Goldman Sachs recently argued that the world economy may be entering a period of Stagnation. “During these episodes, GDP per capita growth hovers below 1 percent and
is less volatile than usual. They are also characterized by low
inflation, rising and sticky unemployment, stagnant home prices, and
lower stock returns,” wrote Jose Ursua, an economist at Goldman Sachs.
Goldman Sachs appears to have described the current environment and applied a name to it, although they have not adequately explained the volatile commodity, debt, and equity prices. My problem with the argument is that the remedy appears very similar to what we've been trying for the past few decades. “Whether these countries manage to avoid a ‘Great Stagnation’ by a
pick-up in the recovery is likely to depend on policy being able to
restore confidence and putting in place reforms that can decisively jolt
growth,” Goldman Sachs argues. I am assuming a "jolt" means stimulus in the form of lower taxes or more spending.
In my opinion, Goldman Sachs misses the underlying problem, which is structural in nature. Decades of activist fiscal and monetary policy to avoid economic slowdowns have produced a perverted economic environment. Inefficiencies have built up into bubbles and then burst, resulting is massive losses of investment and political structures set up to avoid further losses. An economy cannot allocate resources to capital destroying endeavors indefinitely, either due to the siren call of bubbles or politically protected segments. Eventually, the economic activity slows as investors and businesses earn diminishing returns on their investments.
The US economy needs to go through a period of healing, in my opinion, which could prove painful for many. I believe confidence is restored by allowing poor investment decisions to fail, enabling the failure to be understood, and clearing the environment for healthy investments to take their place. The problem is that people are increasingly looking to the government to "fix it." I find it highly ironic that the capital markets, which tend to advocate less government intervention, are breathlessly anticipating a bailout in Europe and further Fed actions. For over 30 years we have been lowering taxes, legislating Keynesian stimulus spending, and providing ever more accommodating monetary policy. Asking for more government intervention is like a drug addict asking for another hit, it feels good initially but only leads to more pain.
Under my Sagflation theme I argue that fundamental deflationary pressures in the economy likely cause slow to negative growth. These deflationary pressures largely stem from the excessive debt to be serviced by governments and consumers. As a result of the debt burden there are deflationary pressures through government austerity measures, falling house prices, weak wages due to high unemployment, falling commodity prices, stronger dollar as other regions weaken, and eventually lower prices for goods and services as costs subside, competition intensifies, and technology advancements improve quality.
Offsetting the deflationary pressures, under my Sagflation theme, are overly active monetary and fiscal policies attempting to avoid deflation. These aggressive policies are more arbitrary, mostly temporary, and reactionary. By aggressively trying to stimulate the economy through tax decreases, spending increases, and monetary jolts, these policies result in more volatile prices (not less) as the economy swings from inflationary pressures back to deflationary pressures. Until the government addresses structural inefficiencies and markets clear the poor investment decisions over the past few decades, I believe we are stuck in an environment of low-to-negative growth and volatile prices.
What the US government should do, in my opinion, is focus on structural changes that enable efficient markets to operate. Reform the tax code, streamline regulations, and as much as possible remove the money from politics. The money flowing around DC creates conflicts of interest and encourages inefficient legal structures that favor one entity over another, to the detriment of society as a whole. The current argument between "no new taxes" and spending to stimulate the economy misses the real problem, in my opinion. I am not opposed to higher tax rates on the wealthy to fund longer-term stimulus spending. This is because tax rates on the wealthy are low by historical standards and the wealthy have generally benefited from the economic inefficiencies to a greater degree. Additionally, performing a thorough "reorganization" of the government that improves efficiency is likely overdue.
Goldman Sach's "Great Stagnation" is closer to identifying the problem, in my opinion, than "Stagflation," but is still off the mark. In my view, "Sagflation" explains the issues better and offers greater insight to make proper investment decisions.
In a deflationary period, which I believe we have been turning towards for much of 2011, I believe long-term treasuries tend to outperform, which the strong performance in my position in 30-year treasuries has supported. As inflation expectations decline the real interest rate improves on longer-term treasuries. In addition, in a deflationary world the economic landscape can look scary, in my view. Under these circumstances investors are looking for safe havens, of which treasuries rank near the top, in my view. For these reasons I have maintained my 30-year treasury position.
Thursday, September 29, 2011
Tuesday, September 27, 2011
European Banks, China Investors and US Consumers
This post is written with the yield on the 30-year treasury floating back up above 3%. This yield is significant because it is a sharp bounce off of the recent low, it suggests the markets anticipate an improving economy largely due to a bail-out in Europe, and it calls into question the level to which the Federal Reserve would like push down long-term yields. In this post I focus on economic stresses caused by volatile markets, arriving at the conclusion that I should hold, for now, the treasury position based on my belief that today's rally is a "dead cat" bounce that ultimately turns back down. That said, it is becoming more difficult to separate volatility from longer-term moves and I have noted that treasury yields can bottom before equity markets.
In my last post on 30-year treasuries, I mentioned that I believe it may take until June 2012 for the full impact of the recent market volatility to completely impact equities. There are a few signs emerging of real world stress on economic activity.
According the WSJ, the rise of perceived risk in European banks has made it more difficult for them to issue new debt. The banks have only issued $34 billion of senior unsecured debt this quarter, on track to being the lowest issuance in any quarter in over a decade. The timing, as is usually the case during a crisis, stinks because of an estimated $1 trillion of debt coming due next year. There is still time for the banks to issue enough debt to meet the required financing of maturing debts. But, the issue is becoming more pressing and the banks potentially have to accept higher rates, placing further pressure on their business.
Adding to the potential hit is the increasing likelihood of new capital requirements for banks, as international regulators push to require banks to hold extra capital. This change would require US banks, collectively, to raise an extra $200 billion in common equity. At a time when most US banks stocks are depressed, this requirement could prove costly.
