Mid-year 2013 Market Overview: The Plates are Shifting

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s. The 1990s had the benefit of being within the Kondratiev Autumn of the long cycle, helped along by the tailwind of falling interest rates and risk spreads (and rising investment valuations) and both consumers and business leveraging up with debt. The 2010s are in the Kondratiev Winter, where interest rates are already low (and risk spreads are already tight, thanks to the Fed's reflationary actions) and consumers are still reducing their debt leverage.

We are heading into the most powerful part of the upwave in both the 15-20 year infrastructure cycle and the 7-10 year standard business investment cycle. Barring some major catastrophe that throws the economy off course, the next 2-5 years are likely to be the best economic years we enjoy in the whole period from 2008 to the mid 2020s, driven by the continued recovery in business investment.

We are probably exiting the "Rounded Bottom" recovery and entering into a US-centric expansion.

So with that background, let's discuss the state of the markets:

Interest Rates

The chart below breaks down the current interest rate yield and risk curves:

Chart One

(click to enlarge)

 

Slide1

As I discussed in "Why Gold is in a Bear Market", real interest rates have risen since my last market update in Q2 2012 "Have Corporate Profits Peaked?" as demand for private investment capital has risen. Private investment remains at levels normally associated with recessions (mainly due to low levels of real estate investment), but today's current level of real interest rates (represented by the interest rate on TIPS in the chart above) is also abnormally low. We are moving from depression levels of real rates to recession levels instead. An improvement nonetheless.

I actually don't think the Fed has helped the yields of treasuries that much…if anything the Fed has kept rates elevated by maintaining inflation expectations in the equilibrium range of 2.25% rather than at the lower levels had deflation been allowed to run its course. Where the Fed has helped the markets is by crowding out private investment from the risk-free treasury bond and government-back mortgage securities market and into the risk markets of corporate bonds and equities. This is evidenced by the lower-than-equilibrium risk spreads even during a relatively weak economy.

The only area where risk spreads are wider than usual is the municipal bond market. Seeing what happened to Detroit recently may make the reason for this obvious. Nevertheless the only cheap asset class in the fixed income market is long term municipal bonds. Floating rate bank debt funds can also make an attractive option to get some spread while hedging against the risk of rising interest rates (which make bond prices fall).

US Dollar

The dollar has been rallying a bit but has remained cheap as the Fed has remained more aggressive on the easy money front than the European Central Bank. Nevertheless as real interest rates rise in the US with increased investment demand, I expect the dollar bull market to continue. Go back to my 2011 piece "Get Ready for a Dollar Bull Market" to see more on why I think we're due and what a stronger dollar means for the financial markets.

Chart Two

(click to enlarge)

Slide4

As we can see in Chart Two above, in nominal terms against major currencies the dollar has rallied to near the top of its long term (downward-sloping) channel. Against a trading basket of all currencies, however, and in real terms (which is what matters economically), the dollar is still weak. This means that the dollar still has alot of potential to rally against emerging market currencies and that the US terms of trade remain pretty favorable (good for exports and US industrial activity).

Housing

The housing market got a good bounce off the bottom in the second half of 2012 and so far in 2013.

Chart Three

(click to enlarge)

Slide5

US housing has gone from being a cheap asset class to a fairly valued one pretty quickly. The stabilized economy and financial system should be good for housing, while rising real interest rates provide a headwind. Its a fine time to buy a house, but not for speculative purposes, assuming the overhang of the bubble will prevent another bubble run to rival the last decade's.

Equities

Figuring out the right price for stocks is trickier. I've long been unenthused about stocks, even as they've risen strongly over the past four years. I've owned them because I maintain a diversified portfolio, but I've felt they are riding the advantages of low interest rates, a cheap dollar, moderate inflation and a particularly capital-friendly environment to artificial heights. That said, the absence of alternative, attractively-priced investment options make stocks seem like the best of a bunch of bad choices.

Here are my calculations:

Chart Four

(click to enlarge)

Slide2

The market is priced at about 16x the $103 earnings assumed by S&P analysts for 2013. That, on the surface, would appear to be fairly priced. I believe, however, that we should price stocks off of long term trend earnings (which smooth out rises and falls in business and inflation cycles) which are currently $66. The 16x multiple (which is the fair multiple) on trend earnings leaves a fair value of the S&P of 1,049, 38% below the current level of 1,686. It should be noted that S&P earnings fell (slightly) in 2012 compared with 2011. Although they do appear to be rebounding in 2013. Perhaps fiscal austerity, a stronger dollar and higher real interest rates won't hurt earnings because the economy is going to move into a higher gear, which I do believe it will.

I have a problem with this alternative hypothesis. The analysis shown in Chart Four shows that my trend line of real earnings shows growth of 2.5% per year over the past 50+ years, which makes perfect sense, as it is in line with or slightly below real GDP growth. If we add a 4.5% equity risk premium to the equilibrium long term treasury bond yield, we get an assumed long term return on stocks of 8.8%, in line with long term performance. If we assume the 8.8% return, and real earnings grow at 2.5%, inflation is assumed to be 2.25% (which is clearly the equilibrium level that has been assumed by the market over the last four years), and we assume the payout yield is 60% (dividends plus buybacks), we mathmatically arrive at the PE of 16x, which is also the historical average (a little higher even). The theory is sound.

