Q3 ’11 Market Update: The Beginning of the End

The Beginning of the End

The world's economic and political tectonic plates are starting to shift. I believe the next 12-24 months will mark a major transition period for the markets and the economy, as we will see several long term trends reverse course. We may finally be working off the investment hangover from the late 1990s in the US, and are setting up for a revival of US business investment and manufacturing. The long term US dollar bear market may be coming to an end, as may be the boom in gold, commodities and emerging markets. While I think we have several years before the bear market in stocks comes to a definitive close, and the US economy still has years to go to work off its excessive debts, the US economy may start to shine on a relative basis. In addition, a number of very long term global trends may be turning, with the worldwide collapse of the welfare state and the end of the global debt buildup. While much of the transition to whatever new worlds awaits us will occur over the course of this entire decade, many market trends will likely be turning over the next 1-2 years. It is time to prepare.

Interest Rates

Using today's interest rates, the market rates of Treasury Inflation Protected Securities ("TIPS"), Treasuries, implied inflation rates, Municipal bonds, investment grade corporates and high yield corporates versus their equilibrium yields at 2, 5, 10 and 30 year maturities looks as follows (click to enlarge):

Chart 1

  Mkt update slides Q3 2011 (alt)
Treasury rates have plunged, driven by both a decline in inflation assumptions and in real interest rates. Corporate bond yields have come down less (and high yield bond yields have risen) as the market turmoil has increased risk perception.

With the possible exception of long term municipal bonds, there is very little of value in the bond market these days, unless you are extremely bearish on the economy, in which case long treasuries could rally from these levels. High yield bonds are close to being attractive, but are vulnerable if we enter a second recession.

Overall, the bond market is telling us that the supply of savings far outstrips the demand for investment, and you see very low or negative real interest rates and below average inflation assumptions out for a very long time. I think this imbalance may turn soon in the US, in which case most of the money from the great bond bull market that began in 1980 has been made.

Stocks

I've updated my numbers and methodology a bit since my last stock market update. The net effect brings the implied and equilibrium returns up, but my overall view on valuation is the same. 

As a reminder, I base my valuation off of inflation-adjusted trend earnings for the S&P 500. While Standard and Poors' analysts project $95.66 for 2012 earnings, the forward trend earnings number is only $62.64. As can be seen in the chart below, earnings in the past two cycles have been unusually high, much of which is due to a series of one-time factors like high oil prices and extraordinary bank earnings. In time, we should expect earnings to revert to trend.

Chart 2

  Slide1

Using trend earnings, I assess the value of the S&P500 as follows (click to enlarge):

Chart 3

Slide3

If I use the long term equilibrium inflation assumption of 2.25%, the stock market is pricing in a 7.8% long term equity return. Under my updated methodology, I use 8.25% as the equilibrium return target (which uses a 4.0% equity risk premium on top of the equilibrium 20-year treasury rate of 4.25%). The equilibrium return would be earned at an S&P500 value of 1011, or 13% below today's level. If we assume the bond market's long term inflation projection of 2.1% is correct (it was assuming 2.7% just last quarter), then we arrive at a long term implied return of 7.7%.

Looking back at Chart 1, we can see that the market is actually pricing in an equity risk premium of 5.1% to the 20-year treasury rate, which would imply an above-equilibrium return. The same can be said for corporate and high yield bonds, who have above-average spreads to treasuries, but lower than equilibrium yields. The problem with the risk asset markets these days is that the base real interest rate is so low. Thus the return on equities and corporate bonds are strong relative to treasuries, but low on an absolute basis. My assumption is that all markets revert to the mean eventually, so unless you're a professional investor that can short the corresponding treasury with the proper duration relative to your investments, it is dangerous to rely on relative values rather than absolute values.

The next chart plots absolute values over time. In this case, it is the earnings yield of the inflation-adjusted S&P500 relative to inflation-adjusted trend earnings. (The earnings yield is the reverse of the price-earnings ratio.)

Chart 4

Slide2
When the earnings yield gets above 6.5%, you can be pretty comfortable that you are buying stocks at a good value. It was above that level in the great bull market of the late 1940s and 1950s and during the bull market of the 1980s and early 1990s. That said, just because we get above that level doesn't mean we're out of a bear market, as we saw in the late 1970s and late 1930s and early 1940s. Also, just because the yield drops below 6.5%, doesn't mean the bull market is over, as stocks kept rallying in the early 1960s and late 1990s.

What I will say, however, is that a necessary condition for a secular bear market cycle (like the one that we've been in since 2000) to end is that stocks reach a low valuation on an absolute basis, like they did back in the great bear market of 1973-74. Stocks may still bounce along the bottom for several years thereafter (like the period 1975 to 1982 or from 1937 to 1942), but these can be great periods to accumulate stocks as we set up for the next secular bull market.

If I had to guess, I would posit that the market will put in a major bottom sometime in the next 12-18 months. It could be soon, if the European crisis reaches its climax, or it could be next year, driven by something else (a crash in China?) After that, retirees and investors will leave stocks for dead and they may stay cheap for the rest of the decade as the economy continues to deleverage. In the latter part of this decade, we will then be set up for a new long term bull market. I hate making predicitions that concrete, but let's just say that's my "base case" and I accept that the actual timing and magnitude of events may vary greatly around that.

Commodities

Commodities in general are expensive (click chart to enlarge):

Chart 5

Slide5
In general charts that look like these don't end well. Can gold or oil or commodities in general (represented here by the CRB Futures index) keep rallying for a few more months? Sure they can. Is buying into a rally like this "investing"? No, it is not.

In the last chart I map the ratio of commodities prices relative to the consumer price index (CPI). Here you can see that the long term trend price of commodities relative to everything we spend money on has been going down. That makes sense, as mining and farming technology has gotten more efficient, more markets have opened up and global transportation networks have expanded. Also, as we get richer, we spend less of our incomes on basic commodities. During both the last decade and the 1970s, that trend was broken. In both decades, all sorts of theories sprouted up to explain why we were running out of resources relative to booming demand. In reality, both spells of commodity inflation were just that: inflation driven by currency debasement.

The Dollar

At last we come to one of the only truly cheap asset classes in the world, the US Dollar. I am on the record stating that a new long term dollar bull market is in the offing, commencing sometime in the next 12 months (if it hasn't begun already).

Charts 6 and 7

Slide6

Slide7
Both dollar indices (the nominal major currency index and the real broad dollar index) are near the bottom of or below their long term trend ranges. Why would the dollar go up? The dollar benefits from market turmoil, which could be a near term catalyst. Also, I think markets are going to come to the realization soon that the US's problems are manageable next to the alternatives, particularly Europe and Japan, and there is a decent chance that the bloom will come off the emerging markets rose (which becomes a self-fulfilling feedback loop when the dollar goes up and commodity prices fall). I addition, I also think the US is setting up for a major business investment cycle after a relatively weak 10 years (as we have now digested the late 1990s investment boom). Once these big currency trends get rolling, they tend to build on themselves.

OK, you ask, but how do I invest in a dollar bull market if I'm not a professional currency trader? Good question. First of all, don't be afraid to hold cash and to reduce exposure to commodity-based investments, foreign bonds and emerging markets. Second there is an exchange traded fund called the PowerShares DB Long US Dollar Fund (ticker: UUP). If you find this argument particularly persuasive, you can buy the PowerShares DB 3x Long US Dollar ETN (ticker: UUPT), which is a 3x leveraged version of the UUP. At the very least, the UUP provides a decent hedge against near term market volatility.

I am not your financial advisor. I write these posts purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations made herein.

 

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