In Asia it is worth noting that China is actually actively attempting to raise the value of its currency. The effort is a result of rising inflation in the country. A stronger yuan helps hold down inflation since imports become less expensive, albeit at the expense of exports and potentially the economy. The key takeaway, in my view, is that investor money has been leaving China as growth opportunities lessen and perceived risk increases. I am not the only one noticing a familiar trend that portends a significant bear market in equities.
Finally, add in the depressed state of US consumer confidence, which was below expectations, and the potential for problems for equity markets over the next few quarters are magnified.
In my last post on 30-year treasuries, I mentioned that I believe it may take until June 2012 for the full impact of the recent market volatility to completely impact equities. There are a few signs emerging of real world stress on economic activity.
According the WSJ, the rise of perceived risk in European banks has made it more difficult for them to issue new debt. The banks have only issued $34 billion of senior unsecured debt this quarter, on track to being the lowest issuance in any quarter in over a decade. The timing, as is usually the case during a crisis, stinks because of an estimated $1 trillion of debt coming due next year. There is still time for the banks to issue enough debt to meet the required financing of maturing debts. But, the issue is becoming more pressing and the banks potentially have to accept higher rates, placing further pressure on their business.
Adding to the potential hit is the increasing likelihood of new capital requirements for banks, as international regulators push to require banks to hold extra capital. This change would require US banks, collectively, to raise an extra $200 billion in common equity. At a time when most US banks stocks are depressed, this requirement could prove costly.
In Asia it is worth noting that China is actually actively attempting to raise the value of its currency. The effort is a result of rising inflation in the country. A stronger yuan helps hold down inflation since imports become less expensive, albeit at the expense of exports and potentially the economy. The key takeaway, in my view, is that investor money has been leaving China as growth opportunities lessen and perceived risk increases. I am not the only one noticing a familiar trend that portends a significant bear market in equities.
Finally, add in the depressed state of US consumer confidence, which was below expectations, and the potential for problems for equity markets over the next few quarters are magnified.
Sunday, September 25, 2011
Neutrinos and Other Little Things Rocking Our World
Some times the smallest of things can turn our understanding of the world upside down. For example, it was announced this week that neutrinos have consistently been measured to travel faster than the speed of light. So much for Albert Einstein and his theory of relativity that forms the bedrock of physics. More importantly, after about 30 years of "educated" thought, this means I can once again fantasize about time travel.
One would think neutrinos affected the financial world as well with a Barron's title like, "A Market in the Twilight Zone." Strategists love to quote P/E multiples during these times, arguing that valuations are irrational based on a multiple of forward earnings estimates. In the article it is noted that the forward-looking valuation of the market today is approaching the valuation of the lows in 2009.
There are two fundamental problems with an analysis based on forward earnings. The first problem is typically the historical analysis is based on either the actual earnings for the "forward" year, or uses the low point of downward revisions of forward earnings. By using the actual figures instead of the changes in estimates as time moved through the year, the point is missed that the market was significantly over-valued at the start. The second problem is that forward earnings for the present situation may not yet reflect what the forward year looks like. Of course determining where forward estimates ultimately go is one of the main jobs of analysts, and one of the hardest.
As can be seen in the chart below, which was published on Dr. Ed Yardeni's blog, forward earnings in 2009 for the SP 500 started in 2008 around $120 per share before declining to below $60 by March 2009, about the time of the market bottom. In fact, the consensus estimate for 2009 SP 500 earnings was still above $100 near the end of 2008, highlighting how quickly an outlook can change.
Source: http://blog.yardeni.com/2011/08/s-500-earnings-valuation.html
Another takeaway from Dr. Yardeni's chart is the significant growth expected to continue in both 2011 and 2012. Earnings in 2011 ans 2012 are expected to grow well in the double digits. How is this possible when real US GDP growth has remained below 4% since 2009, has slowed to 1% in 2Q11, and is forecast to slow even further?
A large portion of the difference is the revenue US companies collect outside the country. The only problem is that foreign economies are stalling. Europe could enter a full-on depression, China is slowing significantly, and commodity-driven emerging markets are showing signs of problems. Looking from the top-down, it is difficult to find the source of the anticipated growth in profits.
Assuming the 2012 world economy is as bad as 2009, an assumption not unrealistic based on the on-going debt burdens in the world, forward earnings for 2012 likely decline again to $60. This suggests the current forward P/E for the SP 500 is 19x, hardly cheap by any historical measure. To use Thomas Lee's 12x multiple from the Barron's article on $60 earnings in 2012 suggests the SP 500 bottoms around 720.
During these unusual times it is helpful to refer to data that factors out economic cycles and inflation in order to reduce the noise level. For this analysis I refer to the Shiller PE Ratio, which bases PE on the average inflation-adjusted earnings from the previous 10 years. From the chart below one can see the SP 500 remains relatively high on a PE basis at 19x. A technical analyst might become worried about the trend of declining highs and declining lows. From a fundamental perspective, it is well above the 15x it touched in 2009 and the 5x for an all-time low. Again, this analysis suggests the SP 500 could fall to around 1,000 if it simply reverts to a historical median of 15.8x, and well below 1,000 if the economic slowdown mirrors the 1930's or 1970's.
Source: http://www.multpl.com/
Little things, like the pennies companies earn per share, have a tendency to upset our belief systems.
One would think neutrinos affected the financial world as well with a Barron's title like, "A Market in the Twilight Zone." Strategists love to quote P/E multiples during these times, arguing that valuations are irrational based on a multiple of forward earnings estimates. In the article it is noted that the forward-looking valuation of the market today is approaching the valuation of the lows in 2009.
