starting out in 2020

The S&P 500 is trading at about 25x current earnings, with 10% eps growth in prospect, implying the market is trading at around 22.7x forward earnings.  During my working career, which covers 40+ years, high multiple/lower growth has virtually always been an unfavorable combination for market bulls.

Could the growth figure be too low, on the idea that forecasters give themselves some wiggle room at the beginning of the year?

For the 50% or so of earnings that come from the US, probably not.  This is partly due to the sheer length of the expansion since the recession of 2008-09 (pent up demand from the bad years has been satisfied, even in left-behind areas of the country–look at Walmart and dollar store sales).  It’s also a function of shoot-yourself-in-the-foot Washington policies the have ended up retarding growth–tariff wars, suppression of labor force expansion, tax cuts for those least likely to consume, no infrastructure spending, no concern about education…  So I find it hard to imagine positive surprises for most US-focused firms.

Prospects are probably better for the non-US half.  How so?  In the EU early signs are emerging that structural change is occurring, forced by a long period of stagnation.  The region is also several years behind the US in recovering from the recession, so one would expect that the same uptick for ordinary citizens we’ve recently seen in the US.  Firms seeking to relocate from the US and the UK are another possible plus.  In addition, Mr. Trump’s life-long addiction to risky, superficially attractive but ultimately destructive, ventures (think:  Atlantic City casinos) may finally achieve the weaker dollar he desires–implying the domestic currency value of foreign earnings may turn out to be higher than the consensus expects.

 

The biggest saving grace for stocks may be the relative unattractiveness of fixed income, the main investment alternative.  The 10-year Treasury is yielding 1.81% as I’m writing this  That’s 10 basis points below the dividend yield on the S&P 500, which sports an earnings yield (1/PE) of 4.  I say “may” because, other than Japan, the world has little practical experience with the behavior of stocks while interest rates are ultra-low.  In Japan, where rates have flirted with zero for several decades, PE ratios have declined from an initial 50 or so into the low 20s. Yes, Japan is also the prime example of the economic destructiveness of anti-immigration, anti-trade, defend-the-status-quo policies Washington is now espousing. On the other hand, it’s still a samurai-mentality (yearning for the pre-Black Ship past) culture, the population is much older than in the US and the national government is a voracious buyer of equities.   So there are big differences.  Still, ithe analogy with Japan holds–that is, if the differences don’t matter so much in the short term–then PEs here would be bouncing along the bottom and should be stable unless the Fed Funds rate begins to rise.

That’s my best guess.

 

The consensus was of viewing last year for the S&P is that all the running was in American tech industries.   Another way of looking at the results is that the big winners were multinational firms traded in the US but with worldwide markets and very small domestic manufacturing and distribution footprints.   They are secular change beneficiaries located in a country whose national government is now adamantly opposing that change.  In other words, the winners were bets on the company but against the country.  Look at, for example,  AMZN (+15%) vs. MSFT (+60%) over the past year.

The biggest issue I see with the 2019 winners is that on a PE to growth basis they seem expensive to me.  Some, especially newer, smaller firms seem wildly so.  But I don’t see the situation changing until rates begin to rise.

 

Having said that, low rates are an antidote to government dysfunction, so I don’t see them going up any time soon.  So my practical bottom line ends up being one of the gallows humor conclusions that Wall Streeters seem to love:  the more unhinged Mr. Trump talks and acts–the threat of bombing Iranian cultural sites, which other governments have politely pointed out would be a war crime, is a good example–the better the tech sector will do.  As a citizen, I hope for a (new testament) road-to-Damascus event for him; as an investor, I know that would be a sell signal.

 

 

 

 

 

 

 

 

thinking about 2020

where we are

The S&P 500 is trading at around 25x current earnings, up from a PE of 20x a year ago.  Multiple expansion, not earnings growth, is the key factor behind the S&P rise last year.In fact, earnings per share growth, now at about +10%/year, has been decelerating since the one-time boost from the domestic corporate income tax cut cycled through income statements in 2018.  Typically earnings deceleration is a red flag.  Not so in 2019.

EPS growth in 2020 will probably be around +10% again.

About half the earnings of the S&P come from the US, a quarter from Europe and the rest from emerging economies.  The US will likely be the weakest of the three areas this year, as ongoing tariff wars take a further toll on agriculture and manufacturing, as population growth continues to wane given the administration’s hostility toward foreigners, and as multinationals continue to shift operations elsewhere to escape these policies.  On the other hand, Europe ex the UK should perk up a bit, emerging markets arguably can’t get much worse, and multinationals will likely invest more abroad.

 

interest rates:  the biggest question 

What motivated investors to bid up the S&P by 30% last year despite pedestrian eps growth and Washington dysfunction?

