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Low Real Yields – You Can’t Avoid Them

July 29, 2020 7 comments

Recently, 10-year real yields went to new all-time lows. Right now, they’re at -0.96%. What that means is that, if you buy TIPS, you’re locking in a loss of about 1% of your purchasing power, per year, over the next decade. If inflation goes up 2%, TIPS will return about 1%. If inflation goes up 8%, TIPS will return 7%. And so on.

With that reality, I’ve recently seen lamentations that TIPS are too expensive – who in the world would buy these real yields?!?

The answer, of course, is everybody. Indeed, if you can figure out a way to buy an asset without locking in the fundamental reality that the real risk-free rate is -1%, please let me know.

Because when you buy a nominal Treasury bond, you are buying them at a nominal interest rate that reflects a -1% real interest rate along with an expectation of a certain level of inflation. The whole point of the Fisher equation is that a nominal yield consists of (a) the real cost of money, and (b) compensation for the expected deterioration in the value of that money over time – expected inflation.[1] So look, if you buy nominal yields, you’re also getting that -1% real yield…it’s just lumped in with something else.

Well golly, then we should go to a corporate bond! Yields there are higher, so that must mean real yields are higher, right? Nope: the corporate yield is the real yield, plus inflation compensation, plus default risk compensation. Your yield is higher because you’re taking more (different) risks, but the underlying compensation you’re receiving for the cost of money is still -1%.

Commodities! Nope. Expected commodity index returns consist of expected collateral return, plus (depending how you count it) spot return and roll return. But that collateral return is just a fixed-income component…see above.

Equities, of course, have better expected returns over time not because they are somehow inherently better, but because buyers of equities earn a premium for taking on the extra risk of common equities – cleverly called the equity risk premium – over a risk-free investment.

In fact, the expected returns for all long positions in investments consist of the same basic things: a real return for the use of your money, and a premium for any risk you are taking over and above a riskless investment (the riskless investment being, we know, an inflation-linked bond and not a nominal bond). This is the whole point of the Capital Asset Pricing Model; this understanding is what gives us the Security Market Line, although it’s usually drawn incorrectly with T-bills as the risk-free asset. Here is the current market line we calculate, using our own models and with just a best-fit line in there showing the relationship between risk and return. Not that long ago, that entire line was shifted higher more or less in parallel as real interest rates were higher along with the expected returns to every asset class:

So why am I mentioning this? Because I have been hearing a lot recently about how people are buying stocks because TINA (There Is No Alternative) when yields are this low. But if the capital asset pricing model means anything, that is poor reasoning: your return to equity investment incorporates the expected real return to a riskless asset. There is an alternative to equities and equity risk; what there’s no alternative to is the level of real rates. The expected real return from here for equities is exceptionally poor – but, to be fair, so are the expected real returns from all other asset classes, and for some of the same reasons.

This is a consequence, of course, of the massive amount of cash in the system. Naturally, the more cash there is, then the worse the real returns to cash because a borrower doesn’t need to compensate you as much for the use of your money when there’s a near-unlimited amount of money out there. And the worse the real returns to cash, the worse the real returns to everything else.

You can’t avoid it – it’s everywhere. I don’t know if it’s the new normal, but it is the normal for now.


[1] Unhelpfully, the Fisher equation also notes that there is an additional term in the nominal yield, which represents compensation being taken on by the nominal bondholder for bearing the volatility in the real outcome. But it isn’t clear why the lender, and not the borrower, ought to be compensated for that volatility…the borrower of course also faces volatility in real outcomes. In any event, it can’t be independently measured so we usually just lump that in with the premium for expected inflation.

Inflation Shocks, Inflation Vol Shocks, and 60-40 Returns

Not surprisingly, there has been a lot of debate about the ultimate outcome of the current crisis in terms of causing inflation or disinflation, or even deflation. It is also not surprising that the Keynesians who believe that growth causes inflation have come down heavily on the side of deflation, at least in the initial phase of the crisis. Some nuanced Keynesians wonder about whether there will be a more-lasting supply shock against which the demand-replacement of copious governmental programs will force higher prices. And monetarists almost all see higher inflation after the initial velocity shock fades or at least levels out.

