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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
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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.
My world economic “to do” list, with emphasis on the US
This is my checklist of the major economic problems produced by the financial crisis, and where I think we now stand:
1. world trade. Trade finance is more or less back to normal. Areas outside the US and the EU which have not been infected by our banking problems have stabilized faster than expected and are beginning to grow again.
China is perhaps the best example. But the Reserve Bank of Australia has recently announced that it has completed the process of bringing short-term interest rates up from their emergency low early in 2009 to a neutral level. Singapore is the latest to declare that its economy is looking up again.
Unlike Japan during its heyday, China is taking an active role in world economic affairs, not only by purchasing assets in other developing countries but also dispensing foreign aid. This serves a dual purpose–spreading China’s influence abroad, as well as shrinking its gigantic pile of US$ reserves.
2. global economic growth
The economic consensus is that 2010 will be a year of “above trend” economic growth around the world. Taken by itself, this is a pretty meaningless statement–sort of like saying that things could be looking up for the New Jersey Nets basketball team (now 3-30).
After an economic low point and the application of expansive monetary and fiscal policy, there’s always a bounceback. For economies like China, India or Brazil, economists seem to be predicting a return to business as usual. But the forecasts for the US and EU, which appear clustered around 3% real growth for the year, are above trend but only by a tiny bit. They’re not much more than half the level one would expect in the typical economic rebound.
If the US and EU forecasts are economists’ best guesses and not an attempt to guard against printing a number that may be too high, they are predicting that it will be years before the developed world shakes off the negative effects of the financial crisis.
The estimates have some common-sense plausibility. Typically, consumer rebounds are driven by renewed purchases of homes, cars and other household durables. With 25% of homeowners holding mortgage debt that’s more than their homes are worth and with 10% unemployment, will spending have the typical oomph to it? Maybe not. On the other hand, economists have always underestimated the resilience of the American consumer.
3. confidence in the US$.
–Are foreigners continuing to buy Treasury securities?–yes, especially at the short end, where the potential for currency losses is smallest.
–will the US do what is necessary to protect foreign creditors from a decline in the real value of their Treasury holdings? that is,
———-will the Fed raise short-term interest rates from their emergency lows to neutral?–yes (remember, short rates will probably go up by 175-200 bp before the Fed is through)
———-will Congress create a sound fiscal policy that will guard against dollar depreciation?–probably not. I don’t think anyone expects fiscal responsibility from Congress, though. That’s why buyers are sticking to short maturities and why the Chinese are so eager to reduce their dollar holdings. My guess, though, is that the world expects at least some action by Congress, other than creating inflation, to narrow the budget deficit. What Congress actually does could be a source of either positive or negative surprise. I’d lean more toward protecting against the negative than benefiting from the positive.
4. financial companies. A lot of progress has been made, but significantly more remains to be done.
–trade finance is back to normal
–business lending. High yield issuance is booming, as large firms are seeking the greater certainty of the bond market. This is true in Europe, where companies have traditionally been much more reliant on bank financing, as well as the US. Smaller firms seem to be waiting for final word on what their health care costs will be before spending on expansion.
–regional banks. Many are up to their eyes in construction loans, not an enviable position to be in. So they’re not lending either.
–consumer lending. Good luck trying to get a loan. High losses on derivatives, mortgages and credit cards have made all banks squeamish about new commitments.
–stock finance. It’s booming in emerging markets…not so much in the US and Europe.
–investors. Data from the Investment Company Institute, the trade association of the investment management industry, seem (to me, anyway) to show that individuals are continuing to act in the same vein they have for about a year. That is, they are:
-reducing money market holdings
-reducing domestic equity mutual fund holdings
-buying exchange traded equity funds instead
-buying taxable bond funds
rearranging their equity holdings to reduce their exposure to the US and increase it to foreign markets, especially emerging countries.
(One way of making sense of this is to say investors are following a barbell strategy, balancing what they perceive as very risky assets (emerging market equities) against ultra-safe ones (bonds). Or you might say they’re buying everything but US stocks. Personally, I don’t get it all, but only time will tell whether this is a prudent strategy or not.)
5. US industrial firms. Overall, US business have shown strong profit growth in the second half of 2009, mostly as a result of cost-cutting. Larger firms have begun to indicate that sales are either stabilizing or improving and that they intend to start purchasing new equipment and rehiring workers in 2010. Temporary help is already on the rise. Sales to non-US buyers are an area of particular strength, at least in part due to the weakness of the US$.
Smaller firms, on the other hand, appear to be more cautious. Several reasons:
–they tend to have little overseas exposure, where economies are stronger,
–many are suppliers to larger US firms, and their revenues tend to lag on the way up, as a result,
–some are concerned about the effect new health care legislation will have on their profits.
It’s probably also important to distinguish between manufacturing and service companies. On the manufacturing side, many publicly-traded industrial companies produce consumer durables, an area I tend to worry about. IT companies, on the other hand, appear to be doing exceptionally well. (See the very interesting, if somewhat specialized, blog by tech veteran Daniel Nenni, who points out that semiconductor companies are anticipating an unusually strong first quarter during what is typically a seasonal lull.)
