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.

the Fed’s inflation target: 2% or 3%?

There seems to me to be increasing questioning recently among professional economists about whether the Fed’s official inflation target of 2% is a good thing or whether the target should be changed to, say, 3%.

The 2% number has been a canon of academic thought in macroeconomics for a long time.  But the practical issue has become whether 2% inflation and zero are meaningfully different.  Critics of 2% point out that governments around the world haven’t been able to stabilize inflation at that level.  Rather, inflation seems to want to dive either to zero or into the minus column once it gets down that low, with all the macro problems that entails.  It’s also proving exceptionally hard to get the needle moving in the upward direction from t sub-2% starting point.  My sense is that the 3% view is gaining significant momentum because of current central bank struggles.

This is not the totally wonkish topic it sounds like at first.  A 2% inflation target or 3% actually makes a lot of difference for us as stock market investors:

–If the target is 3%, Fed interest rate hikes will happen more slowly than Wall Street is now expecting.

–At the same time, the end point for normalization of rates–having cash instruments provide at least protection from inflation–is 100 basis points higher, which would be another minus for bonds (other than inflation-adjusted ones) during the normalization process.

–Over long periods of time, stocks have tended to deliver annual returns of inflation + 6%.  If inflation is 2%, nominal returns are 8% yearly; at 3% inflation, returns are 9%.  In the first case, your money doubles in 9 years, in the second, 8 years.  This doesn’t sound like much, either, although over three decades the higher rate of compounding produces a third more nominal dollars.

Yes, the real returns are the same.

But the point is that the pain of holding fixed income instruments that have negative real yields is greater with even modestly higher inflation than with lower.  So in a 3% inflation world, investors will likely be more prone to favor equities over bonds than in a 2% one.

–Inflation is a rise in prices in general.  In a 3% world, there’s more room for differentiation between winners and losers.  That’s good for you and me as stock pickers.


demographics and interest rates

In an op-ed column in Financial Times yesterday, Gavyn Davies wrote about the effect of demographics on interest rates.  His conclusion seems to be that demographics–not cyclical factors–may be the entire story behind why interest rates can remain so low without sparking an increase in business investment.

The demographic argument has three aspects:

–the slowdown in growth of the working population means that companies need to spend less on productivity-enhancing machinery.  This means lower issuance (supply) of corporate debt finance, therefore less upward pressure on rates.  I’m not sure I buy this, but one might equally argue that the price of tech machinery always falls and arrive in a way I find more plausible at the same conclusion

–life expectancy is increasing.  Therefore workers have to save more to support themselves after they retire, thus increasing demand for bonds

–a large proportion of the population is working, meaning the number of savers is high  …and workers save more than non-workers.  This percentage will gradually decrease as the Baby Boom retires.  But for now the population is in prime saving mode.  This, again, means high demand for bonds.

According to a Federal Reserve research paper Davies cites, demographics explains basically all the downward pressure on rates since 1980.

My reaction?

I think that we’re now truly at a point of inflection with interest rates.  I’m torn between two lines of reasoning in support of that conclusion, however.

The demographic argument is effectively that the current regime of extraordinary efforts to keep interest rates low is doing more harm than good.  It hurts savers, compelling them to accept lower returns for their savings than they would get otherwise, while having no positive effect on corporate borrowers.  If anything, the current stance of world monetary authorities mere fuels speculative financial markets activity.  Therefore, extraordinary money stimulus should be removed.

On the other hand, as they say, the market doesn’t bottom until the last bull capitulates.  In the current situation, this translates into:  the economy doesn’t begin to grow more vigorously until the last growth advocate begins to despair that the turn will never come.   That demographic explanation, i.e. abandoning the conventional business-cycle view, can be seen as evidence of that despair.


I don’t expect that rates will rise quickly or that they’ll rise very much–another aspect of the demographic argument that the conventional view of the “normal” level of rates has them pegged much too high.

Initiating the process in a systematic way will, however, gradually dispel the anticipatory anxiety about rate rises currently in financial markets.  That should, if nothing else, make for smoother sailing.




the euro at $1.30–what’s a stock investor to do?