What is somewhat amazing is that there is still so much debate about whether investments in inflation-related markets and securities, such as TIPS and commodities (not just gold), make sense in this environment. A point I find myself making repeatedly is that given where inflation-sensitive markets are priced (inflation swaps price in 1% core inflation for the next 7 years, and commodities markets in many cases are near all-time lows), the potential results are so asymmetrical – heads I win, tails I don’t lose much – that it’s almost malpractice to not include these things in a portfolio. And it’s just crazy that there’s any debate about that. The chart below shows the trailing 10-year annualized real return for various asset classes, as a function of the standard deviation of annuitized real income.[1]

Most of the markets fall along a normal-looking curve in which riskier markets have provided greater returns over time. No guarantee of course – while expectations for future returns ought to be upward-sloping like this, ex post returns need not be – and we can see that from the extreme deviations of EAFE and EM stocks (but not bonds!) and, especially, commodities. Wow! So if you’re just a reversion-to-the-mean kind of person, you know where you ought to be.

Now, that’s true even if we completely ignore the state of play of inflation itself, and of the distribution of inflation risks. Let’s talk first about those risks.  One of the characteristics of the distribution of inflation is that it is asymmetric, with long tails to the upside and fairly truncated tails to the downside. The chart below illustrates this phenomenon with rolling 1-year inflation rates since 1934. Just about two-thirds of outcomes in the US were between 0% and 4% (63% of total observations). Of the remaining 37%, 30% was higher inflation and 7% was deflation…and the tails to the high side were very long.

This phenomenon should manifest in pricing for inflation-linked assets that’s a little higher than implied by a risk-neutral expectation of inflation. That is, if people think that 2% inflation is the most likely outcome, we would expect to see these assets priced for, say, 2.5% because the miss on the high side is potentially a lot worse than a miss on the low side. This makes the current level of pricing of inflation breakevens from TIPS even more remarkable: we are pricing in 1% for the better part of a decade, and so the market is essentially saying there is absolutely no chance of that long upward tail. Or, said another way, if you really think we’ll average 1% inflation for the next decade, you get that tail risk for free.

Finally, there’s the really amazing issue of how traditional asset classes perform with even modest inflation acceleration. Consider the performance of the classic “60-40” mix (60% stocks, 40% bonds) when inflation is stable, compared to when it rises just a little bit. The following table is based on annual data from NYU’s Aswath Damodaran found here.

Note that these are not real returns, which we would expect to be worse when inflation is higher; they are nominal returns. 60-40 is with S&P 500, dividends reinvested and using Baa corporate bonds for the bond component. And they’re not based on the level of inflation. I’ve made the point here many times that equities simply do poorly when inflation is high, and moreover 60-40 correlations tend to be positive (on this latter point see here). But even I was surprised to see the massive performance difference if inflation accelerates even modestly. Regardless of how you see this crisis playing out, these are all important considerations for portfolio construction while there is, and indeed because there is, considerable debate about the path for inflation. Because once there is agreement, these assets won’t be this cheap any more.


[1] Credit Rob Arnott for an observation, more than a decade ago, that an inflation-adjusted annuity for a horizon is the true riskless asset against which returns over that horizon should be measured. The x-axis here is the volatility of the return stream compared with such a (hypothetical) annuity. This is important because it illustrates that TIPS, for example, are lots less volatile in real space – the one we care about – than are Treasuries.

Categories: Investing, Stock Market, TIPS

Half-Mast Isn’t Half Bad

April 28, 2020 1 comment

As I watch the stock market, implausibly, rise to levels no one expected so soon after the crash, I am also sickened by the cheerleading from those whose fortunes – not to mention egos – are wrapped up in the level at which the Dow trades. Stock market fetishism always fascinates me as much as it repels me. Although my experience as a trader (and a short-term options trader, at that) would seem to suggest otherwise, my makeup is as a long-term investor. I want to buy value, and the mathematics of investing for me is that I want (a) high intrinsic value at (b) a low price. While people who are buy-and-hold investors of a certain age clearly benefit from higher prices, young investors clearly benefit from lower prices since they’re going to be net buyers for a long time. And the price at which you acquire intrinsic value matters. So does the price at which you sell, but not until you sell.