There are two fundamental problems with an analysis based on forward earnings. The first problem is typically the historical analysis is based on either the actual earnings for the "forward" year, or uses the low point of downward revisions of forward earnings. By using the actual figures instead of the changes in estimates as time moved through the year, the point is missed that the market was significantly over-valued at the start. The second problem is that forward earnings for the present situation may not yet reflect what the forward year looks like. Of course determining where forward estimates ultimately go is one of the main jobs of analysts, and one of the hardest.
As can be seen in the chart below, which was published on Dr. Ed Yardeni's blog, forward earnings in 2009 for the SP 500 started in 2008 around $120 per share before declining to below $60 by March 2009, about the time of the market bottom. In fact, the consensus estimate for 2009 SP 500 earnings was still above $100 near the end of 2008, highlighting how quickly an outlook can change.
Another takeaway from Dr. Yardeni's chart is the significant growth expected to continue in both 2011 and 2012. Earnings in 2011 ans 2012 are expected to grow well in the double digits. How is this possible when real US GDP growth has remained below 4% since 2009, has slowed to 1% in 2Q11, and is forecast to slow even further?
A large portion of the difference is the revenue US companies collect outside the country. The only problem is that foreign economies are stalling. Europe could enter a full-on depression, China is slowing significantly, and commodity-driven emerging markets are showing signs of problems. Looking from the top-down, it is difficult to find the source of the anticipated growth in profits.
Assuming the 2012 world economy is as bad as 2009, an assumption not unrealistic based on the on-going debt burdens in the world, forward earnings for 2012 likely decline again to $60. This suggests the current forward P/E for the SP 500 is 19x, hardly cheap by any historical measure. To use Thomas Lee's 12x multiple from the Barron's article on $60 earnings in 2012 suggests the SP 500 bottoms around 720.
During these unusual times it is helpful to refer to data that factors out economic cycles and inflation in order to reduce the noise level. For this analysis I refer to the Shiller PE Ratio, which bases PE on the average inflation-adjusted earnings from the previous 10 years. From the chart below one can see the SP 500 remains relatively high on a PE basis at 19x. A technical analyst might become worried about the trend of declining highs and declining lows. From a fundamental perspective, it is well above the 15x it touched in 2009 and the 5x for an all-time low. Again, this analysis suggests the SP 500 could fall to around 1,000 if it simply reverts to a historical median of 15.8x, and well below 1,000 if the economic slowdown mirrors the 1930's or 1970's.
Little things, like the pennies companies earn per share, have a tendency to upset our belief systems.
Friday, September 23, 2011
Sharpening Pencil on 30-Year Treasury Position
Sharpening my pencil to evaluate my 60+% position in 30-year treasuries. The yield has been plummeting since the Fed's announcement, falling to around 2.8%. Previously I had said I would look to sell my position at a yield below 3%.
Given the Fed's anticipated buying of 20-30 year treasuries, a growing banking crisis in Europe, slowing growth in China, and on-going political gridlock and economic concerns in the U.S.; it is difficult to point to a "proper" yield. So, based on my contrarian Sagflation thesis I believe there are strong fundamental reasons driving the price changes in the markets, I need to look at the timing of my exit strategy from a different angle. Luckily, there is a recent severe drop in 30-year yields from which to learn lessons.
On December 18, 2008 the yield on the 30-treasury closed at 2.54%. Three days earlier it was up around 3%. This event occurred almost three months before the bottom of the SP500 on March 9, 2009. By March 2009 the yield on the 30-year treasury was back above 3.5%, hurting investors who had bought the treasuries for safety reasons while equity market declined between December 2008 and March 2009. During this time there were similar fears about the banking sector and economic slowdowns around the world. From this angle, there is an argument to sell my treasury position well before an anticipated bottom in the equity markets.
One of the biggest signs of "capitulation" in the equity market is a large spike in volume. One interpretation of a capitulation is investors giving up hope of a rally combined with forced selling either to try and protect performance, redemption of money in funds, or margin calls. The day of capitulation may not coincide with the actual market bottom, but it is likely reasonably close. Through this lens we see the largest one day volume in the SP500 occurred on October 10, 2008 when volume spiked to 11.5 billion shares, characterized by wild 7% swings. This event likely coincided with investors shifting to a more cautious stance. It also preceded the bottom of the 30-year yield by about 2 months. While the markets have been volatile, the volume has not come close to 11.5 billion, instead clearing 6 billion a few times. In my view, this suggests investors are holding positions as they hope for economic conditions to turn-around. In other words, I believe we are only at the beginning, implying yields drop further and 2012 is fairly bumpy.
Looking more closely at the events around December 18, I was reminded that the Federal Reserve cut interest rates from 1% to 0-0.25% on December 17, 2008. Included in the announcement was the phrase "the outlook for economic activity has weakened further", adding that the rates would stay at their current levels for some time. This point reminds me that I should ask the question, "Will the Fed release an even more negative statement than what it did this week?" Anything is possible. There is some speculation that the Fed may print more money through QE3 should economic indicators continue to deteriorate. If the Fed made this announcement I would likely sell my treasury position and begin considering buying commodity-related investments due to increased likelihood, in my view, of rising inflation. QE3 would likely initially cause treasury yields to fall due to the added buying pressure from the Fed, but longer-term the inflationary pressures it would create would likely cause yields to rise, in my opinion.
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
Given the Fed's anticipated buying of 20-30 year treasuries, a growing banking crisis in Europe, slowing growth in China, and on-going political gridlock and economic concerns in the U.S.; it is difficult to point to a "proper" yield. So, based on my contrarian Sagflation thesis I believe there are strong fundamental reasons driving the price changes in the markets, I need to look at the timing of my exit strategy from a different angle. Luckily, there is a recent severe drop in 30-year yields from which to learn lessons.
