Broker Check

The Fed Model

| April 13, 2018
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The stock market now exceeds the extreme valuation peak of 1929 and is only exceeded by the 2000 Tech Bubble as measured by the Shiller Cyclically Adjusted Price Earnings (CAPE) ratio.

While the Shiller CAPE ratio may have some critics, both the “Fed Model” or “Risk Premium” offer a more pragmatic approach by comparing the S&P 500 earnings yield to the 10-year US Treasury bond yield.


A comparison of the 10-year US Treasury yield to the earnings yield of the S&P 500 shows that earning yield (S&P earnings/S&P price) in 1999 and 2000 is lower (less expensive) than 10-year US Treasuries. The “Risk Premium”, shown on the top pane, is the difference between the earnings yield of the S&P 500 and the yield of 10-year US Treasury. While the stock market was quite overvalued in 1999 and 2000, it was not until earnings slowed that the market turned down in March 2000 and October 2007. The blend of trailing earnings and expected earnings is both forward looking and historically accurate.


Last year, expectations of lower taxes and an improving economy, drove earnings and the stock market higher. With the passage of The Tax Cut and Jobs Act of 2017, earnings spiked up from December through February with the passage of new tax law and earnings. In March, earnings appear to have peaked. The year-end jump in blended earnings reflects lower corporate tax rates being incorporated into estimates. The recent flattening of earnings suggests that the market has largely discounted the tax cuts.


Earnings and Yields

Recent market volatility is shown by the 10-year US Treasury rate rising at an accelerating rate from 2.354% in November to 2.85% on February 2nd and inspiring our Echoes of the 1987 crash before the market declined intraday 1500 Dow points on February 5th. Estimated earnings also rose from 144.82 in November to 170.38 in early March where they have paused. Since markets (and computer programs) are forward looking and Risk Premium is simply an indication of valuation, we focus on the trend in earnings and trend in interest rates. Presently, the S&P 500 Risk Premium is 3.21%; the market is expensive, but not perilously priced given the low interest rate environment. However, absent obvious exogenous factors like wars, trade wars, or negotiations with North Korea, etc., the market could decline, if interest rates trend higher and or earnings trend lower.

In the last two years both short and long-term interest rates have moved up. Given the recent 18% increase in expected S&P 500 earnings for 2018 (from $144.82 in November to $170.32 at the end of March) the market may have discounted the benefit of the tax law change and leaves the S&P 500 at 15.5x forward earnings–a reasonable valuation level. However, for interest rates to move meaningfully higher from here, a return of in inflation would need to occur.


Current Market Levels

The NASDAQ served up an annualized return of 66% in its final two years of dot-com mania. Only after the balloon had burst did people begin to question the lunacy of paying 10x revenue for the privilege of being a shareholder.


Ironically, since early 2016, the top 10 growth names in tech collectively produced an annualized return of 67%. The NYSE FANG+ Index has topped turn-of-the-century craziness.

We may be witnessing peak FANG fanaticism. Components of the NYSE FANG+ Index like Facebook, Netflix, Twitter and Nvidia currently sport mind-boggling price-to-revenue (P/S) ratios of 13.3, 12.3, 10.9 and 15.3.

The S&P 500's forward P/S above 2.0 already is the most expensive in history, which includes the tech bubble at the start of 2000.

A traditional valuation thinking of a P/S of 10 implies that a company need deliver 100% of its revenue stream for each year across a decade to provide a 10-year payback. Even with massive tax cut relief, highly attractive borrowing terms, and share buybacks by the boatload, it is virtually impossible to deliver 100% of a corporate revenue stream back to shareholders for 10 consecutive years.


Investors may not be investing in the longer-term profitability of FANG+ components either. Amazon has been struggling with its cumulative profits and free cash flow for its entire existence. Pretending that the world's second-largest company by market capitalization justifies its forward price-to-earnings (P/E) ratio of 186 because it has transformed business as we know it is preposterous.