So to me, there’s nothing great about a price that’s high relative to intrinsic value, unless I am preparing to sell. In a broader sense, the idea that we should cheer for higher prices (as opposed to higher intrinsic values) is not only unseemly, but destructive and I’ll explain why in a minute. I will note that the fascination with watching prices ticking every second goes back a long ways: you can read in Reminiscences of a Stock Operator about the bucket shops of the early 1900s where speculators would watch and trade the stock market tape. The general increase in investor twitchiness and short-termism that has accompanied the growth of financial news TV, online investing, and the development of ETFs to trade broad market exposures intraday certainly adds numbers to the cheerleading crowd. But it isn’t new. Depressing, but not new.

The most fascinating example of this belief in the (non-intuitive, to me) connection between the value of the stock market and the value of ‘Merica was presented to me in the aftermath of 9/11. When we first trudged back to lower Manhattan, there were people handing out these cards:

Fight Osama! Buy Cisco! I never did see the connection, and it seemed to me at the time either delusional (the terrorists win if my investment in Lucent goes down) or nakedly self-serving. Certainly the way I feel about my country has nothing to do with where I’m able to buy or sell eBay today. And actually, they really weren’t coming for our 401(k)s, they were coming for our lives. But I digress.

The point I actually want to make is that when the Fed works to stabilize market prices, they’re having a negative effect by destabilizing economic variables. An analogy from manufacturing might be an entry point to this explanation: a truism in manufacturing is that you can stabilize inventory, or you can stabilize production, but you can’t stabilize both (unless your customers are accommodating and provide very smooth demand). If you want to stabilize inventory levels, then you need to produce more when business is high and less when business is low, so you’re on the production roller-coaster. If you want to keep production level, then inventory will be low when business is high and high when business is low, so you’re on the inventory roller-coaster. Only if business itself is stable – which is rare – can you do both.

A similar thing happens in capital markets. You can stabilize the cost of capital, but then you destabilize growth rates. Or you can stabilize growth rates, and the cost of capital (stock and bond prices) will fluctuate. This is true unless you can do away with the business cycle. If you choose, as the Fed has in recent years, to try and stabilize market prices at very high levels (stabilizing the cost of capital at very low levels), then when underlying activity is strong you’ll get a ton of speculative investment in capacity, new ventures that depend on the availability of cheap capital, and strong growth. And then when economic activity heads lower, you’ll find that lots of businesses go bust and the recession is deeper. In fact, it’s not just the speculative businesses that go bust, but the overbuilding in the expansion can cause even prudent enterprises to have more difficulties in the downturn.

The Fed’s historical response to this has been to let the speculative activity happen when the cost of capital is held too low, but not let companies go bust when economic activity wanes…so they lower the cost of capital even further.

I’m obviously not the first person to point out that the Fed’s constant intervention has deleterious effects and tends to increase the amplitude of boom and bust. And, for what it’s worth, I’m not blaming the current recession on the Fed. Clearly, the proximate cause of this recession was COVID-19 and the global economic shutdown. What made it worse was that the Fed, by holding down the cost of capital, had previously precipitated the development and preserved the success of many more speculative enterprises. And the fetishism about stock prices, and about how important it is to have lots of money “working for you” in the stock market, is also one of the reason that people don’t save enough.

Of course, right now is probably not the time for the Fed and Congress to pull back and let huge numbers of people and companies go bankrupt. There’s a case to be made for the sort of government response we are having in this episode, in which personal income is being replaced by money creation while workers are ordered to stay home. There will be a piper to pay for that policy – a loss of price stability which is a consequence of trying to preserve output stability, but a consequence that it’s arguably acceptable to pay. Afterwards, though, I hope that central banks can start to let natural rhythms replace the autocratic ones. I am not hugely optimistic on that score, but one place to start is this: stop lowering the bar for central banks to intervene in markets. Stop targeting equity prices and interest rates. It’s okay to let the Dow trade at half-mast, and the bull will come back without the Fed’s help.

In fact, if we don’t keep trying to artificially increase the length of the mast, the Dow might never need to trade down to half-mast in the first place. Certainly, intrinsic values don’t retrace 50% in a recession!

The Downside of Balancing US-China Trade

January 18, 2019 Leave a comment

The rumor today is that China is going to resolve the trade standoff by agreeing to balance its trade with the US by buying a trillion dollars of goods and services over the next four years. The Administration, so the rumor goes, is holding out for two years since that will look better for the election. They should agree to four, because otherwise they’re going to have to explain why it’s not working.

