discounting and the stock market cycle

stock market influences

earnings

To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded.  But profit levels and potential profit gains aren’t the only factor.  Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting:  fear vs. greed

Stock prices typically anticipate or “discount” future earnings.  But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news.  As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence.  This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09.  During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level.  The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon.   S&P 500 earnings rose by 5% that year.  The index itself soared by 30%, however.  What happened?   Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again.  This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

Where are we now in the fear/greed cycle?

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.

 

REITs when interest rates are rising

Finally, to the question of REITs (Real Estate Investment Trusts).

A REIT is a specialized type of corporation that accepts restrictions on the kind of business it can do and limits to how concentrated its ownership structure can be.  It must also distribute virtually all its profits to shareholders.  In return it gets an exemption from corporate income tax.  It’s basically the same legal structure as mutual funds or ETFs.

Traditionally, REITs have concentrated on owning income-generating real estate.  But they are also allowed to to develop and manage new projects, provided they do so to hold as part of their portfolios instead of to resell.

Because they must distribute basically all of their profits, and to the degree that their property development efforts are small relative to their overall asset size, REITs look an awful lot like bonds.  That is to say, their main attraction is their relatively steady income.  Yes, they hold tangible assets of a type that should not be badly affected by inflation.  But current holders, I think, view them as bond substitutes.

As I suggested in Monday’s post, that’s bad in a time of rising interest rates.  Both newly-issued bonds–and eventually cash as well–become increasingly attractive as lower-risk substitutes.  This is the reason REITs have underperformed the S&P by about 5 percentage points so far this month, and by 9 points since the end of September.  I don’t think we’ve yet reached the back half of this game.

How can an investor fight the negative influence of interest rate rises in the REIT sector?   …by finding REITs that look as much as they can like stocks.  That is, by finding REITs that are able to achieve earnings–that therefore distributable income–growth.

This means finding REITs that can raise rents steadily or whose development of new properties is large relative to their current asset size.

 

stocks vs. bonds when interest rates are rising

A regular reader asked what I think about REITs in a comment last Friday.  I thought I’d answer him here, starting in a more general way.

One of the safer conclusions we can draw from the US election results is that interest rates are going to be rising over the next couple of years.  Most likely this will happen at a more rapid rate than under the Washington gridlock scenario a Hillary victory would probably have perpetuated.

Two reasons:

–the US appears to be at or near full employment, as evidenced by recent wage gain acceleration, so rates would be rising to fend off future inflation in any event, and

–Republicans, who have been blocking Obama’s infrastructure spending proposals (for no good economic reason), are in favor of fiscal stimulus now that they will get the credit. This will remove some of the pressure the Fed is now under to compensate for congressional failure to do its part to restore economic stability.

 

What happens to stocks and bonds as rates go up?

cash

— a point of merely academic interest right now, but something to tuck away in the back of our minds, there could come a time when the returns on cash are high enough to draw money to it that would otherwise have gone to stocks and bonds.  I don’t know what that point might be, just that it’s a long time away.  The question to answer is:  if the expected return for stocks is 8% a year and I can get, say, 4% in a savings account, am I willing to take the greater risk of owning stocks?

government bonds

–if we take the simplest case, a government bond is a high-quality promise (i) to pay a specified amount of interest for a set period of time, and (ii) to return the principal at the end of the bond’s term.

The annual return on a bond should be the return on cash + a premium to compensate for tying one’s money up for a long period of time.  At the moment, the rate for a 10-year Treasury bond is about 2.16%.  That compares with, say, 0.5% for overnight money.

Suppose the rate on overnight money rises to 2.0%.  A newly-issued 10-year would likely have to yield at a minimum, say, 3.25% to draw buyers (yes, the time premium normally fades as rates rise).  This implies that an already-existing 10-year yielding 2.16% must be worth less than par (since the going rate for a bond at par is 3.25%).

In other words, as interest rates go up, the value of an existing bond goes down.  There’s nothing the issuer can do to change that dynamic.  Since the issuer has the use of what is now cheap money, he will presumably have no desire to change it, either.

 

More tomorrow.

what are bond vigilantes? …are they making a comeback?

vigilantes…

Vigilantes were members of 19th century American “vigilance committees,” composed of citizens who banded together to render immediate, and often rough, justice in circumstances where they felt formal law enforcement actions were insufficient.  Whether this was a good thing or not, I don’t know.  But the idea of vigilantes has become part of American folklore.

…and bond vigilantes

I first saw the term “bond vigilantes” in the 1980s in the work of brokerage house economist Ed Yardeni.  My impression is that he invented it   …but, hey, I’m a stock guy not a bond expert.  The idea was that should the Fed falter, due to political pressure, in its mandate to contain inflation under Paul Volcker (as it had throughout the 1970s, under his predecessors), private bond investors would step into the Treasury market and tighten money policy (by pushing up bond yields) whether the Fed liked it or not.

The concept later morphed into the idea that private bond investors would routinely raise and lower bond prices, and thereby interest rates, in the way sound money policy would dictate.  The market would act in advance of formal Fed moves.  Fed actions wouldn’t normally break new ground, but would serve to validate the direction the market was already taking.  This supposedly took some political heat away from the Fed during the long and difficult road of containing the runaway inflation of the Seventies.

Like most generalizations from current experience, the bond vigilante idea worked for a while.  But it has long since lost its usefulness.  For one thing, China became a huge factor in the US bond market as it recycled its trade surpluses.  And Alan Greenspan gradually developed a penchant for smoothing every little bump in the economic road with another huge dollop of easy money.  Ironically, one of the “problems” he dealt with in this manner was the Y2K scare–popularized almost single-handedly by the same Ed Yardeni.

(If you recall, the thesis was that, due to a programming shortcut, every electronic device that contained a computer chip with a clock in it would stop working at the stroke of midnight on 12/12/1999.  That meant refrigerators, elevators, ATMs, PCs…everything.  Software of all types would go kablooey, as well.  So bank and medical records would likely disappear.  During 1999, survivalists were in their glory.  They stockpiled horse-drawn plows–inconveniencing the Amish considerably–and gold and silver coins.  Regular people stockpiled water and gasoline (because pumps might not work, either.

It’s hard to know–since none of the bad stuff happened–whether Yardeni was a hero for alerting the world in time to avert the worst, or just a little nuts.  But he certainly gave Greenspan an excuse for maintaining an easy money policy.)

why the trip down memory lane?

I think I saw the activity of bond vigilantes in trading during the first quarter of this year.  The 30-year yield moved up from 2.94% in December 2011 to 3.33% last week.  The 10-year yield went from 1.94% to 2.21% over the same span.  This, despite Ben Bernanke’s continual assertion that the Fed intends to keep interest rates low through this year and next.

Of course, yields have reversed themselves sharply in the current mini-panic over the latest Employment Situation report and the uptick in southern EU bond yields.  But I read this more as a ripple caused by short-term traders than anything else.

And why shouldn’t the bond vigilantes re-appear?  After all, Mr. Greenspan no longer has his hand on the money spigot.  And China is much less of a net buying force in Treasuries than in the past.

Significance?  We may be seeing the first steps in the normalization of interest rates–far in advance of when the Fed wishes.  Two implications, assuming the markets are correct:

–the US economy is in better shape than the consensus realizes, and

–a sharp divergence in performance between stocks and bonds–in favor of the former (previously, I’d made a typo here)–may be about to begin.