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).

 

 

 

 

 

navigating through confusion

a (very) simple sketch

I can’t recall a more complex, hard to read, time in the stock market than the present.  There have certainly been more panicky times–like October 1987 or early 2000 or late 2008.  But all of these, however frightening, were about financial markets building a speculative house of cards which ultimately collapsed of its own weight.  The basic framework in which the game was played remained more or less the same:  continuously declining interest rates, the growth of multinational companies, revolutionary developments in computer technology, the shift in developed economies from laborers to knowledge workers, continuing dominance of the US economy.

what has changed?

–the Internet is here, with its attendant powerful hardware (servers, smartphones) and software (the cloud, Amazon, Facebook…  e-commerce, information, entertainment) devices

–the aging–and, ex the US, increasing lifespans–of the populations of developed economies

–ultra-low interest rates, negative in parts of Europe

–the rise of China, and to a much lesser extent, India as global economic powers

–most recently, the Huawei moment, sort of like Sputnik, when the US realizes that a Chinese company is producing more advanced/ less expensive cutting-edge telecom equipment than it can

–fracturing of belief in the invisible hand aka trickle-down economics, the (ultimately religious/Enlightenment philosophical) belief that individuals acting in their own self-interest somehow create the best possible outcome, both for the world as a whole and for each individual.  This fracturing fuels the rise of the radical right in the US and Europe, I think.

 

more tomorrow

 

 

 

what to do on a rebound day

It doesn’t appear to me that the economic or political situation in the US has changed in any significant way overnight.  Yet stocks of most stripes are rising sharply.

What to do?   …or if you prefer, what am I doing?

Watching and analyzing.

A day like today contains lots of information, both about the tone of the market and about every portfolio’s holdings.  Over the past month, through 2:30 pm est today, the S&P is down by 4.8%.  The small-cap Russell 2000 has lost 7.7%, NASDAQ 7.8%.   All three important indices are up significantly so far today—NASDAQ +2.2%, Russell 2000 +1.9%, S&P 500 +1.8%.  So this is a general advance.  Everything is up by more or less the same amount, meaning investors aren’t homing in on size or foreign/domestic as indicators for their trading.

What we should all be looking for, I think, is what issues that should be going up–either because they’re high beta or have been beaten up recently–are shooting through the roof and which are lagging.  (“Lagging” means underperforming other similar companies or underperforming the overall market.)  The first category are probably keepers.  The poor price action for the latter says they should be subjects for further analysis to figure out why the market doesn’t appreciate their merits.  Maybe there aren’t any.  

We should also note defensive stocks that are at least keeping up with the S&P.  That’s better than they should be doing.  They may well be true defensives, meaning they stay with the market (more or less) on the way up and outperform on the way down.  This is a rare, and valuable, breed in today’s world, in my view, and can be a way to hedge downside risk.

 

 

Another topic:  Over the past few days, I’ve been in rural Pennsylvania filming my art school thesis project–yes, I’ve gone from stills to video–so I haven’t kept up with the news.  I’m surprised to see that the UK, which still remembers the enormous price it paid a generation ago resisting fascism, has done an abrupt about-face and allowed Mr. Trump to make a state visit.  The anticipated consequences of Brexit must be far more dire than the consensus expects.

more tariffs?

Wall Street woke up today to an announcement from Mr. Trump that he intends to place a tariff on all goods coming into the US from Mexico.  The levy will be in effect until that country prevents immigrants/asylum seekers from reaching its border with the US.  The initial rate will be 5%, escalating to 25% by October.

As an American, I think I can understand the issues the administration wants to address.  But I find it more than a little unsettling that there seems to be no coherent, well-reasoned plan being implemented.  I’m pretty sure tariffs are not the way to go.  Also, both sides of the aisle in Congress appear to be eerily content to watch from the sidelines, rather than make it clear that Mr. Trump does not have authority to levy tariffs without legislative consent (my personal view, for what it’s worth) or limit/revoke that authority if the president does have it now.

 

As an investor, however, my main concern is the much narrower question of how Washington will affect my portfolio.

As to Mexico:  let’s say the US sells $300 billion yearly to Mexico and buys $350 billion.  Most of that is food and car parts.  Even if we sell less to Mexico because of retaliatory tariffs and if imported goods are 15% more expensive–to pluck a figure out of the air–the total direct negative impact on the US + Mexican economies would probably be a loss of around $100 billion in GDP.  How that would be split between the two isn’t clear, but the aggregate figure is 8% of Mexican GDP and 0.5% of US GDP.  So, potentially much worse for Mexico than for the US.

Given the nature of US-Mexico trade, the negative economic impact in the US will be concentrated on lower-income Americans.  If earnings reports from Walmart and the dollar stores are to be believed (I think they are), these are people whose fortunes have finally, and only recently, begun to turn up post-recession.

