, and (a couple of times, though only briefly so far) 200-day moving averages. The 50-day has now crossed below the 100-day. And the longer that the market chops sideways the weaker the momentum talisman becomes. Eventually, the value anchor will take over. There may be more chop to come but as I said above, I think another leg down is likely to come after earnings season.

And so, in neither case have you “missed it.”

What Has Changed (but Only a Little)

February 8, 2018 1 comment

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed. Also note that next Wednesday my real-time tweets around the CPI report will only be available to subscribers!


A ten percent decline in stocks is not exactly a big deal. Perhaps it feels like a big deal because 10% in one week is somewhat dramatic, but then so is +7% in one month, on top of already-richly-valued markets, in the grand scheme of things. But can we put this in perspective?

Oh dear! How awful!

I pointed out on Monday that saying “nothing has changed in the economy – it’s still strong” is useless pablum if we are entering a bear market. But it’s useful to remember that over a one-week period, literally almost nothing changes about the backdrop. We have no new information on inflation, not much new information on earnings, not much new on the interest rate cycle. Bob Shiller won a Nobel prize in part for pointing out that market volatility is very much higher than can be explained by changes in underlying fundamentals, so this shouldn’t be a surprise. What does change when the market move is expectations for forward returns. When prices are lower, future expected returns are higher, and vice-versa. (This is why anyone under 40 years old, for whom the lion’s share of their investing life is in front of them, should be totally cheering for a massive market rout: that would imply they have the opportunity to invest at lower prices).

So let’s look at how those forward returns look now, and how they have changed. Of course, we look at these things every day, and every day develop a forecast of expected real returns across a number of asset classes. A subset of these is shown below, for prices as of January 26th: the day of the market high.

On January 26th, our expectations for the annualized 10-year real return for equities was -0.39%. In other words, we expected investors to underperform inflation by about 40bps per year on average over the next decade. 10-year TIPS yields were at 0.57%, and we expected commodity indices to return about 1.57% per annum. So, commodities had an advantage of about 2% per year over equities – plus some inflation-protection beta to boot. Expected commodities returns have been fairly stagnant, actually, because while the indices have rallied (implying lower future spot commodity returns) they have also gotten a push from higher interest rates and carry. (I wrote in mid-January about “Why Commodities Are a Better Bet These Days” and that’s worth reviewing.)

After the debacle of the last ten days or so, here is where our expected returns stand, as of the close on February 8th:

The expected total real return to equities over the next decade is now positive, if only barely. Our model has equity expected real returns at 0.35% per annum over the next decade, compared to 0.74% for TIPS (so the equity risk premium is still negative, though less so) and 2.33% for commodities (higher interest rates and lower spot prices have helped there). Again, these are entirely model-based, not discretionary. It is interesting that the premium for commodity index investing is still about 2% over stocks. Also interesting is that the slope of the risk curve is steeper: in late January, you had to accept 11% more annualized real risk to get just 1% additional real return; as of today, that slope implies 7% as risky assets have cheapened up. But as recently as 2014, that slope was 3%!

A flattening of the risk/reward curve over the last half-dozen years was no accident. I’ve written over the years about the “Portfolio Balance Channel,” which is how the Fed referred to helping the economy by taking all of the safe instruments away so that people had to buy riskier assets. The result, of course, was that riskier assets got much more expensive, as they intended. (Back in July I wrote a piece called “Reversing the ‘Portfolio Balance Channel’” where I pointed out that unwinding QE implies that the Portfolio Balance Channel would eventually cause money to come out of equities and other asset classes to go into bonds.)

In my mind, an expected real return of 0.35% from stocks while TIPS yield more (with no risk at the horizon) is still not very attractive. I think the risk curve needs to steepen more, and we know that in the long run the expected return to equities and commodities should re-converge. Whether that’s from commodity returns coming down because commodity prices rally, or from equity returns going up because equity prices fall, I don’t know. But I would skew bets at the risky end of the curve to commodities, personally (it’s not like I haven’t said this before, however).

I started this article by pointing out how relatively insignificant the movement in the markets has been so far. I don’t mean, by pointing this out, that investors should therefore dive back in. No, in fact I think it is fairly likely that the decline has much further to go. Merely retracing 38% of the bull market – which is a minimum retracement in a normal Fibonacci sequence – would put the S&P back to 2030. This would also have the advantage from a techie’s standpoint of causing the decline to terminate in the range of the prior fourth wave…but I digress.[1] A decline of that magnitude would also, in conjunction with rising earnings, bring the Shiller P/E back to the low-20s – still above average, but not outrageous. And it would raise the expected 10-year real return up to around 3%, which is arguably worth investing in. It would also mean that, in real terms, the S&P 500 index would have had no net price appreciation since the peak of the tech bubble – your dividends would be your whole return, and not so bad as all that, but…that’s thin gruel for 18 years of “stocks for the long run.”