On December 18, 2008 the yield on the 30-treasury closed at 2.54%. Three days earlier it was up around 3%. This event occurred almost three months before the bottom of the SP500 on March 9, 2009. By March 2009 the yield on the 30-year treasury was back above 3.5%, hurting investors who had bought the treasuries for safety reasons while equity market declined between December 2008 and March 2009. During this time there were similar fears about the banking sector and economic slowdowns around the world. From this angle, there is an argument to sell my treasury position well before an anticipated bottom in the equity markets.
One of the biggest signs of "capitulation" in the equity market is a large spike in volume. One interpretation of a capitulation is investors giving up hope of a rally combined with forced selling either to try and protect performance, redemption of money in funds, or margin calls. The day of capitulation may not coincide with the actual market bottom, but it is likely reasonably close. Through this lens we see the largest one day volume in the SP500 occurred on October 10, 2008 when volume spiked to 11.5 billion shares, characterized by wild 7% swings. This event likely coincided with investors shifting to a more cautious stance. It also preceded the bottom of the 30-year yield by about 2 months. While the markets have been volatile, the volume has not come close to 11.5 billion, instead clearing 6 billion a few times. In my view, this suggests investors are holding positions as they hope for economic conditions to turn-around. In other words, I believe we are only at the beginning, implying yields drop further and 2012 is fairly bumpy.
Looking more closely at the events around December 18, I was reminded that the Federal Reserve cut interest rates from 1% to 0-0.25% on December 17, 2008. Included in the announcement was the phrase "the outlook for economic activity has weakened further", adding that the rates would stay at their current levels for some time. This point reminds me that I should ask the question, "Will the Fed release an even more negative statement than what it did this week?" Anything is possible. There is some speculation that the Fed may print more money through QE3 should economic indicators continue to deteriorate. If the Fed made this announcement I would likely sell my treasury position and begin considering buying commodity-related investments due to increased likelihood, in my view, of rising inflation. QE3 would likely initially cause treasury yields to fall due to the added buying pressure from the Fed, but longer-term the inflationary pressures it would create would likely cause yields to rise, in my opinion.
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.
Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.
Wednesday, September 21, 2011
Thirty Year Yield Approaching 3%, Now What?
On August 2 I had stated a strategy of maintaining my position in 30-year
treasuries until the yield dipped below 3%. Well, thanks to the recent
announcement by the Federal Reserve the yield is now around 3%. My position in treasuries is based on my Sagflation theme and its current deflationary outlook. The announcement by the Fed hastened a drop in yields I expected to occur over the next year. The question now becomes what to do with the position?
One of the biggest problems with the Federal Reserve buying treasuries is that it sends contradictory signals into the market. On the one hand, a large buyer should drive prices up and therefore yields down. On the other hand, the purchase is designed to stimulate the economy and therefore yields should rise due to the potential for rising economic growth and inflation. In short, the intervention in the markets makes it difficult to understand what the market is signaling.
In relation to 30-year treasuries, the announcement said specifically that the Fed plans to use 29% of the $400 billion devoted to "operation twist" to buy treasuries with a duration of 20 to 30 years, or about $116 billion, up until June 2012. This amount is the estimated amount of new issuance in 30-year treasuries over the next year. Thus it effectively soaks up all of the anticipated treasuries to be sold, unless the issuance increases significantly.
So what happens from here? Where is the bottom for the 30-year yield? I believe the yield likely continues to decline, driven by both anticipated Fed purchases and a darkening economic outlook. In short, I do not believe the announcement by the Fed can have a significant positive impact on the future economic growth for the following reasons:
(1) This policy hurts the banks and insurance companies by flattening the yield curve. This is reinforced by Moody's decision to downgrade the debt of many of the banks after the Fed's announcement. Moody's argues the government is less willing to bail out troubled banks during a recession. All I can say to this point is that hopefully this is not an issue we have to face. A less healthy financial sector likely points to worse economic conditions.
(2) By lowering yields on the longer-term treasuries the Fed hopes, in part, to enable a wave of re-financing by homeowners. There are a couple problems with this strategy. The spread between mortgages and treasuries can expand, the "bang-for-the-buck" is relatively small to homeowners, and many homeowners cannot re-finance due to a lack of equity in their house and high fees. Maybe Congress enacts a procedure to help re-finance, but I wouldn't hold my breath for Congress to do anything. As a result, I believe the stimulus of the Fed's actions are relatively weak.
(3) By raising the yield on shorter duration treasuries it actually aids the dollar. This is good in the respect that it provides the US consumer with more purchasing power on imports. However, it also likely weakens US manufacturing and strengthens the deflationary pressures in the economy as commodity prices decline, and thus reverses recent inflationary pressures. If the consumer was in a healthier economic position with less debt, I would argue that demand would pick-up as prices fall. My problem is that the debt outstanding likely keeps a more muted demand outlook. As the CPI declines, one would expect longer-term yields to decline, thus further hurting the financial institutions.
(4) By committing to soaking up all of the anticipated 30-year issuance over the next year, the Fed has effectively reduced the risk of investing in this instrument. In a world of increasing systemic risk, investors are looking for safe places to park their cash. The longer-term treasuries just became more attractive to them.
(5) Pensions for companies and governments are likely hurt by the lower yields. Pensions that need to adjust down their expected future returns due to the lower yields suddenly require large infusions of cash to make up funding shortfalls. Furthermore, the lower yields makes it more difficult for pensions to invest their funds without taking on greater risk. In a time of budget deficits in many states and a weak economy, this could provide a significant drag as states are forced to cut spending in other areas to shore up their pension funds.
I believe we can expect many other side effects to the Fed's announcement, many of them not pleasant. For all of these reasons I plan to hold onto the treasury position for the foreseeable future as I ride the buying power of the Federal Reserve and try to avoid volatility in the equity markets.
