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.

 

 

 

discounting in the age of algorithms

what discounting is

In traditional Wall Street parlance, discounting is factoring into today’s prices the anticipated effect of expected future events.  Put another way, in the best possible case, it’s buying a stock for, say $.25 extra today, thinking that in a week, or a month or a year, news will come out that makes the stock worth $1, or $10, or $100 more than it is today.

two components

They are:

—having/developing superior information, and

–correctly gauging what effect dissemination of the news will have on the stock.

In my experience, the first of these is the easier task.  Also, the answer to the second problem will likely be imprecise.  In most cases, “The stock will go up a lot when people understand x” is good enough.

examples

In the early days of the Apple turnaround, the company launched the iPod, which ended up doubling the company’s size.  So the key to earnings growth for AAPL was the rate of increase in iPod sales.  The heart of the iPod back then was a small form factor hard disk drive.  There were only two suppliers of this component, Hitachi and Seagate (?), so publicly available information on production of the small HDDs had some use.  Much more important, however, was that there was only one supplier of the tiny spindles the disks rotated around.  And, unknown to most on Wall Street, that small Japanese firm published monthly spindle production figures, which basically revealed AAPL’s anticipated sales.

Same thing in the early 1980s.  Intel chips ran so hot that they had to be encased in ceramic packaging–for which there was only one, again Japanese, source, Kyocera.  Again, monthly production figures, in Japanese, were publicly available.

In both cases, the production figures were accurate predictors of AAPL (INTC) unit sales a few months down the road.  Production ramp-up/cutback information, again public–though not easily accessible–data, was especially useful.

Third:  Back in the days before credit card data were widely available, retail analysts used to look at cash in circulation figures that the Federal Reserve published to gauge the temper of yearend holiday spending intentions.  The fourth-quarter rally in retail stocks sometimes ended in early December if the cash figures ticked down.

In all three cases, clever analysts found leading indicators of future earnings.  As the indicators became more widely known, Wall Street would begin to trade more on the course of the indicators rather than on the actual company results.

today’s world

Withdrawal of brokerage firms from the equity research business + downward pressure on fees + investor reallocation toward index investing have made traditional active management considerably less lucrative than it was during my working career.

A common response by investment firms has been to substitute one or two economists and/or data scientists for a room full of 10k-reading securities analysts who developed especially deep knowledge of a small number of market sectors.  As far as I can see, the approach of the algorithms the economists/programmers employ isn’t much more than to react quickly to news as it’s being disseminated.  (They may also be looking for leading indicators, but, if so, I don’t see any notable success.  Having seen several failed attempts–and having worked at the one big 1950s -1970s  success in this field, Value Line–I’m not that surprised at this failure.)

My thoughts: 

–there’s never been a better time to be a contrarian.  Know a few things well and use bouts of algorithmic craziness to trade around a core position

–For anyone who is willing to spend the time watching trading during days like Wednesday there’s also lots of information to be had from how individual stocks move.  In particular, which stocks fall the most but barely rebound?   which fall a little but rise a lot when the market turns?  which are just crazy volatile?

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)

the state of play in US stocks

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.