Investors don’t buy stocks in a vacuum.  We’re constantly comparing stocks with bonds and cash as alternative liquid investments.  And in 2019 bonds and cash were distinctly unattractive.   The yield on cash is close to zero here (elsewhere in the world bank depositors have been charged for holding cash).  The 10-year Treasury started 2019 yielding 2.66%.  The yield dipped to 1.52% during the summer and has risen to 1.92% now.  In contrast, the earnings yield (1/PE, the academic point of comparison of stocks vs. bonds)) on the S&P was 5% last January and is 4% now.

The dividend yield on the S&P is now about 1.9%.  That’s higher than the 10-year yield, a situation that has occurred in our lifetimes only after a bear market has crushed stock valuations.  In my working career, this has happened mostly outside the US and has always been a clear buy signal for stocks.  Not now, though–in my view–unless we’re willing to believe that the current situation is permanent.

The situation is even stranger outside the US, where the yield on many government bonds is actually negative.

In short, wild distortions in sovereign bond markets, a product of unconventional central bank measures aimed at rescuing the world economy after the 2008-09 collapse, have migrated into stocks.

How long will this situation last and how will it unwind?

 

more on Monday

 

 

 

 

America: a weakening brand

When I first became interested in Tiffany (TIF) as a stock years ago, one thing that stood out was that the company was doing a land office business in almost all facets of its rapid international expansion.  One exception:  the EU.  I quickly became convinced that the reason was because TIF is an American company.

For Europeans, France, Germany, Italy, and to a lesser extent the rest of the EU, are the font of all knowledge and culture.  As local literature and philosophy make clear, being situated on the sacred soil of (fill in any EU country) is the key to its superiority.  The US,  lacking requisite hallowed ground, is a semi-boorish johnny-come-lately.  Sporting a piece of jewelry from an American firm therefore implies one has suffered a devastating reversal of fortune that puts “authentic” jewelry out of reach.

 

In the rest of the world, however, the US is a symbol of aspiration.  America stands for freedom, opportunity, cutting-edge technology, the best universities and an ethos that prizes accomplishment not heritage.  It’s “all men are created equal”  “give me your …huddled masses yearning to be free” and “I am not throwing away my shot.”  Wearing, or just owning, a piece of American jewelry becomes a symbolic linking of the holder to these national values.  It hasn’t hurt, either, particularly with an older generation (paradoxically, ex the EU) that the US made a monumental effort to help heal the world after WWII.

 

The “brand” of the United States has taken a real beating since Mr. Trump has become president.  Surveys, one of which is reported in INC magazine, show a sharp drop in US prestige right after his victory and continuing deterioration since.   I don’t think the biggest negative issue is the president’s insecurities, his constant prevarication, his very weak record as a real estate developer or his (hare-brained) economic policies while in office.  I see the worst damage coming instead from his love of leaders with poor human rights records and his disdain for women and people of color …plus the whiff of sadism detectable in his treatment of both.

 

Whatever the precise cause may be, the deterioration of the America’s reputation under Mr. Trump is a very real worry for domestic consumer companies.  Damage will likely show itself in two ways:  weaker sales to foreign tourists, and the absence of positive surprises from foreign subsidiaries.  For domestic retail firms, it seems clear that economic recovery has finally come to the less wealthy parts of the US over the past year or two–witness the profit performance of Walmart or the dollar stores.  On the other hand, it seems to me that people who have trusted Mr. Trump in the past–like the banks that lent him money, the contractors who built his casinos, those who bought DJT stock and bonds, farmers who voted for him–have all ended up considerably worse off than the more wary.  So while they may be good temporary hiding places, holders should be nimble.

One final thought:  brands don’t deteriorate overnight but the cumulative damage can be enormous.  The first to react will be younger consumers, who have the least experience with/of the “old” brand.   They will be the most difficult to win back.  As well, as time passes, their views will be increasingly important in commerce.

 

 

 

shrinking bond yields ii

why look at bonds? 

If we’re stock market investors, why are we interested in bonds anyway?  It’s because at bottom we’re not really interested in stocks per se.  We’re interested in liquid publicly-traded securities–i.e., stocks, bonds and cash.  We’re interested in publicly-traded securities because we can almost always sell them in an instant, and because there’s usually enough information available about them that we can make an educated decision.

 

comparing bonds with stocks

bond yields, at yesterday’s close

One-month Treasury bills = 2.18%

Ten-year Treasury notes = 2.07%

30-year Treasury bonds = 2.57%.

S&P 500

Current dividend yield on the index = 1.7%.

 

According to Yardeni Research (a reputable firm, but one I chose because it was the first name up in my Google search), index earnings for calendar year 2019 are estimated to be about $166, earning for the coming 12 months, about $176.

