down by 12% 

From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium.  If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade.  That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well.  If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4%  — or 115 basis points from where it is this morning.  Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town.  PEs contract.

Stocks are not totally defenseless during a period like this.  Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong.  If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago.  So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program.  It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment.   It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive.  However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead.  This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months.  I’m assuming this trend doesn’t reverse itself, at least until the end of the summer.  But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks.  If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any  individual stock mispricing that algorithms may cause.