During the current bull-bear cycle, the stock shares of great companies have been getting pushed exponentially higher by machines that employ algorithmic trading. When the bear portion of the cycle hits, the "algos" may crush the overly leveraged FANG+ fanatics.


Peak FANG+ extremism is a sign. Another in the current bull-bear cycle is peak corporate debt.


The median S&P 500 (ex. Financials) company's net debt to earnings before interest, tax, depreciation and amortization (EBITDA) has hit a 50-year high.


We saw corporate leverage creating a problem in the last two stock disasters (i.e., 2000, 2008). Excessive borrowing preceded the previous three recessions (i.e., 1990-91, 2000-2002, 2008-2009).


Many corporations could not resist the lure of extremely cheap money that global central banks made possible since the 2008 financial crisis. The Federal Reserve is simultaneously hiking overnight lending rates as well as allowing its balance sheet to erode so that borrowing costs become more expensive. Similarly, the European Central Bank is buying less assets. This tapering is akin to tightening in that borrowing costs around the globe will be costlier.


Sharp increases in key borrowing rates is a risk to corporations that must continually reissue more bonds. As interest rates rise, their costs to service interest expense goes up. That may divert money away from dividends and/or buybacks. It also may take a toll on capital expenditures for growth as well as hinder profitability and profitability perceptions (earnings per share).


Creating tens of trillions in electronic currency credits has been the greatest coordinated experiment in the history of finance. There is little debate on the exceptionally high correlation between global stock performance and the expansion of global central bank balance sheets.

If central bank support has peaked, should we be concerned that economies themselves have peaked in this current bull-bear cycle?


Real estate refinancing just hit a nine-year low. With property prices surpassing the all-time highs of the housing bubble on a nominal basis, many prospective homeowners can no longer afford payments because of higher mortgage costs. If the Federal Reserve continues along its tightening path, it is difficult to imagine home buying rates getting cheaper in the near-term.


Regardless of the recent tax cut package, even the Federal Reserve has dramatically downshifted its own projections for Q1 U.S. economic growth. It seems that the nine-year economic recovery will still be anchored near an annual average growth rate of 2%, not 3%. Higher borrowing costs from tighter monetary policy are likely to offset the fiscal stimulus of government spending.


One of the major sources of economic well-being is confidence. Businesses and consumers are reporting extraordinary levels of positiveness.


This is generally what tends to happen at peaks. Is unemployment more likely to keep falling below the 4% level, or is it more likely to be a point of inflection?


We may be dealing with peak economic well-being, peak central bank support, peak corporate debt as well as peak FANG fanaticism in the current bull-bear cycle.


The potential threats in the political/geo-political realm are greater than we had in years past. How much will trade wars between world economies escalate?


Even without a trade war, it is questionable if central banks will stay in sync with one another. The European Union and the United States may be able to remain on the same page, but Japan has trillions of yen-denominated reasons not to play nice in the global sandbox.


Specifically, the Bank of Japan’s “yield control” policy of printing as much yen as necessary to make sure that its 10-year government bond remains anchored at 0% may not sit well with other countries. Other nations may view endless yen creation to gain an unfair advantage in exporting goods.


Trade wars. Currency wars. This is not even accounting for the possibility that the Mueller investigation becomes decidedly ugly for Trump's agenda. The mid-term elections could prove to be even more challenging and swing the balance of power in Congress.


The Last Time Energy Stocks Underperformed That Badly, They Went on To A Multi-Year Bull Market

Many feel commodities are cheap. Commodities have long cycles, as well. A comparison of the total return of the Standard & Poor’s 500 index to the total return of the Goldman Sachs Commodity Index shows the cycles. In the 1970s, commodities started to outperform. They outperformed the S&P 500 by 800%, and then gave it all back. Then there was another wave up, and commodities outperformed again by 800%, 900%, which continued into 2008. A resurgence in inflation comparable to recent cycles could be disruptive.