One of the biggest problems with the Federal Reserve buying treasuries is that it sends contradictory signals into the market. On the one hand, a large buyer should drive prices up and therefore yields down. On the other hand, the purchase is designed to stimulate the economy and therefore yields should rise due to the potential for rising economic growth and inflation. In short, the intervention in the markets makes it difficult to understand what the market is signaling.
In relation to 30-year treasuries, the announcement said specifically that the Fed plans to use 29% of the $400 billion devoted to "operation twist" to buy treasuries with a duration of 20 to 30 years, or about $116 billion, up until June 2012. This amount is the estimated amount of new issuance in 30-year treasuries over the next year. Thus it effectively soaks up all of the anticipated treasuries to be sold, unless the issuance increases significantly.
So what happens from here? Where is the bottom for the 30-year yield? I believe the yield likely continues to decline, driven by both anticipated Fed purchases and a darkening economic outlook. In short, I do not believe the announcement by the Fed can have a significant positive impact on the future economic growth for the following reasons:
(1) This policy hurts the banks and insurance companies by flattening the yield curve. This is reinforced by Moody's decision to downgrade the debt of many of the banks after the Fed's announcement. Moody's argues the government is less willing to bail out troubled banks during a recession. All I can say to this point is that hopefully this is not an issue we have to face. A less healthy financial sector likely points to worse economic conditions.
(2) By lowering yields on the longer-term treasuries the Fed hopes, in part, to enable a wave of re-financing by homeowners. There are a couple problems with this strategy. The spread between mortgages and treasuries can expand, the "bang-for-the-buck" is relatively small to homeowners, and many homeowners cannot re-finance due to a lack of equity in their house and high fees. Maybe Congress enacts a procedure to help re-finance, but I wouldn't hold my breath for Congress to do anything. As a result, I believe the stimulus of the Fed's actions are relatively weak.
(3) By raising the yield on shorter duration treasuries it actually aids the dollar. This is good in the respect that it provides the US consumer with more purchasing power on imports. However, it also likely weakens US manufacturing and strengthens the deflationary pressures in the economy as commodity prices decline, and thus reverses recent inflationary pressures. If the consumer was in a healthier economic position with less debt, I would argue that demand would pick-up as prices fall. My problem is that the debt outstanding likely keeps a more muted demand outlook. As the CPI declines, one would expect longer-term yields to decline, thus further hurting the financial institutions.
(4) By committing to soaking up all of the anticipated 30-year issuance over the next year, the Fed has effectively reduced the risk of investing in this instrument. In a world of increasing systemic risk, investors are looking for safe places to park their cash. The longer-term treasuries just became more attractive to them.
(5) Pensions for companies and governments are likely hurt by the lower yields. Pensions that need to adjust down their expected future returns due to the lower yields suddenly require large infusions of cash to make up funding shortfalls. Furthermore, the lower yields makes it more difficult for pensions to invest their funds without taking on greater risk. In a time of budget deficits in many states and a weak economy, this could provide a significant drag as states are forced to cut spending in other areas to shore up their pension funds.
I believe we can expect many other side effects to the Fed's announcement, many of them not pleasant. For all of these reasons I plan to hold onto the treasury position for the foreseeable future as I ride the buying power of the Federal Reserve and try to avoid volatility in the equity markets.
Monday, September 19, 2011
CPI Sending Misleading Signals?
There has been an on-going debate about inflation and whether policy makers should be focused on reducing it. The CPI increased to 3.8% y/y in August, further accelerating from 3.6% in July. These figures are above the Federal Reserve's comfort zone of 1% to 3%.
As defined by the BLS, the CPI is "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." First off, I have a couple broadly shared problems with using the CPI as the main measure of inflation. The first is that it only measures a relatively small fraction of the goods and services exchanged in the US, and thus may provide false reading on overall inflation. The second is that it does not account for changes in quality of products. For example, a t-shirt manufacturer could begin using less cotton in their shirts but continue to charge the same price. My final issue is the weighting of the basket of goods and services, which can provide skewed results should consumption patterns change.
However, the issue I see currently is that the CPI inflation measurements are more apt to provide misleading guidance, in my opinion.
Generally, inflation is the result of demand exceeding supply. Thus if inflation is too high, policy makers try to reduce demand through levers like raising interest rates. Alternatively, if deflation is a risk, policy makers attempt to increase demand by lowering interest rates.
The problem currently is that inflation is not a result of excess demand, in my view. Instead, I believe the root cause of the current inflation has been dramatic rises in costs due to higher commodity prices. These higher commodity prices are a result of, at least in part, by a weakening dollar associated with monetary easing. Companies have attempted to manage these costs through various tactics, including streamlining of operations, possibly reducing quality, and even layoffs. Eventually, however, they have been forced to pass along these costs to consumers, thus driving up CPI. These commodity cost increases have been an issue for companies for the past couple years.
Why is this important? Well, in short, the problem is not weak demand. The problem is much more structural and thus monetary policy is a dull tool against it. At its core, I believe the current economy is suffering from the mis-allocation of resources and excess supply. After decades of activist monetary policy that avoided more severe economic slowdowns, many less competitive companies have been able to survive due to lower interest rates. The lower rates both enabled consumers to service larger debt balances, artificially raising demand, and has enabled weaker companies to remain in business, artificially increasing supply.
I believe we are reaching a point where monetary policies can no longer prop up demand. This diminishing boost is due partly to historically low interest rates that offer less and less "fuel" as they decline, in my view. I also believe the distortion of the allocation of resources is the fundamental problem with which businesses are struggling. At the extreme, bubbles have formed and disappeared due in part to the distorting side effects of an activist monetary policy. The dot-com bubble, the housing bubble, and the recent rise in commodity prices are examples of these side effects, in my opinion. The rise in commodity prices appears to have actually hurt demand as prices have been increasing, thereby reducing consumption.
