December 27, 2010
A Fed-Induced Speculative Blowoff
Why are Treasury yields rising despite hundreds of billions of Treasury purchases by the Federal Reserve? There are two possibilities in the current debate. One is that the Fed's policy of purchasing Treasuries has scared the willies out of the bond market on fears of higher inflation, and that the policy is a failure. The other is that the policy has been such a success at boosting the prospects for economic growth that interest rates are rising on anticipation of a better economy.
From our standpoint, neither of these explanations hold much water. On the inflation front, the recent bond selloff has hit TIPS prices as well as straight Treasuries, which isn't something you'd expect to see if inflation expectations were being destabilized. And although precious metals and other commodity prices have been pressed higher, the commodity run can be more accurately traced to negative real interest rates at the short-end of the maturity curve, coupled with a downward trend in long-term yields that has now reversed dramatically (more on that below). I've long argued that unproductive government spending and profligate fiscal policy are ultimately inflationary (regardless of how the spending is financed, and particularly if it is monetized), but I continue to view persistent inflation as a long-term, not near-term concern. A rise in T-bill yields of more than 15-25 basis points would change that assessment. Until then, velocity can be expected to collapse in direct proportion to changes in the monetary base, with little impact on prices.
As for the notion that the Fed's targeted Treasury purchases have directly aided the economy, the argument requires bizarre logical gymnastics. It demands one to believe that although the purchases were intended to stimulate the economy by lowering rates, they have been successful without lowering them, and in fact by raising them, because the expectation of lower rates was so stimulative that it caused rates to rise, so that the higher rates can be taken as evidence that lowering rates without lowering them was a success. Oh, brother.
It's clear that we've seen some firming in various indicators such as the Purchasing Managers Index, the ECRI Weekly Leading Index and weekly claims for unemployment. The question is whether these can be traced to lower yields and greater availability of liquidity. On the interest rate front, the answer is clearly no, as Treasury and mortgage rates are even higher than they were before QE2 was announced. On the "liquidity" front, the additional reserves have simply added to an existing pile of well over a trillion dollars of idle reserve balances in the banking system. And while we did see a pop in consumer credit in the latest report, it was entirely due to Federal loans to students (arguably people displaced from the labor force and seeking an alternative). Other forms of consumer credit have collapsed at an accelerating rate.
So neither side typically taken in the debate over the Fed's Treasury purchases is particularly satisfying. Fortunately for fans of logic, there is a third explanation that is much more plausible, and has the benefit of having data behind it. Despite my extreme criticism of Fed actions in recent years, I would argue that QE2 has in fact been "successful" over the short-term, but not through any monetary mechanism. Rather, QE2 has been successful a) by creating a burst of enthusiasm that released some pent-up demand in the same way that Cash for Clunkers and the new homebuyer tax credit did, and b) by encouraging investors to believe that the Fed has provided a "backstop" for stocks and other risky assets, creating a speculative blowoff in these securities, to the detriment of what investors perceive as "safe" assets, which ironically includes Treasury securities.
In short, the main effect of QE2 has not been monetary but has instead been rhetorical - and that rhetoric may very well be nearly empty.
The key event related to QE2 wasn't its formal announcement, but was instead the Op-Ed piece that Ben Bernanke published a few days later in the Washington Post, which essentially advanced the argument that the Fed was targeting a "wealth effect" in stocks and other risky assets, in hopes of getting people to consume off of that perceived wealth. At that moment, Bernanke unleashed a speculative bubble in risky assets, and a selloff in safe ones. This has rewarded risk-seeking and punished risk-aversion, but it has also unfortunately driven the markets into an overvalued, overbought, overbullish, rising-yields condition that has historically ended in steep and abrupt losses.
Ned Davis Research tracks a set of "factor attribution" portfolios, which measure the performance between the top 10% of stocks ranked by a given factor, and the bottom 10% of stocks as ranked by that factor. The factors are things like market beta, dividend yield, 26-week momentum, and so forth. Essentially, the these factor portfolios track the return of hypothetical portfolios that are long the top 10% and short the bottom 10% of stocks based on any given variable.
The performance of these 133 factor portfolios over the past 13 weeks offers tremendous insight into the extent to which the Federal Reserve has encouraged speculative risk. Investors are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk and volatility. Conversely, securities demonstrating reasonable valuation, stability, quality, or payout have been virtually abandoned by investors. Here is a sampling:
For us, the past few months have felt like our own miniature equivalent of a bear market. The Strategic Growth Fund has pulled back by several percent, and though our occasional drawdowns have been a fraction of those experienced by the S&P 500 over time, the past four weeks have felt relentless on a day-to-day basis. During this period, the strongest four factors have been: Market Beta (8.98%), Sigma Risk (8.50%), Small vs. Large Beta (8.05%), and Cyclical vs. Consumer Beta (7.75%). Meanwhile, factors such as High vs. Low Quality Beta (-2.18%), Dividend Yield (-3.07%), and EPS Stability (-5.16%) have been particularly unrewarding.