[1] Although I have used some technical analysis terms recently, I’m not really a technician. However, I recognize that many traders are, and having some knowledge of technical analysis gives one some guideposts around which a tactical plan can be formulated.

Categories: Stock Market, Technicals

Historical Context Regarding Market Cycles

February 5, 2018 4 comments

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.

Point Forecast for Real Equity Returns in 2018

January 3, 2018 2 comments

Point forecasts are evil.

Economists are asked to make point forecasts, and they oblige. But it’s a dumb thing to do, and they know it. Practitioners, who should know better, rely on these point forecasts far more than they should. Because, in economics and especially in markets, there are enormous error bars around any reasonable point forecast, and those error bars are larger the shorter-term the forecast is (if there is any mean-reversion at all). I can no more forecast tomorrow’s change in stock market prices than I can forecast whether I will draw a red card from a deck of cards that you hand me. I can make a reasonable 5-year or 10-year forecast, at least on a compounded annualized basis, but in the short term the noise simply swamps the signal.[1]

Point forecasts are especially humorous when it comes to the various year-end navel-gazing forecasts of stock market returns that we see. These forecasts almost never have fair error bars around the estimate…because, if they did, there would be no real point in publishing them. I will illustrate that – and in the meantime, please realize that this implies the forecast pieces are, for the most part, designed to be marketing pieces and not really science or research. So every sell-side firm will forecast stock market rallies every year without fail. Some buy side firms (Hoisington springs to mind) will predict poor returns, and that usually means they are specializing in something other than stocks. A few respectable firms (GMO, e.g.) will be careful to make only long-term forecasts, over periods of time in which their analysis actually has some reasonable predictive power, and even then they’ll tend to couch their analysis in terms of risks. These are good firms.

So let’s look at why point forecasts of equity returns are useless. The table below shows Enduring’s year-end 10-year forecast for the compounded real return on the S&P 500, based on a model that is similar to what GMO and others use (incorporating current valuation levels and an assumption about how those valuations mean-revert).[2] That’s in the green column labeled “10y model point forecast.” To that forecast, I subtract (to the left) and add (to the right) one standard deviation, based on the year-end spot VIX index for the forecast date.[3] Those columns are pink. Then, to the right of those columns, I present the actual subsequent real total return of the S&P 500 that year, using core CPI to deflate the nominal return; the column the farthest to the right is the “Z-score” and tells how many a priori standard deviations the actual return differed from the “point forecast.” If the volatility estimate is a good one, then roughly 68% of all of the observations should be between -1 and +1 in Z score. And hello, how about that? 14 of the 20 observations fall in the [-1,1] range.

Clearly, 2017 was remarkable in that we were 1.4 standard deviations above the 12/31/2016 forecast of +1.0% real. Sure, that “forecast” is really a forecast of the long-term average real return, but that’s not a bad place to start for a guess about next year’s return, if we must make a point forecast.

This is all preliminary, of course, to the forecast implied by the year-end figures in 2017. The forecast we would make would be that real S&P returns in 2018 have a 2/3 chance of being between -10.9% and +11.1%, with a point forecast (for what that’s worth) of +0.10%. In other words, a rally this year by more than CPI rises is still as likely as heads on a coin flip, even though a forecast of 0.10% real is a truly weak forecast and the weakest implied by this model in a long time.

It is clearly the worst time to be invested in equities since the early 2000s. Even so, there’s a 50-50 chance we see a rally in 2018. That’s not a very good marketing pitch. But it’s better science.[4]


[1] Obligatory Robert Shiller reference: his 1981 paper “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends” formulated the “excess volatility puzzle,” which essentially says that there’s a lot more noise than signal in the short run.

[2] Forecasts prior to 2009 predate this firm and are arrived at by applying the same methodology to historical data. None of these are discretionary forecasts and none should be taken as implying any sort of recommendation. They may differ from our own discretionary forecasts. They are for illustration only. Buyer beware. Etc.

[3] The spot VIX is an annualized volatility but incorporating much nearer-term option expiries than the 1-year horizon we want. However, since the VIX futures curve generally slopes upward this is biased narrow.

[4] And, I should hasten point out: it does have implications for portfolio allocations. With Jan-2019 TIPS yielding 0.10% real – identical to the equity point forecast but with essentially zero risk around that point – any decent portfolio allocation algorithm will favor low-risk real bonds over stocks more than usual (even though TIPS pay on headline CPI, and not the core CPI I am using in the table).

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