I ascribe approximately a 10% chance that the trade balance with China will be at zero in four years. (I’m adjusting for overconfidence bias, since I think the real probability is approximately zero.) But if it does happen, it is very bad for our financial markets. Here’s why.

If China buys an extra trillion dollars’ worth of US product, where do they get the dollars to do so? There are only a few options:

  1. They can sell us a lot more stuff, for which they take in dollars. But that doesn’t solve the trade deficit.
  2. They can buy dollars from other dollar-holders who want yuan, weakening the yuan and strengthening the dollar, making US product less competitive and Chinese product more competitive globally. This means our trade deficit with China would be replaced by trade deficits with other countries, again not really solving the problem.
  3. They can use the dollars that they are otherwise using to buy financial securities denominated in dollars, such as our stocks and bonds.

The reality is that it is really hard to make a trade deficit go away. Blame the accountants, but this equation must balance:

Budget deficit = trade deficit + domestic savings

If the budget deficit is very large, which it is, then it must be financed either by running a trade deficit – buying more goods and services from other countries than they buy from us, stuffing them with dollars that they have no choice but to recycle into financial assets – or by increased domestic savings. So, let’s play this out and think about where the $500bln per year (the US trade deficit, roughly, with the rest of the world) is going to come from. With the Democrats in charge of Congress and an Administration that is liberal on spending matters, it seems to me unlikely that we will see an abrupt move into budget balance, especially with global growth slowing. The other option is to induce more domestic savings, which reduces domestic consumption (and incidentally, that’s a counterbalance to the stimulative growth effect of an improving trade balance). But the Fed is no longer helping us out by “saving” huge amounts – in fact, they are dis-saving. Inducing higher domestic savings would require higher market interest rates.

The mechanism is pretty clear, right? China currently holds roughly $1.1 trillion in US Treasury securities (see chart, source US Treasury via Bloomberg).

China also holds, collectively, lots of other things: common equities, corporate bonds, private equity, US real estate, commodities, cash balances. Somewhere in there, they’ll need to divest about a trillion dollars’ worth to get a trillion dollars to buy US product with.

The effect of such a trade-balancing deal would obviously be salutatory for US corporate earnings, which is why the stock market is so ebullient. But it would be bad for US interest rates, and bad for earnings multiples. One of the reasons that financial assets are so expensive is that we are force-feeding dollars to non-US entities. To the extent that we take away that financial inflow by balancing trade and budget deficits, we lower earnings multiples and raise interest rates. This also has the effect of inducing further domestic savings. Is this good or bad? In the long run, I feel reasonably confident that having lower multiples and more-balanced budget and trade arrangements is better, since it lowers a source of economic leverage that also (by the way) tends to increase the frequency and severity of financial crack-ups. But in the short run…meaning over the next few years, if China is really going to work hard to balance the trade deficit with the US…it means rough sledding.

As I said, I give this next-to-no chance of China actually balancing its trade deficit with us. But it’s important to realize that steps in that direction have offsetting effects that are not all good.

What’s Bad About the Fed Put…and Does Powell Have One?

January 8, 2019 3 comments

Note: Come hear me speak this month at the Taft-Hartley Benefits Summit in Las Vegas January 20-22, 2019. I will be speaking about “Pairing Liability Driven Investing (LDI) and Risk Management Techniques – How to Control Risk.” If you come to the event I’ll buy you a drink. As far as you know.

And now on with our irregularly-scheduled program.


Have we re-set the “Fed put”?

The idea that the Fed is effectively underwriting the level of financial markets is one that originated with Greenspan and which has done enormous damage to markets since the notion first appeared in the late 1990s. Let’s review some history:

The original legislative mandate of the Fed (in 1913) was to “furnish an elastic currency,” and subsequent amendment (most notably in 1977) directed the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” By directing that the Federal Reserve focus on monetary and credit aggregates, Congress clearly put the operation of monetary policy a step removed from the unhealthy manipulation of market prices.

The Trading Desk at the Federal Reserve Bank of New York conducts open market operations to make temporary as well as permanent additions to and subtractions from these aggregates by repoing, reversing, purchasing, or selling Treasury bonds, notes, and bills, but the price of these purchases has always been of secondary importance (at best) to the quantity, since the purpose is to make minor adjustments in the aggregates.