So where are we headed? The Fed appears intent on at least trying something, even if its chance of success are minimal. So we likely get another manipulation of the yield, distorting economic decisions. Deflation likely becomes more and more prevalent if the core reason of past CPI increases diminishes, which I believe has been commodity prices. Ultimately we avoid addressing the structural problems in the economy in the near-term, likely leading to slower growth in the future.
All these points imply long-term yields decline despite the recent CPI figures.
As defined by the BLS, the CPI is "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." First off, I have a couple broadly shared problems with using the CPI as the main measure of inflation. The first is that it only measures a relatively small fraction of the goods and services exchanged in the US, and thus may provide false reading on overall inflation. The second is that it does not account for changes in quality of products. For example, a t-shirt manufacturer could begin using less cotton in their shirts but continue to charge the same price. My final issue is the weighting of the basket of goods and services, which can provide skewed results should consumption patterns change.
However, the issue I see currently is that the CPI inflation measurements are more apt to provide misleading guidance, in my opinion.
Generally, inflation is the result of demand exceeding supply. Thus if inflation is too high, policy makers try to reduce demand through levers like raising interest rates. Alternatively, if deflation is a risk, policy makers attempt to increase demand by lowering interest rates.
The problem currently is that inflation is not a result of excess demand, in my view. Instead, I believe the root cause of the current inflation has been dramatic rises in costs due to higher commodity prices. These higher commodity prices are a result of, at least in part, by a weakening dollar associated with monetary easing. Companies have attempted to manage these costs through various tactics, including streamlining of operations, possibly reducing quality, and even layoffs. Eventually, however, they have been forced to pass along these costs to consumers, thus driving up CPI. These commodity cost increases have been an issue for companies for the past couple years.
Why is this important? Well, in short, the problem is not weak demand. The problem is much more structural and thus monetary policy is a dull tool against it. At its core, I believe the current economy is suffering from the mis-allocation of resources and excess supply. After decades of activist monetary policy that avoided more severe economic slowdowns, many less competitive companies have been able to survive due to lower interest rates. The lower rates both enabled consumers to service larger debt balances, artificially raising demand, and has enabled weaker companies to remain in business, artificially increasing supply.
I believe we are reaching a point where monetary policies can no longer prop up demand. This diminishing boost is due partly to historically low interest rates that offer less and less "fuel" as they decline, in my view. I also believe the distortion of the allocation of resources is the fundamental problem with which businesses are struggling. At the extreme, bubbles have formed and disappeared due in part to the distorting side effects of an activist monetary policy. The dot-com bubble, the housing bubble, and the recent rise in commodity prices are examples of these side effects, in my opinion. The rise in commodity prices appears to have actually hurt demand as prices have been increasing, thereby reducing consumption.
So where are we headed? The Fed appears intent on at least trying something, even if its chance of success are minimal. So we likely get another manipulation of the yield, distorting economic decisions. Deflation likely becomes more and more prevalent if the core reason of past CPI increases diminishes, which I believe has been commodity prices. Ultimately we avoid addressing the structural problems in the economy in the near-term, likely leading to slower growth in the future.
All these points imply long-term yields decline despite the recent CPI figures.
Saturday, September 17, 2011
Performance Update Through August
The large 60+% position in 30-year treasuries based on the Sagflation theme paid off in August, driving the YTD performance through the end of August of my IRA up over 6%. For the previous year ending in August my IRA has increased almost 20%, benefiting from bond performance this year and equity positions at the end of 2010. The three year performance shows an average increase of 7%, slightly below the longer-term average because my investments were largely in cash for most of 2008 and 2009 as I was not actively managing them. The average five year performance was 9%, improving relative to the three performance due to my movement in Oct. 2007 to cash to avoid the market crash and stock picks prior in 2006 and 2007. Since the inception of my IRA in January 2003 my average annual performance has been 9.5% due largely to stock picks. These performance figures are calculated by my brokerage firm.
The annual performance of my IRA has exceeded both the SP500 and Bond indices over every period. It also exceeds the performance of most indices for hedge funds over these period.
YTD 1-Year 3-Year 5-Year Inception*
IRA 6.1% 19.7% 7.2% 9.4% 9.5%
S P 500 (1.8)% 18.5% 0.5% 0.8%
Bonds** 5.9% 4.6% 7.2% 6.6%
* IRA was established in January 2003.
** Bonds is defined as the Barclays Capital US Aggregate Bond Index.
The annual performance of my IRA has exceeded both the SP500 and Bond indices over every period. It also exceeds the performance of most indices for hedge funds over these period.
YTD 1-Year 3-Year 5-Year Inception*
IRA 6.1% 19.7% 7.2% 9.4% 9.5%
S P 500 (1.8)% 18.5% 0.5% 0.8%
Bonds** 5.9% 4.6% 7.2% 6.6%
* IRA was established in January 2003.
** Bonds is defined as the Barclays Capital US Aggregate Bond Index.
Tuesday, September 13, 2011
Analyzing Bottoms
Many investors are pointing to "cheap" valuations as a reason for buying equities. Based on the current "bottoms-up" consensus, the SP 500 is trading at 10x, cheap by many measurements. Well, cheap things usually break easy and don't last long and from this viewpoint I would agree that this market is "cheap."
Looking at the projected "bottoms-up" earnings for the SP 500 we find the following: 2011 of $98 and 2012 of $112. Put differently, the earnings growth rate analysts are expecting in 2011 is 17% and in 2012 is 14%. Seems aggressive when U.S. GDP growth is slowing. Analysts argue that a large portion of the revenue from companies within the SP 500 comes from outside the U.S.. Fair enough, but Europe isn't exactly exploding with growth. Exploding possibly, but not in a good way. Developing markets are increasingly pinched between high inflation and slowing growth. And, let's face it, if both Europe and the U.S. enter a deflationary period the chances of developing countries side-stepping a recession are remote.