Comparing the contrast between 2002 and today, it was approximately 9 months after oil prices started to rise, energy stocks followed. Everyone wants to be a contrarian, but when given the opportunity, no one takes it.


For energy (XOP & XLE) investors, the volatility in February that resulted in risk-off in global equities did not see the same enthusiasm return.

Great returns often follow times of despair, such as early 2016. The only time that severe underperformance in energy stocks relative to the broader market level took place was followed by one of the greatest multi-year bull markets in history.


The energy sector's public share of total public equity was down to 5%, which was lower than where it was in early 2016 when WTI was at $26:

(Source: Warren Pies)


The last time such underperformance took place was in 2002, but the broader market was also in a bear market then, making this underperformance even more unprecedented.


(Source: Warren Pies)


What followed the year after was a multi-year bull market for energy stocks. However, the backdrop of the oil market fundamentals needs to remain bullish for energy stocks to keep performing.


2003:   24.81%

2004:   30.93%

2005:   40.53%

2006:   18.21%

2007:   34.69%


The energy underperformance was like 2002-2003, when 9 months following the rise in oil prices, energy equities start to catch up.

(Source: HFI Research; the chart above is S&P energy sector versus WTI, comparing the two periods)


Being contrarian is hard, but you get paid for the pain. Outsized gains may await if you are contrarian and you are right.


“You can’t do the same things others do and expect to outperform.” ~ Howard Marks


What Lies Ahead for Bonds?

As investors have recently rediscovered, stocks have risks. So, do bonds.


When Fed Chairman Jerome Powell recently hinted his agency could boost rates as many as four times this year, volatility ensued. The stock turbulence demonstrated that weakness may be looming for bonds, as well.


A misconception investors have is thinking that their portfolios are safe, because they are mostly invested in bond funds.


Rising bond yields coupled with relatively high fees hidden inside several fixed-income investment vehicles, could lead to some underwhelming returns for bond funds.


As of mid-March, the benchmark Bloomberg Barclays Aggregate bond market index was down almost 2% year-to-date. Twice in the past two decades (in 1999 and again in 2013), bond funds have suffered down years on fears of inflation and rising interest rates, in addition to some losses in 2008 during the financial crisis.


One approach is to focus on credit risk, the chance that issuers will not meet their interest payout and bond redemption promises. Where stocks serve as the engine and the bonds serve as the airbag. Investing in low-quality bonds could be the equivalent of filling your car air bag with shrapnel.


Any event that causes stock prices to fall — interest rate hikes, geo-political issues, weak economy, etc. can cause the airbag to deploy, spreading shrapnel that can damage the investment plan.


Bonds are to cushion a portfolio in a market downturn, so it is important that they be high quality. Bonds are intended to be the unsexy, vanilla piece of the portfolio. Maintaining a high-quality bond cushion allows for increased risk in other parts of a portfolio. That is where stocks come into play.


Investors frequently expect unrealistically high returns from bonds. It is possible to receive higher returns from low-quality, risky bonds. Funds holding low-quality bonds may have credit risk, but funds with higher quality bonds are by no means risk free. Rising bond yields would likely have an impact on several different types of bond funds.


Bond funds that mainly invest in high-quality securities would be more affected, because they have lower coupons and thus less support to protect them during periods of rising rates.

Also, a rise in yields may cause several investors to pull money from bonds funds. This could force those portfolio managers to sell securities to meet redemptions. If bond fund managers are forced to sell various investments to meet growing redemptions, regardless of how strategic they are to the investment portfolio, this could be to the detriment of all shareholders.


Lack of maturity: Credit risk and interest rate risk can impact individual debt issues, yet bond funds have another possible trap. Typically, there is no scheduled return of investment.


Individual bonds are different than bond funds, because they have stated maturity dates. Investors know what the yield to maturity — or ‘yield to worst’ if a bond is callable — will be at the time of original purchase. With bond funds, investors might see share value drop and not rebound.