This operating procedure changed dramatically in the global financial crisis as the Fed made direct purchase of illiquid securities (notably in the case of the Bear Stearns bankruptcy) as well as intervening in other markets to set the price at a level other than the one the free market would have determined. But many observers forget that the original course change happened in the 1990s, when Alan Greenspan was Chairman of the FOMC. Throughout his tenure, Chairman Greenspan expressed opinions and evinced concern about the level of various markets, notably the stock market, and argued that the Fed’s interest in such matters was reasonable since the “wealth effect” impacted economic growth and inflation indirectly. Although he most-famously questioned whether the market was too high and possibly “irrationally exuberant” in 1996, the Greenspan Fed intervened on several occasions in a manner designed to arrest stock market declines. As a direct result of these interventions, investors became convinced that the Federal Reserve would not allow stock prices to decline significantly, a conviction that became known among investors as the “Greenspan Put.”

As with any interference in the price system, the Greenspan Put caused misallocation of resources as market prices did not truly reflect the price at which a willing buyer and a willing seller would exchange ownership of equity risks, since both buyer and seller assumed that the Federal Reserve was underwriting some of those risks. In my first (not very good) book Maestro, My Ass!, I included this chart illustrating one way to think about the inefficiencies created:

The “S” curve is essentially an efficient frontier of portfolios that offer the best returns for a given level of risk. The “D” curves are the portfolio preference curves; they are convex upwards because investors are risk-averse and require ever-increasing amounts of return to assume an extra quantum of risk. The D curve describes all portfolios where the investor is equally satisfied – all higher curves are of course preferred, because the investor would get a higher return for a given level of risk. Ordinarily, this investor would hold the portfolio at E, which is the highest curve he/she can achieve given his/her preferences. The investor would not hold portfolio Q, because that portfolio has more risk than the investor is willing to take for the level of expected return offered, and he/she can achieve a ‘better’ portfolio (higher curve) at E.

But suppose now that the Fed limits the downside risk of markets by providing a ‘put’ which effectively caps the risk at X. Then, this investor will in fact choose portfolio Q, because portfolio Q offers higher return at a similar risk to portfolio E. So the investor ends up owning more risky securities (or what would be risky securities in the absence of the Fed put) than he/she otherwise would, and fewer less-risky securities. More stocks, and fewer bonds, which raises the equilibrium level of equity prices until, essentially, the curve is flat beyond E because at any increment in return, for the same risk, an investor would slide to the right.

So what happened? The chart below shows a simple measure of expected equity real returns which incorporates mean reversion to long-term historical earnings multiples, compared to TIPS real yields (prior to 1997, we use Enduring Investments’ real yield series, which I write about here). Prior to 1987 (when Greenspan took office, and began to promulgate the idea that the Fed would always ride to the rescue), the median spread between equity expected returns and long-term real yields was about 3.38%. That’s not a bad estimate of the equity risk premium, and is pretty close to what theorists think equities ought to offer over time. Since 1997, however – and here it’s especially important to use median since we’ve had multiple booms and busts – the median is essentially zero. That is, the capital market line averages “flat.”

If this makes investors happy (because they’re on a higher indifference curve), then what’s the harm? Well, this put (a free put struck at “X”) is not costless even though the Fed is providing it for free. If the Fed could provide this without any negative consequences, then by all means they ought to because they can make everyone happier for free. But there is, of course, a cost to manipulating free markets (Socialists, take note). In this case the cost appears in misallocation of resources, as companies can finance themselves with overvalued equity…which leads to booms and busts, and the ultimate bearer of this cost is – as it always is – the citizenry.

In my mind, one of the major benefits that Chairman Powell brought to the Chairmanship of the Federal Reserve was that, since he is not an economist by training, he treated economic projections with healthy and reasonable skepticism rather than with the religious faith and conviction of previous Fed Chairs. I was a big fan of Powell (and I haven’t been a big fan of many Chairpersons) because I thought there was a decent chance that he would take the more reasonable position that the Fed should be as neutral as possible and do as little as possible, since after all it turns out that we collectively suck when it comes to our understanding of how the economy works and we are unlikely to improve in most cases on the free market outcome. When stocks started to show some volatility and begin to reprice late last year, his calculated insouciance was absolutely the right attitude – “what Fed put?” he seemed to be saying. Unfortunately, the cost of letting the market re-adjust is to let it fall a significant amount so that there is again an upward slope between E and Q, and moreover let it stay there.