The problem with this outcome is that the speculative factors being rewarded over the short-term have nothing to do with the characteristics that have historically been rewarded over the long-term. Despite various periods where valuation is out-of-favor, value has been the clear winner over time. Moreover, it has been destructive to discard valuation in preference for chasing momentum and relative strength after the fact. In contrast, chasing high beta or momentum has conferred no durable benefit for investors. Here is a sampling of 10-year factor returns:
From a stock selection perspective, we've found it most effective over the long-term to maintain a discipline favoring cash-flow based valuation, supplemented by measures of price/volume behavior, overweighting or underweighting individual sectors to the degree that they overlap our selection criteria. So we're perfectly happy holding cyclical stocks, technology stocks, or other sectors, but we hold those stocks because they exhibit characteristics that have historically been rewarding. What we don't do is speculate on a given industry when its component stocks are clearly overvalued, or chase a given sector just because it happens to be the favorite momentum concept of the quarter. I should note that market action can be useful as a component of a stock selection approach, but it has historically been a dangerous sign when investors chase speculative momentum while at the same time penalizing favorable valuation and quality, which is what we see at present.
We've seen this movie a few times now, and the ending never changes. As the market approached the peak of the last market cycle, I noted that the performance of value managers has often been least impressive when the market was approaching a long period of dull and often negative returns. Following that piece (When Value Mavens Lag - November 18, 2006), the S&P 500 actually advanced for another 14 weeks, gaining nearly 4% in that period. It then dropped about 6% in the next few sessions. The market would eventually recover about 15%, before losing the gain in the next 13 weeks, and then falling in half from there. While the current speculative run may be shorter or longer, I doubt that any of the returns of recent months will prove to be any more durable. We've introduced some changes into our Market Climate approach that will allow us to accept moderate exposures to market fluctuations more frequently than we have in recent years, but our stock selection approach remains unchanged, despite the recent discomfort.
In the "Value Mavens" piece, I made some observations about Berkshire Hathaway's long-term record under Warren Buffett: "Though Berkshire's stock price has historically been much more volatile than its book value, they have soared together over the long run. That's not to say that they've grown every year - they haven't. But over time, price has followed value. That says something. It says that the attention of a good investor should be on the worth of the underlying businesses. If those are solid and growing, market prices will come to reflect that over time. In my view, a good fund manager spends a lot of time thinking about the underlying value of the businesses that are owned on behalf of shareholders, and doesn't gamble a great deal of shareholder capital when the only merit is speculative momentum. The responsibility is to own assets and claims on probable future cash flows, not just hot air. If the underlying values in the portfolio have a solid foundation (and particularly if investor sponsorship supports that assessment, as evidenced by price-volume behavior), market prices generally come to reflect the underlying values over time."
In short, we are observing what can only be described as a Fed-induced speculative blowoff. While this has been avidly encouraged by the Fed, it is important to recognize that there is no actual economic mechanism at play here other than words. Investors are chasing stocks because Ben Bernanke told them to, and despite the fact that we have seen two plunges of more than 50% each over the past decade, investors are at least temporarily willing to believe that the Fed will "backstop" their risk-taking by preventing the market from falling. As for any "transmission mechanism" attributable to QE2 itself, Treasury yields and mortgage rates have increased sharply since the Fed first announced QE2, and the additional reserves created by Fed purchases have simply added to the already massive and idle pool held by banks. Unless one twists logic into a pretzel so that up is down, one can identify nothing of substance in the Fed's policy that is supporting the markets. Stocks are being buoyed solely by a combination of words, sentiment and superstition. As Stevie Wonder put it, "When you believe in things that you don't understand, then you suffer."
From a longer-term perspective, the simple fact is that Fed-induced bubbles do not change the long-term mathematics of investment returns, which are based on deliverable cash flows. Over the short-term, Fed actions can undoubtedly postpone market declines. But as we've repeatedly observed, the Fed can do so only by making those losses far worse when they arrive.
On the valuation front, the consensus estimate from the strongest models we track indicates that the S&P 500 is most likely priced to achieve 10-year total returns averaging about 3.6% annually. Given the inverse relationship between the Russell 2000/S&P 500 ratio and subsequent relative returns for the Russell 2000, I expect that returns will most likely be negative for small-cap stocks over the coming 4-year period, even without the assumption of renewed economic weakness.