Service companies are, I think, in better shape than manufacturers. They are also the area where the US has a true competitive advantage over foreign firms–although “creative destruction” is heavily rewriting the formulae for success in entertainment and publishing.
6. The US consumer. It’s a mixed picture.
a. the positives
–Housing prices probably bottomed sometime in late spring or early summer.
–Layoffs are slowing, and the labor situation may reverse into net hiring in the next few months.
–Holiday spending appears to have been better than (low) expectations.
–Almost two years of recession would imply considerable “pent-up demand” for consumer durables.
b. the negatives
–Consumers are continuing to trade down, implying they are still not feeling very confident
–Banks are still severely rationing credit to consumers, as well as dramatically raising the cost of maintaining credit card balances
–companies may have discovered during the downturn that they can operate with fewer workers than they thought. If so, unemployment may remain higher for longer than in past recoveries. For perhaps different reasons, I think this is the consensus expectation.
c. past patterns
The timing of US business cycle recoveries has been unique, in that the American consumer has typically picked up first and industry has followed later on. The opposite is true in the rest of the world. Perhaps the most dangerous words in all of investing are, “It’s different this time.”, but, like the economists forecasting a sub-par recovery, I wonder…
That’s it for this post. Next, I want to write about what stock markets have been doing and what their performance seems to be implying for the future. Then I’ll write about where I see the possibilities to profit this year from the current lay of the land.
Economists explain the depth of the recessions of 1973-74 and 1980-1982 by pointing to extraordinary shocks to the world economic system that occurred during these periods. In both cases, the shock involved was a sudden two-or threefold rise in the price of oil in economies very dependent on petroleum.
The current case
In the case of the current financial crisis, the “shock” was the sudden collapse in 2008 of major international banking firms in the US and the EU. The reason? –the realization that trillions of dollars of exotic securities that commercial and investment banks created, owned in very large size (and therefore counted as an integral part of their capital) and traded with one another were pretty much worthless. As a result, many of these financial institutions were essentially bankrupt.
The housing problem
What triggered the crisis? Many of these “toxic” securities were based on home mortgages taken out by “sub-prime” borrowers, who by and large didn’t have the income to make their mortgage payments. These borrowers began to default.
What separates the current housing bubble from previous ones is the duration, and consequently, the size of the lending to unqualified borrowers. Fed money policy in the US was unusually loose (see my June 3, 2009 post in Odds and Ends reviewing John Taylor’s book on the crisis, Getting Off Track) for several years at the start of the decade. Government and trade groups estimate that:
–over 10% of outstanding mortgages were given to unqualified buyers,
–one in four residential housing commitments were made to speculators, vs. one in ten during a “normal” boom, and
–for a quarter of current mortgage holders, their home is worth less than the mortgage amount they owe.
Other, related, problems
Bad credit and weak banks aren’t the only problem. the booming housing market signaled continuing economic prosperity. So housing and commercial construction companies expanded and hired more workers, as did materials suppliers, retailers, hoteliers, airlines–and just about every other economic entity in the US. When the bubble burst, we found ourselves with an economic infrastructure that is 5%-10% too big for what we can use.
The crisis also underlined the poor state of government finances in Washington, weakened by the Bush administration’s policies of increased social spending and tax cuts, while also waging an expensive war in the Middle East.
Derivatives allowed US problem loans to be exported to Europe and infect the banks there. France was a hotbed of “financial engineering” expertise, which helped the process along. The fact that most transactions originated in London, where laws differ from those in the US and where regulatory supervision was lax, poured gasoline on the fire.
Two low points
1. In September 2008, Secretary of the Treasury Paulson decided to allow the investment bank Lehman Brothers to go into bankruptcy.
This had two immediate unintended effects, which both spread the financial crisis far beyond the housing market. International trade finance, and therefore the lion’s share of international trade, immediately dried up on intensified concerns over counterparty risk (if Lehman could fail, who was safe?). Also, worries about counterparty risk spread to money market funds, some of whom had bought Lehman short-term debt to try to raise their yields. As investors shifted to federally-insured bank deposits instead, they all but eliminated an important source of working capital finance for American industry.
During this time, industrial layoffs intensified. Armed with sophisticated supply chain management tools, companies could see the full extent of the economic contraction that the crisis was bringing. Many also realized they had made a mistake during the 2000-2002 downturn by not cutting production–and workforces–quickly enough. So they cut very sharply this time around.
2. In March 2009, sentiment reached its lowest ebb when Congress initially refused to appropriate funds for a bailout of the financial system. For a while, the world feared that the global financial system would collapse, bringing on a new version of the Great Depression of the 1930s–not because the problem, although large, was not understood or was too big to handle, but because of cognitive/intellectual deficiencies among myopic US legislators.
The repair process
A lot of positive things have happened since the darkest days of nine months ago. The repair process will be the subject of my next post.