The jury is out on whether Powell does in fact have a price level in mind, or if he merely has a level of volatility in mind – letting the market re-adjust in a calm and gentle way may be acceptable to him, with his desire to intervene only being triggered by a need to calm things rather than to re-inflate prices. I’m hopeful that is the case, and that on Friday he was just trying to slow the descent but not to arrest it. My concern is that while Powell is not an economist, he did have a long career in investment banking, private equity, and venture capital. That might mean that he respects the importance of free markets, but it also might mean that he tends to exaggerate the importance of high valuations. Again, I’m hopeful, and optimistic, on this point. But that translates to being less optimistic on equity prices, until something like the historical risk premium has been restored.

Spinning Economic Stories

January 4, 2019 5 comments

As economists[1] we do two sorts of things. We do quantitative work, and we tell stories.

One of the problems with economics is that we aren’t particularly regimented about how we convert data into stories and about how we look at stories to decide how to interrogate the data. So what tends to happen is that we have a phenomenon and then we look at what story we like and decide if that’s a reasonable way to explain the data…without asking if there isn’t a more reasonable way to explain the data, or at least another way that’s equally consistent with the data. I’m not saying that everyone does this, just that it’s disturbingly common especially among people being paid to be storytellers and for whom a good story is really important.

So for example, there is a well -known phenomenon that inflation tends to accelerate after the Fed begins raising interest rates.[2] Purporting to explain this phenomenon, here is a popular story that the Fed is just really smart, so they’re ahead of inflation, and when they seeing it moving up just a little bit they can jump on it real quick and get ahead of it and so inflation goes up…but the apparent causality is there because we just knew it was going to go up and acted before the observation of the higher inflation happened. This is basically Keynesian theory combined with “brilliant person” theory.

There is another theory that is consistent with this, of course: monetarism, which explains that increasing interest rates actually causes inflation to move higher, by causing velocity to increase. But, because this isn’t the popular story, this doesn’t get matched up to the data very frequently. In my mind it’s a better theory, because it doesn’t require us to believe that the Fed is super brilliant to make it work. (And, not to get snarky, but the countervailing evidence versus Fed staff economist genius is pretty mountainous). Of course, economists – and the Fed economists in particular – like theories that make them look like geniuses, so they prefer the prior explanation.

But again, as economists we don’t have a good and rigorous way to say that one way is the ‘preferred’ story or to look at other stories that are consistent with our data. We tend to look at what part of the data supports our story – in other words, confirmation bias.

Why this is relevant now is that the Fed is in fact tightening and inflation is in fact heading higher, and the story being pushed by the Fed and some economists is “good thing the Fed is tightening, because it looks like inflation was going up!” The story on the other hand that I have been telling for quite some time (and which I write about in my book) is that it’s partly because the Fed is tightening and interest rates are going up that that inflation is rising, in a feedback loop that is missed in our popular stories. The important part is the next chapter in the story. In the “Fed is getting ahead of it” story, inflation comes down and the Fed is able to stop tightening, achieving a soft landing. In the “rate increase is causing velocity to rise and inflation to rise” story, the Fed keeps chasing the dog which is only running because the Fed is chasing it.

There is another alternative, which really excites the stock market as evidenced by today’s massive – although disturbingly low-volume – rally. That story is that the Fed is going to become more “data dependent” (Chairman Powell suggested something along these lines today), which is great because the Fed has already won on inflation and growth is still okay. So the Fed can stop the autopilot rate hikes. This story unfortunately does require a little suspension of disbelief. For one thing, today’s strong Employment report (Payrolls 370k, including revisions, compared to 184k expectations) is unfortunately a December figure which means it has huge error bars. Moreover, the Unemployment Rate rose to 3.9% from 3.7%, and while a higher Unemployment Rate doesn’t mean the economy is definitely slowing (it could just be that more people are looking for jobs because the job market is so robust – another fun story), it is certainly more consistent with the notion that the economy is slowing at the margin. The fact that the Unemployment Rate went up, while Hourly Earnings rose more than expected and Jobs rose more than expected, should make you suspect that year-end quirkiness might have something to do with the figures. For the decades I’ve watched economic data, I always advise ignoring the January and February Employment Reports since the December/January changes in payroll are so large that the noise swamps the signal. But professional storytellers aren’t really content to say “this doesn’t really mean anything,” even if that’s the quantitative reality. They get paid to spin yarns, so spin yarns they do.