As the market approached its 2007 peak, I published a piece titled Fair Value - 40% Off (not a forecast, but don't rule it out) where I noted that stocks were grossly overpriced not only on the basis of earnings-driven models, but also based on discounted dividends (including the impact of repurchases):
"Suppose we look back over history, and at each date, add up all the dividends the S&P 500 actually delivered over the subsequent years, discounted at a long-term rate of return of 10%. We could literally check whether investors got what they paid for. Of course, the more recent the date, the more we'd have to project some future dividends. But that's not a terribly difficult matter. As it turns out, the average dividend growth rate since 1900 has been about 5%, the average since 1940 has been 6%, and the highest growth rate for any 30-year period has been 6.4%. We also know that S&P 500 earnings growth has displayed a very, very durable 6% growth rate measured from peak-to-peak across economic cycles. So assuming anything between 6% to 7% long-term dividend growth will give us a very robust series of likely future dividends."
As it turned out, the "40% off" valuation assessment was actually optimistic, as the S&P 500 lost more than half of its value over the next two years. Below, I've updated the chart that appeared in that study. Even if we assume a future dividend growth rate of 6.7%, which is the fastest growth rate observed over any 25-year span during the past century (and again, includes the impact of share repurchases), the S&P 500 would currently have to stand at 748 in order to be priced to achieve long-term total returns of 10% annually.
Of course, with the S&P 500 at about 1256 despite a contraction in dividends over the past few years, this analysis would imply that fair value is again about 40% below present levels. It would be nice to be able to rule that conclusion out. Then again, it would have been nice to rule it out in 2007, not to mention in 2000, when our 10-year total return projection for the S&P 500 was negative based on every historically consistent assumption we could make about terminal valuations.
What's interesting today is that a projected 3.6% annual total return for the coming decade, compared with a "normal" 10-year return of 10% annually, implies roughly the same level of overvaluation as indicated by discounted dividends - putting fair value roughly 40% below present levels. On that note, I was struck by Alan Abelson's latest piece in Barron's, where he offered:
"The latest calculation by Andrew Smithers, the smart Brit who runs the eponymous London-based investment firm Smithers & Co., is that U.S. equities are more than 70% overpriced, according to q, his favorite yardstick and essentially a measure based on replacement value.
"Just to put you at ease, we haven't quite lost our minds, nor Andrew his. The market, rest assured, isn't about to vanish into the void. And Andrew is quick to point out that by his reckoning, stocks are well below their valuation peaks of 1929 and 1999, but more or less even-steven with the highs of 1906, 1937 and 1968.
In the chart below - courtesy of Doug Short - the historical norm for Q is 0.70, which is nearly 40% below the recent Q ratio of 1.12. Equivalently, the recent level is nearly 70% above the historical norm.
Abelson continues, "For all his wariness for the long pull, he doesn't see share prices suffering a steep fall so long as the Federal Reserve keeps pumping liquidity into the system and Washington stalls on meaningful deficit reduction. Frankly, although we greatly esteem Andrew's perspicacity, we aren't so sure he's right. Not least because so many market mavens now share his view, which suggests to us, as the old Street cliché has it, it probably has already been discounted in the latest bump up in equities."
With advisory bullishness back to 2007 extremes and equity put/call ratios at similarly extreme levels, I have to agree with Alan on that point.
So that is where valuations stand. I recognize that the conclusions seem implausible. I would not be inclined to share this data if it didn't have a strong historical record. The first criticism of these valuation implications is undoubtedly that they imply P/E ratios on forward operating earnings that seem far "too low." On this note, it's important to recognize that profit margins are currently about 50% above the historical norm. Moreover, while a multiple of 15 may be appropriate for trailing net earnings on normalized profit margins, it is a wholly inappropriate multiple to apply to forward operating earnings on elevated margins.
It is one thing to factor that reality into valuations - if margins can remain 50% above the norm for a full decade before contracting, it's easy to show that stocks should be valued about 15% higher than otherwise. But it is entirely another thing to assume that profit margins will remain 50% above historical norms forever, ignoring every bit of historical evidence that they revert to the norm over time. Analysts who blindly apply a multiple that "feels right" to next year's projected operating earnings are implicitly assuming that margins will remain permanently elevated at record levels. The common practice of blindly applying an arbitrary multiple to the coming year's projected earnings is an error that reflects profound misunderstanding of how securities are priced.
