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The economy is healing
We know the US economy has turned the corner. At some point, activity will be strong enough that the Fed will begin to raise short-term interest rates from their intensive-care-unit level of today. (Yes, the Fed has already begun to raise the discount rate, but this has been to force the major banks back into the commercial paper market instead of dealing solely with the government.)
what happens when the fed funds rate rises?
Even though the initial move may be months off, when is less important than how high the rate is likely to go and the effect the move will have on stocks and bonds. It’s not too soon to begin thinking about any of this.
two parts to this post
–The first will be what financial theory, such as it is, says about what should happen.
–The second will be an examination of the historical record of fed funds rate increases over the past twenty-five years.
fed funds rate behavior
One of the Fed’s jobs is to help carry out our highest-level national economic objective: maximum sustainable growth with low and stable inflation. “low and stable” means nothing much higher than 2%.
This gives us our first benchmark. Under normal conditions the fed funds rate, the price of overnight interbank deposits, will be slightly positive in real terms–about .5%-1.0% higher than the target inflation rate.
If the economy is running too hot, the Fed temporarily raises the rate, both to telegraph its concern and to raise the cost of borrowing, thus slowing the economy back down. When the economy is down in the dumps, on the other hand, the Fed drops the rate below inflation to try to pep activity back up.
Today, the rate is at about .25%, meaning the economy has been in a train wreck and is barely breathing.
Where is normal, then? Assuming inflation is under control, that is, 2% or less (and I think it is), the fed funds rate should be somewhere around 2.5%-3.0%. That means that one the Fed starts upping the rate, it won’t stop until it has tacked on 200 basis points, and possibly as many as 250.
Long rates won’t rise by as much, since this isn’t bond investors’ first rodeo and thus to some degree have already priced in some of the short-term interest rise. The extent of the yield curve flattening (meaning a smaller rise in long rates than in short) remains to be seen, but the ten- and thirty-year bond yields could easily rise by 100 bp.
the effect on stocks
Strictly speaking, there is no independent demand either for stocks or for bonds. This is because, to a great extent, the two asset classes are substitutes for one another. There is demand for the more general class of long-lived investment securities, which includes both stocks and bonds.
Why is this distinction important? If stocks and bonds are more or less substitutes, then anything that changes the price of bonds also tends to change, in the same direction, the price of stocks, and vice versa.
As interest rates go up, the price of bonds goes down. So rising interest rates should exert downward pressure on stocks as well.
For government bonds, that’s the end of the story. Not so for stocks, however.
The Fed only raises interest rates when economic activity–and thus corporate profits–are expanding as well. Rising profits tend to put upward pressure on stock prices, offsetting part or all of the negative force of rising interest rates. One can at least imagine circumstances where interest rates are rising slowly enough, or profits are growing fast enough, that stock prices are either stable or have a rising bias.
One can also look at what the equilibrium relationship between stocks and bonds should be. This is usually done by comparing the interest yield on government bonds with the earnings yield on stocks. The earnings yield is typically calculated as the annual earnings per share of an index like the S&P 500 divided by the price of the index. It’s the inverse of the PE ratio.
If we assume that the 2010 earnings per share for the S&P 500 will be 85 and the index level is a bit below 1200, then the earnings yield is about 7.0%, which equates to a price earnings ratio of 1/.07, or 14.
Let’s say that as a result of the rise in fed funds to 2.75%, the ten-year bond yield increases to 5.0%.
The “right” proportion between a unit of yield in the bond market and in the stock market is a function of investor preferences and changes as they do.
If investors were indifferent to whether the earnings came from stocks or bonds (a big if, but more or less the relationship that has prevailed over the past twenty years), equilibrium would occur when the interest yield and the earnings yield were equal. A 5% long bond would imply a 20 times price earnings ratio (a 5% earnings yield) on the stock market.
Whatever the exact right number for today’s world may be, one can observe that a unit of earnings is available today much more cheaply than has historically been the case in the stock market vs. the bond market.
To sum up: increasing earnings give stocks some defensive power against rising fed funds and long-bond interest rates. Also, relative to one another, stocks are priced much more cheaply than government bonds–again arguably giving them some protection against rising rates/lower bond prices.
History Continue reading
Here’s the link–or you can just click the tab at the top of the page.
Before we start, remember what we’re trying to do.
We’re not trying to analyze (much less solve) all the world’s problems. We’re not trying to have a lot of opinions about different stuff.
We are trying to figure out what the most significant factors influencing stock market performance will be this year. We’re going to divide these factors into ones we have very strong conviction about–or, alternatively, ones we want to build into your portfolio–and the ones we don’t.
Then, we’re going to construct a portfolio that will outperform if the things we have the strongest conviction in turn out to be correct. At the same time, to the extent that we can, we’re going to neutralize (index-weight) the areas where we’re relatively clueless, so that we don’t get hurt by fooling around with things we don’t know much about.
Here’s what I think: Continue reading
Facts and figures from the 2009 stock market
The S&P 500 ended 2009 at a level of 1115. This represented a gain of 26.5% on a total return basis for the year. Capital change made up 23.5% of that and dividend payments 3%.
The median stock was up 29% or so, meaning that smaller capitalization issues outperformed their larger brethren.
Recovery from the market lows of early March was even more dramatic, with the index up 67% since then. The rise represents a reversal of about half the market losses since the highs of 2007.