So what is a realistic earnings assumption? Going back to WWII, companies in the SP 500 have seen earnings pull back on average about 15% during a recession. Assuming earnings come in around $95 for 2011, this would imply 2012 earnings of about $82 and a current P/E of 14x. Not an unreasonable valuation if you expect the economy to bounce back quickly. The 2008-2009 recession witnessed a 50% pullback in earnings largely due to the decimation of the financial sector, implying earnings of around $50 in 2012 and a P/E of 23x. Given that some investors are claiming the potential problems in Europe are worse than the collapse of Lehman due to the sovereign debt risk, this outlook cannot be pushed aside. Suddenly the market does not look so cheap.
The final point I'd like to make is that the P/E tends to contract when prices are less stable. Both high inflation and deflation tend to result in lower P/E multiples. An inflation rate, as measured by CPI, above 5% or below 0% is highly correlated with a P/E below 12x. This suggests if we enter a recession and deflation takes hold the P/E for the market likely contracts on top of lower earnings.
Using an average recession as the baseline for my investment decisions, I am going to assume that a realistic earnings forecast for 2012 is $82. I will note that this puts me at the low end of published forecasts and well below the mean of $112. I also believe that deflationary pressures are quite strong in the economy due to falling house prices, fiscal austerity, weakening monetary stimulus, high unemployment, anticipated falling prices in commodities, high consumer debt levels, and over-supply of retailers. Due to these potential deflationary pressures, I'm going to assume the CPI turns negative at some point in 2012. Putting a 10x multiple of this estimate I arrive at a SP 500 price of $820. Of course if this scenario plays out, or proves more like 2008-2009, the fear in the market is likely high, potentially causing the SP 500 to dip well below this mark.
Based on this analysis I plan to keep my 60+% position in 30-year treasuries. If the yield falls below 3% then I will need to re-evaluate the position. I also am maintaining a significant cash position of around 20%. My 20% position in equities is largely focused in higher dividend yielding domestic energy, healthcare, utilities, and consumer staple companies.
Looking at the projected "bottoms-up" earnings for the SP 500 we find the following: 2011 of $98 and 2012 of $112. Put differently, the earnings growth rate analysts are expecting in 2011 is 17% and in 2012 is 14%. Seems aggressive when U.S. GDP growth is slowing. Analysts argue that a large portion of the revenue from companies within the SP 500 comes from outside the U.S.. Fair enough, but Europe isn't exactly exploding with growth. Exploding possibly, but not in a good way. Developing markets are increasingly pinched between high inflation and slowing growth. And, let's face it, if both Europe and the U.S. enter a deflationary period the chances of developing countries side-stepping a recession are remote.
So what is a realistic earnings assumption? Going back to WWII, companies in the SP 500 have seen earnings pull back on average about 15% during a recession. Assuming earnings come in around $95 for 2011, this would imply 2012 earnings of about $82 and a current P/E of 14x. Not an unreasonable valuation if you expect the economy to bounce back quickly. The 2008-2009 recession witnessed a 50% pullback in earnings largely due to the decimation of the financial sector, implying earnings of around $50 in 2012 and a P/E of 23x. Given that some investors are claiming the potential problems in Europe are worse than the collapse of Lehman due to the sovereign debt risk, this outlook cannot be pushed aside. Suddenly the market does not look so cheap.
The final point I'd like to make is that the P/E tends to contract when prices are less stable. Both high inflation and deflation tend to result in lower P/E multiples. An inflation rate, as measured by CPI, above 5% or below 0% is highly correlated with a P/E below 12x. This suggests if we enter a recession and deflation takes hold the P/E for the market likely contracts on top of lower earnings.
Using an average recession as the baseline for my investment decisions, I am going to assume that a realistic earnings forecast for 2012 is $82. I will note that this puts me at the low end of published forecasts and well below the mean of $112. I also believe that deflationary pressures are quite strong in the economy due to falling house prices, fiscal austerity, weakening monetary stimulus, high unemployment, anticipated falling prices in commodities, high consumer debt levels, and over-supply of retailers. Due to these potential deflationary pressures, I'm going to assume the CPI turns negative at some point in 2012. Putting a 10x multiple of this estimate I arrive at a SP 500 price of $820. Of course if this scenario plays out, or proves more like 2008-2009, the fear in the market is likely high, potentially causing the SP 500 to dip well below this mark.
Based on this analysis I plan to keep my 60+% position in 30-year treasuries. If the yield falls below 3% then I will need to re-evaluate the position. I also am maintaining a significant cash position of around 20%. My 20% position in equities is largely focused in higher dividend yielding domestic energy, healthcare, utilities, and consumer staple companies.
Monday, September 5, 2011
Possible Bottom in One to Two Months?
In the next one to two months I expect panic in the markets to reach a new high due to three issues:
(1) U.S. "Paying the Piper"
(2) European Debt Crisis
(3) Slowing Asian Economic Growth
During this time I expect the yield on the 30-year treasury to dip well below 3% as investors seek out safe harbors and away from volatile equity markets. Yields on longer term treasuries may even go lower if the markets believe the Federal Reserve may pursue "Operation Twist." This initiative by the Fed would effectively involve buying longer-term bonds in an effort to push down the yield curve, a theoretical economic stimulus. I am not yet convinced of this potential action since I believe the Fed is increasingly pointing the finger at Congress to address structural problems in the economy. But, if speculation builds and yields fall, then I may sell my 30-year treasury position into the buying strength.