From a US stock market point of view, neither autos nor food has large index representation.  My guess is the negative impact will be roughly equally divided between negative pressure on directly-affected stocks, including names that cater to the less affluent, and mild downward pressure on stocks in general from slower domestic growth.  Because small caps are more domestically focused than the S&P 500, only half of whose earnings come from the US, the Russell 2000 will likely suffer more than large caps.

 

There are deeper, long-term questions that Washington is raising–about whether the US is an attractive place to establish manufacturing businesses and whether it can be relied on as a supplier to buy from.  In addition, it’s hard to figure out what government policy today is–for example, how new tariffs on Mexican imports square with just-reworked NAFTA, or how imposing tariffs that hurt domestic car manufacturers square with the threat of tariffs on imported vehicles, which do the opposite.

Neither of these concerns are likely to have a significant impact on near-term trading.  But heightened Washington dysfunction must even now be becoming a red flag in multinationals’ planning.

 

 

the Huawei questions

Huawei is a Chinese telecom company.  It makes niftier smartphones than Apple and has 5G technology that’s better than anything US companies can offer.  The company is certainly a competitive threat to US cellphone makers, as well as to manufacturers of telephone equipment worldwide.

The question that arises with a firm like Huawei, also the perennial question raised about dominant US tech companies since WWII, is the degree to which Huawei will act in the national interest of China.  That is, can/will Beijing eavesdrop on conversations or collect/alter data being carried on Huawei networks–maybe even stop them operating, if Beijing so chooses.

The Trump response to Huawei’s technological edge has been two-fold:  to blacklist Huawei, and to aid its US rival, Qualcomm.

Two questions:

1.is this the proper response?   …or is it like Mr. Trump’s invoking national security to price better-performing Asian and European cars to unaffordable levels, forcing citizens to buy US automobiles that three-quarters of the population now shun?

I’m guessing the former.

 

2. does Mr. Trump have a strategy?   Has he thought out the consequences of what he’s doing?

Here my guess is no.  Otherwise, he would have been promoting science education and welcoming skilled foreign scientists, rather than compelling tech firms to relocate their tech hubs to Canada and elsewhere.

(An aside, sort of:  I was recently listening to a podcast which dealt with Mr. Trump’s weak record in real estate by saying that he was rich before he started in the family business and he remained rich after negotiating treacherous waters during the 1980s.  Really?

My read of the president’s career:  he ended (prior to licensing his name and performing in a reality show) with about as much money in real terms as he started with.  So in that highly technical sense what the podcast said is right.  Over the same period, however, a run-of-the-mill real estate developer made, adjusting for risk, four times what Trump did.  A really competent real estate person might have made 10x.  In achieving his result, Mr. Trump was also aided by the public listing, debt refinancing and subsequent bankruptcy declaration of his Atlantic City casinos.  Although Mr. Trump prevailed in the litigation that ensued, as a professional investor I find this an eyebrow-raising episode.

Mr. Trump was “successful” in running a business in the sense that he went fishing during a time when tons of fish were jumping into the boat and he came back with the boat.  Nothing in it …though he was in the area where the most fish were to be had   …and he was soaking wet in a way that suggested he fell out at some point.

I’m also extrapolating from that.)

investment implications?

Throughout my investing career, politics has never made much of a difference.  In fact, to my mind professional investors who based their decisions on reading Washington’s runes simply revealed the poverty of their thought.  I think now is different.  Mr. Trump has exposed the surprising weakness of Congress.  The reality of China as a rival superpower to the US has been made clear.

Unfortunately, Mr. Trump is executing an early twentieth-century strategy to solve a twenty-first century dilemma.  Arguably, but not necessarily, this is a drama where the US is playing the role of post-WWI Britain and China is the 1920s US.  We all know how that worked out. By simultaneously discouraging innovation at home and forcing China to up the pace of its own tech progress, I think the administration is auditioning for the UK part, and thereby potentially doing significant long-term harm to the economy.  Ironically, those hurt most badly will likely be Mr. Trump’s most rabid supporters.  Withdrawal from the Trans Pacific Partnership, for example, is already putting US farms at a disadvantage vs. Australian, Canadian and New Zealand rivals.

What to do?

I’m taking a two-pronged strategy in the US.  I’m looking for companies with worldwide reach and innovative products.  For domestically-oriented companies, I’m taking an approach that might be called, for lack of a better term, “value with a catalyst” (regular readers will likely know that I don’t believe traditional value works any more in the US).  This term usually means a value stock where a turnaround has progressed far enough that the path for the firm to return to health can be identified.  E.g., the stock is trading at 20% of book value in an environment where healthy firms are trading at book.  Only “deep” value investors might be interested.  Then the company recruits a CEO who’s a turnaround expert and the stock begins to trade at 30% of book–this is value with a catalyst.  I’m not so interested in book, though.  I’m looking at price/cash flow.

I’m also looking harder in the Pacific Basin.  I’m even thinking about the EU, although that’s an area where market participants have a thorough value orientation and where lots of local market lore is needed to be successful.  So I find it a bit scary–better said, the rewards not worth the effort.