The lack of a certain maturation or return of principal is not the least risk of holding bond funds.


Price declines due to interest rate rises are not necessarily the end of the story. If bond funds make sense, it must be accepted that the funds' share prices are going to fluctuate.


There always will be some risk of their principal value falling below the purchase price, if only temporarily.

Such price declines can be offset by ongoing reinvestment of the income distributions, at higher rates. Even in a rising interest rate environment, the manager can reinvest the proceeds in higher yielding new bonds as the individual securities within the fund’s portfolio mature. That should eventually result in the fund's income yield ‘equilibrating’ to the higher interest rate environment.


A rate-caused decline in share price can be only temporary, if a holding period approximates the fund's duration. The investment should be better off after a rate rise, not worse off. As rates rise, a bond fund manager can re-position the portfolio in now higher yielding bonds as older bonds mature.


It makes senses to utilize a mix of bond funds that vary by bond maturity. Currently, these funds are either short-term or intermediate-term, reducing interest-rate risk as well as credit risk.


Risk tolerance does not dictate the percentage allocation among bond funds, so the fund mix remains constant while the allocation to fixed income can vary. If an investor has a higher risk tolerance, more risk can be taken in stocks.


The cycle of unprecedented financial accommodation since the financial crisis of 2008 by the Fed dropped Fed Fund rates from over 5% in 2007 to nearly zero. They are now rising with the Federal Reserve signaling further hikes. 10-year Treasury rates fell from 5.3% to 1.36% in July 2016 and now are headed over 3%. In recent years, the yield on safe liquid investment options like money market instruments and Treasuries, dropped so low that they offered virtually no return and forced investors into risky assets. Now increasingly attractive yield instruments are undermining the stock, bond and real estate markets.

In this cycle, the difference is that interest rates are rising from extreme and artificially low levels. In response to the 2008 financial crisis, the Federal Reserve and global central banks provided unprecedented accommodation by buying nearly $15 trillion in securities. This action artificially lowered interest rates so much that there are currently $9.7 trillion in negative interest rate bonds globally. With the economy recovering, the Federal Reserve is attempting to unwind these bond and accommodation bubbles. The Federal Reserve is raising interest rates and will likely tighten more this year. The Federal is also letting its $4.5 trillion in debt on its balance sheet expire–turning a nine-year period of “Quantitative Easing” into “Quantitative Tightening.” This action effectively ends tens of billions in Treasury and mortgage purchases every month, further pressuring the bond markets and, by extension, the equity and real estate markets.


Is the bond market waving a flag that we should pay attention to?

Historically, one of the more reliable precursors of recessions has been the slope of the U.S. Treasury yield curve. An inverted curve may reflect an overly restrictive monetary policy that risks destabilizing economic growth.


The slope of the yield curve (as represented by the difference between 10-year and 2-year bond yields) has typically inverted in advance of economic recessions. The current spread is now under 50 basis points, and below longer-term norms. Although the flattening curve is still some distance from an inversion, the recent trend highlights that this spread has been rapidly shrinking.


U.S. Treasury Yield Curve Spread (10-Year less 2-Year Yields)

If we extrapolate the U.S. Federal Reserve's guidance of more rate hikes in 2018 at the short end of the curve, it is not unrealistic to see the curve inverting should the long end hold steady over the course of the year. The 10-year yield had started to climb higher in the first couple of months of 2018, in response to stronger global growth and the potential for a long-awaited revival of inflation, before retrenching somewhat in late March.


While risks of a recession are not immediate, the directional trend of some indicators, including the potential for an inversion of the yield curve, the current market environment, and particularly the backdrop of expensive U.S. equity valuations, highlights the need for heightened vigilance. This includes the trade-off between continued participation in the bull market for risk assets and the potential for material losses should recessionary conditions eventuate sooner rather than later.

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