U.S. "Paying the Piper"
Everyone has an opinion about who is at fault for the mess, and even a few have opinions about the correct path forward. However, as I laid out in my July 12 article of Pro-inflation Democrats versus Pro-deflation Republicans, whatever path we follow likely involves pain. The future pain is called "paying the piper" for 30+ years of rising debt levels, perversion of the government by special interest money, and an over-active monetary policy that enabled bad behavior. Given the anticipated on-going partisan politics, I expect nothing short of complete crisis to force the two sides into constructive efforts forward. A telling sign of what's to come is the composition of the super committee put together to find $1.5 billion in deficit reductions. Both sides favored members who lean away from compromise. Given that both sides are gearing up for a Presidential election, the outlook for country first, party second is quite bleak.
So with the consumer confidence falling, zero job growth, a government actively suing for billions of dollars from the banks, and a government favoring austerity; it seems like an economic slowdown is in the cards going forward. Americans are already sick of politicians fighting and I expect to hear a lot more partisan bickering over the next couple months. This is likely bad for stocks and good for treasuries in the short-term.
European Debt Crisis
Europe appears caught in a death spiral of austerity initiatives to reduce deficits resulting in slowing economic growth and thus larger deficits. Greece and Spain are about a year into this spiral and now Italy looks set to follow in its foot steps. As yields on the country's ten-year bond approaches 7%, I expect increasing panic to set in since 7% is considered an unsustainable level for debt service. The CEO of Deutsche Bank warned that weaker banks in Europe are vulnerable to a revaluation of sovereign debt, suggesting that sticking the problem to the banks is not a viable solution. Thus the issue likely circles back to the governments who either vote for bailouts of weaker countries (unpopular in Germany) or a combination of further austerity measures and debt defaults. I expect these issues to come to a head over the next couple months as bond investors increasingly fear a default, thus driving up yields and forcing the hands of the politicians.
Slowing Asian Economic Growth
China's economy appears to be slowing, as shown by a service sector flirting with actual contraction, increasing signs of corruption impacting middle class decisions, and signs of the potential popping of a real estate bubble. China's economy is the second largest in the world and therefore a slowdown likely impacts global financial markets. For some time there has been speculation that the growing wealth within the middle class could propel internal growth, lessening the reliance on exports. However, it is hard to imagine how China could continue to prosper if both the U.S. and Europe went into a recession since well over a third of China's GDP comes from exports. Even more so since the government already made a massive fiscal stimulus into the economy in 2008. Therefore, I believe financial markets likely increasingly focus on slowing growth in Asia as a concern.
(1) U.S. "Paying the Piper"
(2) European Debt Crisis
(3) Slowing Asian Economic Growth
During this time I expect the yield on the 30-year treasury to dip well below 3% as investors seek out safe harbors and away from volatile equity markets. Yields on longer term treasuries may even go lower if the markets believe the Federal Reserve may pursue "Operation Twist." This initiative by the Fed would effectively involve buying longer-term bonds in an effort to push down the yield curve, a theoretical economic stimulus. I am not yet convinced of this potential action since I believe the Fed is increasingly pointing the finger at Congress to address structural problems in the economy. But, if speculation builds and yields fall, then I may sell my 30-year treasury position into the buying strength.
U.S. "Paying the Piper"
Everyone has an opinion about who is at fault for the mess, and even a few have opinions about the correct path forward. However, as I laid out in my July 12 article of Pro-inflation Democrats versus Pro-deflation Republicans, whatever path we follow likely involves pain. The future pain is called "paying the piper" for 30+ years of rising debt levels, perversion of the government by special interest money, and an over-active monetary policy that enabled bad behavior. Given the anticipated on-going partisan politics, I expect nothing short of complete crisis to force the two sides into constructive efforts forward. A telling sign of what's to come is the composition of the super committee put together to find $1.5 billion in deficit reductions. Both sides favored members who lean away from compromise. Given that both sides are gearing up for a Presidential election, the outlook for country first, party second is quite bleak.
So with the consumer confidence falling, zero job growth, a government actively suing for billions of dollars from the banks, and a government favoring austerity; it seems like an economic slowdown is in the cards going forward. Americans are already sick of politicians fighting and I expect to hear a lot more partisan bickering over the next couple months. This is likely bad for stocks and good for treasuries in the short-term.
European Debt Crisis
Europe appears caught in a death spiral of austerity initiatives to reduce deficits resulting in slowing economic growth and thus larger deficits. Greece and Spain are about a year into this spiral and now Italy looks set to follow in its foot steps. As yields on the country's ten-year bond approaches 7%, I expect increasing panic to set in since 7% is considered an unsustainable level for debt service. The CEO of Deutsche Bank warned that weaker banks in Europe are vulnerable to a revaluation of sovereign debt, suggesting that sticking the problem to the banks is not a viable solution. Thus the issue likely circles back to the governments who either vote for bailouts of weaker countries (unpopular in Germany) or a combination of further austerity measures and debt defaults. I expect these issues to come to a head over the next couple months as bond investors increasingly fear a default, thus driving up yields and forcing the hands of the politicians.
Slowing Asian Economic Growth
China's economy appears to be slowing, as shown by a service sector flirting with actual contraction, increasing signs of corruption impacting middle class decisions, and signs of the potential popping of a real estate bubble. China's economy is the second largest in the world and therefore a slowdown likely impacts global financial markets. For some time there has been speculation that the growing wealth within the middle class could propel internal growth, lessening the reliance on exports. However, it is hard to imagine how China could continue to prosper if both the U.S. and Europe went into a recession since well over a third of China's GDP comes from exports. Even more so since the government already made a massive fiscal stimulus into the economy in 2008. Therefore, I believe financial markets likely increasingly focus on slowing growth in Asia as a concern.
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