Based on this, the S&P at 3000 means a PE ratio of 18.0 for calendar year 2019, and 17.0 for the 12 months ending June 2020.

Inverting those figures, we obtain an “earnings yield,” a number we can use to compare with bond yields–the main difference being that we get bond interest payments in our pockets while our notional share of company managers remains with them.

The 2019 figure earnings yield for the S&P is 5.6%; for the forward 12 months, it’s 5.8%.

the result

During my time in the stock market, there has typically been a relatively stable relationship between the earnings yield and 10-/30-year Treasury yields.  (The notable exception was the period just before the 2008-09 recession, when, as I see it, reported financials massively misstated the profitability of banks around the world.  So although there was a big mismatch between bond and stock yields, faulty SEC filings made this invisible.)

At present, the earnings yield is more than double the government bond yield.  This is very unusual.  Perhaps more significant, the yield on the 10-year Treasury is barely above the dividend yield on stocks, a level that, in my experience, is breached only at market bottoms.

Despite the apparently large overvaluation of bonds vs. stocks, there continues to be a steady outflow from US stock mutual funds and into bond funds.

the valuation gap

Using earnings yield vs coupon rationale outlined above, stocks are way cheaper than bonds.  How can this be?

–for years, part of world central banks’ efforts to repair the damage done by the financial crisis has been to inject money into circulation by buying government bonds.  This has pushed up bond prices/pushed down yields.  Private investors have also been acting as arbitrageurs, selling the lowest-yielding bonds and buying the highest (in this case meaning Treasuries).  This process compresses yields and lowers them overall.

–large numbers of retiring Baby Boomers are reallocating portfolios away from           stocks

–I presume, but don’t know enough about the inner workings of the bond market to be sure, that a significant number of bond professionals are shorting Treasuries and buying riskier, less liquid corporate bonds with the proceeds.  This will one day end in tears (think:  Long Term Capital), but likely not in the near future.

currency

To the extent that 1 and 3 involve foreigners, who have to buy dollars to get into the game, their activity puts at least some upward pressure on the US currency.  The dollar has risen by about 2.4% over the past year on a trade-weighted basis, and by about 3% against the yen and the euro.  That’s not much.  In fact, I was surprised when calculating these figures how little the dollar has appreciated, given the outcry from the administration and its pressure on the Fed to weaken the dollar by lowering the overnight money rate. (My guess is that our withdrawing from the TPP, tariff wars, and the tarnishing of our image as a democracy have, especially in the Pacific, done much more to damage demand for US goods than the currency.)

high-yielding stocks as a substitute for bonds?

I haven’t done any work, so I really don’t know.  I do know a number of fellow investors who have been following this idea for more than five years.  So my guess is that there aren’t many undiscovered bargains in this area.

 

my bottom line

I’m less concerned now about the message low bond yields are sending than I was before I started to write these posts.  I still think the valuation mismatch between stocks and bonds will eventually be a problem for both markets.  But my guess is that normalization, if that’s the right word, won’t start until the EU begins to repair the serious fissures in its structure.  Maybe this is a worry for 2020, maybe not even then.

It seems to me that the US stock market’s main economic concern remains the damage from Mr. Trump’s misguided effort to resuscitate WWII-era industries in the US.  The best defense will likely be cloud-oriented cash-generating software-based US multinationals.  (see the comments by a former colleague attached to yesterday’s post).

 

 

 

 

 

shrinking global bond yields

valuing bonds   …and stocks

Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken.  For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.

If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.

Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.

last Friday

the 10-year

Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!

Austria

Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%.  Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since.  Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.

Trumponomics

Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates.  I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration.  If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection.  One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year.  In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly.  More forethought is likely out of the question for the administration   …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.

???

I’ll happily confess that I’m not a bond expert.  For what it’s worth, I don’t like bonds, either.  But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation.  The last thing we need is higher taxation through tariffs and even more distortion of yields.

 

What would make someone want to buy the proposed Austrian century bonds anyway?

…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?

…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?

…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?

…I’m shorting negative yield bonds against this long position?

 

global/demographic/government influences on yields

aging populations…

Another general principle:  as people get older and as they get wealthier they become more risk averse.  Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.

The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years.  The remainder goes into stocks.  For example, for a 65-year old, 65% of the portfolio should be in fixed income.  (I don’t think this is a particularly good rule, but it’s simple and it is used.)

What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force.  In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds.  At the end of last year, the total was $681 billion, of which 40% was in equities.  Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.

national economic policy

For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy   …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.

The chief characteristic of expansive monetary policy is the suppression of interest rates.  The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.

 

More tomorrow.

 

 

 

 

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

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.