Yeah, about those wages: I’m not really sure why economists were expecting hourly earnings to decelerate this month. All of the anecdotal data, along with other wage measures, are suggesting that wages are rising apace (see chart, source Bloomberg, showing the Atlanta Fed Wage Tracker vs AHE). Not really a surprise, even given its compositional challenges, that AHE is also rising.

The thing about all of these stories is that while they can’t change the actual reality, they can change how reality is priced. This is one of the reasons that we get bubbles. The stories are so powerful that trading against them, with a ‘value’ mindset for example, is quixotic. Ultimately, in the long run, the value of the equity market is limited by fundamentals. But in the short run, it is virtually unlimited because of valuation multiples (price as a speculative multiple of fundamental earnings, e.g.) and those valuation multiples are driven by stories. And that’s a big reason that bullish stories are so popular.

But consider this bearish footnote on today’s 3.4% S&P rally: volume in the S&P constituents today was lower than the volume was on December 26! To be fair, the volume yesterday, when the S&P declined 2.5%, was even a bit lower than today’s volume. It’s typical thin and whippy first-week-of-the-year trading. Let’s see what next week brings.


[1] People occasionally ask me why I didn’t go on for my MA or PhD in Economics. I reply that it’s because I learned my Intermediate Microeconomics very well: I stopped going for a higher degree when the marginal costs outweighed the marginal benefits. When you look at it that way, it makes you wonder whether the PhD economists aren’t just the bad students who didn’t absorb that lesson.

[2] It’s referred to as the “price puzzle”; see Martin Eichenbaum, “Interpreting Macroeconomic Time Series Facts: The Effects of Monetary Policy: Comments.” European Economic Review, June 1992. And Michael Hanson, “The ‘Price Puzzle’ Reconsidered,” Journal of Monetary Economics, October 2004.

Developed Country Demographics are Inflationary, not Deflationary

July 17, 2018 4 comments

I’m a relatively simple guy. I like simple models. I get suspicious with models that seem overly complicated. In my experience, the more components you add to a model the more likely it is that one of them ceases having explanatory power and messes up your model’s value. In this it is like (since tonight is Major League Baseball’s All-Star Game I thought I’d use a baseball analogy) bringing in relievers to a game. Every reliever you bring in has some chance that he just doesn’t have it tonight, so therefore you ought to bring in as few relievers as you can.

Baseball managers don’t seem to believe this, so they bring in as many relievers as they can. Similarly, economists don’t seem to believe the rule of parsimony. The more complexity in the model, the better (at least, for the economist’s job security).

Let’s talk about demographics and inflation.

Here’s how I think about how an aging population affects inflation:

  1. Fewer workers in the workforce implies a lower unemployment rate and higher wages, c.p.
  2. A higher retiree/active worker ratio implies lower saving, which will tend to send interest rates higher and equity prices lower, and tend to increase money velocity, c.p.
  3. A higher retiree/non-retiree ratio probably implies lower spending, c.p.

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around #3, and the idea that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. But if there’s lower spending, that doesn’t necessarily indicate a wider output gap because of #1. The best you could say about the effect on the output gap of an aging population is that it is indeterminate: potential output growth should decline because of workforce decline (potential output growth » growth in the # of workers + growth in productivity per worker), while demand growth should also decline, leading to uncertain effects on the output gap.

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MVºPQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

So, my model is simple, and you don’t need to have a lot of extraneous dynamics if you simply say: slower potential growth implies higher potential inflation, and demographics implies lower potential future growth. Qed.

One other item I would point out about the three points above: all three are negative for stock markets. If you truly believe that the dominant effects are lower spending, less savings, and higher wages the you can’t possibly think that demographics are anything other than disastrous for equity valuations in the future.

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.

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.

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