a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.

 

 

 

oil right now–the Iran situation

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface.  The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand.  This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector.  This suggested professional investors would be casting about for other places to invest new money.  Oil looked like a plausible alternative.

 

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio.  But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

 

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979.  As far as oil production was concerned, they were totally ineffective.  Why?  Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output.  Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different.  This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.