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.

 

 

 

 

 

 

 

 

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).

 

 

 

 

 

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.

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

stocks in a 4% T-bond world

There are two questions here:

–what happens to stocks as interest rates rise? and

–what should the PE on the S&P 500 be if the main investment alternative for US investors, Treasury bonds, yield something around 4%?

On the first, over my 38+ year investment career stocks have gone mostly sideways when the Fed is raising short-term interest rates.  The standard explanation for this, which I think is correct, is that while stocks can show rising earnings to counter the effect of better yields on newly-issued bonds, existing bonds have no defense.

Put a different way, the market’s PE multiple should contract as rates rise, but rising earnings counter at least part of that effect.

The second question, which is not about how we get there but what it looks like when we arrive, is the subject of this post.

in a 4% world

The arithmetic solution to the question is straightforward.  Imagining that stocks are quasi-bonds, in the way traditional finance academics do, the equivalent of a bond coupon payment is the earnings yield. It’s the portion of a company’s profits that each share has a claim on ÷ the share price.  For example, if a stock is trading at $50 a share and eps are $2, the earnings yield is $2/$50 = 4%.  This is also 1/PE.

A complication:  Ex dividends, corporate profits don’t get deposited into our bank accounts; they remain with management.  So they’re somewhat different from an interest payment.  If management is a skillful user of capital, that’s good.  Otherwise…

If we take this proposed equivalence at face value, a 4% earnings yield and 4% T-bond annual interest payment should be more or less the same thing.  In the ivory tower universe, stocks should trade at 25x earnings if T-bonds are yielding 4%.  That’s almost exactly where the S&P 500 is trading now, based on trailing 12-months “as reported” earnings (meaning not factoring out one-time gains/losses).  Why this measure?   It’s the easiest to obtain.

More tomorrow.