The second criticism of course, is that 10% may not be an appropriate discount rate, given 30-year Treasury yields at 4.5%. On this, I'll make two observations. The first is that in post-war data, the projected long-term total return for stocks has averaged about 4.25% more than long-term Treasury bonds. So if one believes that long-rates will remain at 4.5% forever, it's probably appropriate to bring the discount rate down, which would make stocks less overvalued, but highly vulnerable to any interest rate surprise. The second observation is that the S&P 500 has historically carried an average duration of about 30 years (if you work through some calculus, the duration of stocks turns out to be roughly equal to the price/dividend ratio), so the appropriate benchmark would normally be a 30-year zero coupon bond. Presently, the S&P 500 has a duration upward of 53 years. In order to price it properly, you can't simply refer to the current, depressed 10-year yield on a coupon-bearing Treasury. You have to think of the rate of return investors will demand 5 years, 10 years, 20 years, 30 years, and even 40 years from today. A 10-year Treasury has a duration of roughly 7 years. There's neither a theoretical nor historical basis (if you actually test it, which most people don't) for using the 10-year Treasury as a benchmark return for equities.
We focus on valuation models where the deviation from fair value is strongly correlated with subsequent market returns over the following 5-10 years. We hear a lot of "valuation" calls from analysts who seem to believe it is unnecessary to subject their models to historical tests. But investors should demand no less than a 7th grade math teacher does - "Please show your work." We're certainly open to alternative models that have a testable historical record. We're not interested in making a bullish case or a bearish case - our objective is to estimate prospective returns accurately. From where we stand, the evidence is presently not encouraging.
To say that fair value is far below present levels does not imply that the market will revert quickly to that level - only that long-term total returns are likely to be tepid as prices grow slower than fundamentals for an extended period. Moreover, to say that stocks may not revert quickly to our estimates of fair value means that we will need to have some willingness to accept market risk even in periods when stocks are still overvalued from a longer-term perspective. As I've noted in recent weeks, we've broadened the range of Market Climates we define in a way that we believe is robust, and will allow us to accept moderate exposures to market fluctuations more frequently than we have in recent years. In short, while we are not enthusiastic at all about market valuations, we've also improved our ability to play the hand that the market deals us as we move forward.
As of last week, the Market Climate for stocks continued to be characterized by an overvalued, overbought, overbullish, rising-yields conformation that has historically been very hostile to stocks. That said, this Climate is also characterized by what I've frequently called "unpleasant skew" - if you think of day-to-day market returns as being drawn from a sort of "bell curve," the highest probability area of the bell is actually a small positive gain, but there is also a shortened right tail (a lower-than-normal likelihood of large gains) and a fat left tail (a much higher-than-normal likelihood of steep losses). So the average outcome is negative, but the most frequent "draw" is actually a small gain.
To offer a basic feel for this, below is a sample path of 100 draws from a probability distribution where there is a 98% chance of a 0.2% gain, coupled with a 2% chance of a 9.8% loss. Clearly, real-world distributions are more subtle, but my concern about this Climate should be evident.
Both Strategic Growth and Strategic International Equity are fully hedged. With option volatilities extremely depressed, we have a "staggered strike" position in Strategic Growth, which tightens our hedge by raising our put option strikes closer to the level of the market.
In bonds, the Market Climate was characterized last week by relatively neutral yields and unfavorable yield pressures. The Strategic Total Return Fund continues to carry a defensive duration of just under 2 years.
On the precious metals front, it's useful to recognize how important falling Treasury bond yields and negative short-term interest rates have been in the recent commodities run. Historically, the Philadelphia gold stock index (XAU) has advanced at a 23.0% annual rate when the 10-year Treasury bond yield has been below its level of 6 months earlier, but has declined at a -5.9% annual rate when Treasury yields have been rising. With respect to short-term real interest rates, the XAU has advanced at a 16.1% annual rate when 3-month Treasury bill yields have been below the year-over-year CPI inflation rate, and just 4.1% otherwise. Put falling Treasury yields together with negative short-term real rates, as we've seen during much of the recent commodity price run, and you'll find that the XAU has historically advanced at a 33.9% annual rate. Notably, Treasury yields have recently reversed course, and are now above their levels of 6 months ago. While real short rates are still negative, this has historically not been enough to overcome rising bond yields and produce positive returns in the XAU, on average, except when the Gold/XAU ratio has been well above 7.In short, my impression is that investors chasing commodities have not paused to recognize that one of the major supports for this run - falling Treasury bond yields - has been knocked away from them. There may be some pure momentum remaining for commodities, but this is now purely speculative. A much better environment for gold stock holdings would include falling Treasury yields, negative real rates at the short-end of the maturity curve, reasonable valuations of gold stocks to the bullion (which is presently still the case), and some amount of downward economic pressure, such as a Purchasing Managers Index below 50. The present Market Climate for precious metals shares isn't terrible by any means - it's just not positive anymore.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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