The €, which had been on a steady rise vs the US$ since spending time at around the $1.20 level two years ago, has been sliding again, after peaking at $1.39 in May.

Several related reasons:

–anemic economic growth, which has conjured up in investors’ minds the specter of deflation and begun to evoke comparisons of the EU with 1990s Japan

–political troubles with Russia and Ukraine, which have created higher uncertainty and lower trade flows, and

–further cuts in interest rates by the ECB to address the persistent economic weakness.  Today’s include a reduction in the equivalent of the Fed Funds rate from 0.15% to 0.05%, and in increase in the penalty fee for keeping deposits with the ECB (instead of lending out the money) from 0.1% to 0.2%.

The important thing for equity investors to note is that the financial markets are reacting to the bad economic developments by selling the currency rather than by selling €-denominated stocks and bonds.  The latter two have been rising in € terms, rather than falling.  The decline against the $ and £ has been about 6% since the peak in May, and about 4% against the yuan.

The currency decline will likely end up being a much larger spur to economic growth than the interest rate cut, which is all about numbers that are basically zero already.  But currency declines rearrange the focus of growth, as well as promoting growth overall.  Export-oriented and import-competing industries are relative winners: purely domestic companies, like utilities, are relative losers.   Typically, too, the currency decline comes in advance of the positive equity reaction.

So, I think it’s time to look at Continental Europe-based multinationals again.  This “good” news doesn’t apply, of course, to their UK-based counterparts, since sterling has been steady as a rock against the dollar recently.

The flip side of this coin is that US- or UK-based multinationals that have large businesses on the Continent have lost a significant amount of their near-term allure.



the European Central Bank (ECB) is now charging for overnight money storage

Yesterday, the ECB reduced interest rates across the board in he EU and pledged to provide extra financing at cheap rates for four years to banks that lend to consumers and businesses.  The real eyecatcher, however, was the central bank’s decision to reduce the rate it pays member banks on overnight deposits to -.10%.

What’s this all about?

The standard way for governments to fight economic slowdowns in the post-WWII world is to reduce interest rates until they’re substantially below the rate of inflation–and keep them there until recovery begins.  If the interest on a loan is, say, 3% and prices/salaries are rising at a 5% annual clip, the borrower is getting a 2% subsidy from the government just to take the funds and invest them.

The process is well understood and virtually always employed.

Two things are unusual about the current situation in the US and the EU.  One is that we’ve had negative real interest rates for such a long time.  In the US, for example, we’ve had negative real interest rates for over five years.  In a garden variety recession, rates might be negative for five months.

The second is what economists call the “zero bound” issue.  Conventional wisdom says that governments can’t/shouldn’t reduce nominal interest rates below zero.  This is partly because it sounds weird and the issue has seldom come up.  Mostly, though, it’s because the world has no experience with negative nominal interest rates.  The fear is that there will be unintended negative consequences of having the central bank set rates below zero.

On the other hand, there’s the quarter-century of economic stagnation in Japan to consider, where rates stayed above zero while the economy contracted slightly year after year.  Real interest rates remained strongly positive, as a result, depressing any sparks of economic progress–year after year.  Not a happy outcome.

In the case of the EU, overall prices are now rising at a mere +0.5%, with economist predicting that it is likely to contract further in coming months.  This is making Europe look increasingly like Japan circa 1990, when that country’s long-lasting malaise began.

So, the ECB has apparently concluded that negative rates don’t look so bad.

Market reaction so far seems to be that while the move has a certain shock value, rates are unlikely to move lower.  Quantitative easing, of the type now being “tapered” in the US is the likely next step.  But if so, why break the zero bound in the first place?  Maybe some idle cash now parked in euros will move elsewhere, thereby weakening the currency.  More likely, to me at least, is that someone on the ECB board needs to be convinced that all other avenues have been explored before commencing with QE.

If that’s correct, negative interest rates will remain a curiosity.  My guess is that any substantial economic impact will only come if the ECB lowers rates further into negative territory.

It’s certainly worth thinking about what might happen if the bank does so.