S&P estimates earnings for 2010 on the 500 index at about $76, meaning the benchmark stands on a p/e ratio of 14.5x expected year-ahead results. Value Line, which uses a very different methodology in estimating a market p/e, arrives at a roughly equivalent result–one suggesting also that smaller stocks are now trading on somewhat higher p/e ratings than large caps.
The prospective dividend yield on the market is 2%.
What they imply for 2010
Multiples are no longer at the give-it-away-for-free levels of March, but they’re not really expensive, either versus history or versus other asset classes. At the moment, cash returns effectively nothing. And the stock earnings yield (the upside-down p/e that academics prefer) of 6.9% compares favorably with the 10-year Treasury coupon of 3.9% and the 30-year of 4.7% (both of which will likely rise as the year progresses).
Over the past several months, S&P has steadily been revising the $76 figure upward. If history is any guide, it will continue to do so. Why is that? Several reasons:
–the effect of operating leverage (the outsized effect on earnings of small changes in revenues) is notoriously difficult to forecast around turning points in the economy,
–analysts don’t want to look foolish by publishing numbers that turn out to be too high,
–institutional customers want conservative figures and probably won’t trust anything else,
–companies are doubtless exerting their usual pressure on analysts to conform to company “guidance” that leaves room for positive earnings surprises, and
–most earnings estimates originate in New York, the epicenter of the financial meltdown, where people are gloomier than elsewhere in the US (except possibly for the large bonus-collecting bankers who created the problems).
Editorializing aside, the first reason, operating leverage, is by far the most important factor.
If we figure that the actual eps number will end up being, say, $80, then the market is trading on under 14x earnings for 2010.
A 15% advance for the market this year?
I think it wouldn’t be at all unreasonable to think the S&P could rise by 10%-15% from here by yearend. That would mean a rough target for the market of being at 1225-1275 in December.
How the bull market has played out so far
You can find what I’ve written about bull markets in my posts from the first half of last year. In addition, I recently came across an excellent article on the subject written by Sam Stovall, the chief equity strategist for S&P. It’s short and well worth reading.
On page 6 of the article, Mr. Stovall presents a chart in which he has compiled the performance by sector of the S&P 500 in the first year of recovery from every bear market (ten of them) since World War II. He has also aggregated the results, so we can see what the average performance of sectors and the market has been.
Three points in particular stand out to me:
1. The rebound from the lows this time has been much faster than from prior bottoms. Recovery from the second oil shock, up 52% in the first year, is the closest to the 2009 performance. The average first-year bounceback was 33%.
2. Sector returns are more widely dispersed in the current return than in earlier ones, especially for sectors that have underperformed to date. For example, relative to the index return, defensive sectors have performed as follows:
——————–2009————-average bull market
Telecom -38%——————- -13%
Utilities -30%——————- -11%
Staples -24%——————– -4%
Healthcare -22%——————- flat.
Among the outperforming sectors, Materials is the only outlier. This sector is up 19% more than the index vs. a typical performance of flat. (I’ve excluded Financials from this list because of their most unusual performance during this cycle.)
Another sector I find interesting is IT, which is up a lot, but at the index +15 percentage points it is about in line with its recovery average of the index +16.
What does all this mean?
I think the numbers say that the lagging sectors are so far behind the index that at some point they are going to have to play catch up. A trader would doubtless want to overweight the laggards in hopes that a rally will come soon. My preference would be to keep these sectors at neutral weight and be prepared to underweight them if/when they show a period of relative outperformance.
I find the technology performance reassuring. IT is a sector I like, but I’ve been bothered a bit by the fact that it is fast approaching 20% of the market, a relatively large size for any sector.
Growth vs. Value
In the first year of a typical upturn, value stocks outperform growth stocks. The Stovall research shows this same pattern continuing during the current upturn. In fact, 2009 shows the sharpest outperformance for value of any bull market listed. This would seem to imply that the stock market is trumpeting the start of a vigorous economic rebound that will carry even the most commodity-like firm along with it. I don’t think that’s correct.
The numbers for the bull market so far are certainly correct. But if we take a slightly different time frame, we see a somewhat different picture. Looking at full-year 2009, we see significant outperformance of growth over value. Why the difference?
Bank stocks are classified as value stocks. They’re the sector that cratered in early 2009. They rebounded by 135% through November, possibly creating the illusion of a value stock market when, ex banks, there hasn’t been one.
Of course, especially if you know that I’m a growth stock investor, you may be thinking (as I have been while writing this) that he doesn’t like what the data say so he’s manipulating the facts away. A fair point. It may be that the stock market is signaling a stronger upturn than the consensus expects and I’m just not hearing the message.
I’ll deal with this issue in my next post, on where I think we should be putting our equity money. The short answer: I’ll concede I have a point that may have questionable origins. There’s no need for me to make this issue a keystone of my investment strategy, however. Better to have a couple of good ideas to organize investments around and reject the rest than incorporate a dozen half-baked ones into a portfolio.
Nevertheless, I should also be on the lookout for signs that the recovery may be stronger than I, or the consensus, expect.
There’s still a lot of money on the sidelines, although it has begun to trickle back in small amounts into stocks over the past few months. As I’ve mentioned in a previous post in this series, individual investors have been mostly absent so far from the stock market during the rebound. They have, instead, been seeking the “safety” of bond funds, a decision that will probably cause a considerable degree of financial pain as/when the Fed begins to raise rates back to normal.
The current asset allocation is bullish for stocks, since at some point continuing reasonable equity performance will compel individuals to increase their equity exposure.