So where could I be wrong? My trend line could be using the wrong y-intercept, because it doesn't have data going back far enough. Perhaps if earnings were higher in the 1940s and 1950s, the full long cycle trend would have a 2.5% growth line cutting through today's assumed earning level of $103 as the mid-cycle trend earning level. The other thing that could be wrong is that the equity risk premium has shifted permanently to a lower level, like 3%. Or maybe earnings will continue to grow faster than the economy.

This last chart is what makes me nervous when I try to embrace any of the above theories:

Chart Five

(click to enlarge)

 
Slide3

Corporate profit margins are at a peak level as a percent of GDP. Given the historical pattern (i.e. margins don't seem to linger a peak levels very long), we should assume that corporate earnings start growing more slowly than the economy for a spell. Perhaps margins will continue to hit new records (possible) or perhaps it won't matter because the economy is going to start growing very quickly. I don't see a catalyst to make stocks plunge anytime soon, but I'm weary nonetheless. I will continue to take profits if stocks rise and keep myself hedged. Stockpicking is the name of the game, I think. Large cap growth will likely have the upper hand.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here. 

Why Gold is in a Bear Market

First of all, apologies for not writing this column many months ago. I haven't had much time to sit down and convey my thoughts on this matter. Most of the money being short gold has probably been made, but I'd like at least to do my best to hypothesize why gold has slipped into a major bear market even while the Fed and other central banks around the world have been "printing money" with their QEs, Abenomics and the rest. Gold has slipped into a bear market because the improving economy and increasing private investment are pointing to an eventual normalization of real interest rates to a positive level away from a gold-friendly negative level.

Gold as a neutral currency

Over the long term, the way to look at gold is as the "neutral currency", i.e. a store of value against paper currency inflation and the price of things in general. In the short run, however, gold is as prone to speculation as any asset and tends to go through long bull and bear markets depending on traders' views of monetary policy and the structural state of the economy.

Why does gold serve as a store of value more than other commodities? Because it doesn't get "used" in the same way that oil or corn get used, nearly every ounce ever mined is still in human possession either as jewlery or bullion. That means the gold supply is extremely stable, virtually unaffected by the amount that gets mined each year.

This quality is why gold has been used as a monetary asset throughout history. As an investment, however, gold doesn't pay interest, so it only serves as a long term store of value or as a short term vehicle for speculation.

In a normal environment, holding a dollar in the bank would pay enough interest to compensate you for the risk of holding that dollar. Because the FDIC guarantees cash bank deposits against default, the only risk of holding cash at a bank is that the interest rate may improperly compensate the holder for inflation.

Gold versus cash

All things being equal, if the interest rate on bank deposits is less than the rate of inflation, then the value of bank deposits are losing purchasing power and thus gold would serve as a better store of value than cash and the price of gold in dollars would rise. If the interest rate on cash is above the rate of inflation, then you would get a positive "real" return on cash and because gold pays no interest you would prefer cash and the price of gold in dollars would fall.

As a side note, if we assume a 2% inflation target and a 28% average tax rate on bank interest (or short term treasury securities), the "neutral" overnight interest rate would be 2.8%, generating an after-tax, after-inflation risk free return is 0%. So if there was no business cycle and/or the Federal Reserve Bank was perfect at executing policy, then all future maturities of US Treasury bonds would yield 2.8%, inflation would always be the Fed's 2% target and the rate on Treasury Inflation Protected Securities ("TIPS") of all maturities would be 0.8% (to compensate investors for taxes).

The forward market for real interest rates

Of course all things are never equal. The capital markets are always
trying to anticipate the future. When looking at the market for Treasury
securities, investors are making assumptions about how real interest
rates will average out in the future based on the Fed's reaction to the
business cycle and how it will effect inflation and the business cycle
itself. The business cycle is primarily driven by the changes in
psychology of the suppliers of cash (savers and banks) and the demanders
of cash (businesses, governments and real estate developers). The
treasury market represents the market's assumptions about the future of
the market for risk-free cash, while the rest of the securities markets
represent the market's assumptions about the performance of
non-risk-free investments relative to the market for cash.

Because the future is uncertain, a normal treasury curve has a rising, positive slope to reflect increasing amounts of uncertainty over time. The assumption I have always used for my market model is that the overnight level of real rates is 0.8% and that the 2-year TIPS yield would be 1%, the 5-year TIPS would be 1.3%, the 10-year would be 1.8% and the 30-year would be 2.3%.

During recessions, when the demand for cash by savers is high relative to longer term investments, the Fed engineers cash interests rates below the rate of inflation to entice savers to increase their demand for longer term securities.

When savers become more optimistic, the prices of long term securities improves and the Fed would then be able to normalize the level of short term rates to balance the demand for cash versus long term securities.

When savers become too optimistic about the business cycle, the excess demand for long term securities pushes the cost of capital too low, causing more marginal projects to get funded. If the Fed sees this happening, it raises the short term interest rate to above the rate of inflation to entice savers to invest less in long term securities and hold more cash. Of course it's very hard to get this exactly right, as we'll see below.

The chart below reflects the assumptions of the treasury market over the course of the recent bull market in gold (2003- ):

Chart 1

(click to enlarge)

Slide1

The real estate boom, 2002-2005. In the early 2000s, we can see that even though the short term interest rate (in green) was well below its equilibrium (and the rate of inflation) following the downturn of the early 2000s, the TIPS market was assuming that the Fed would get the balance basically right over time and the rate on the 5-year and 10-year TIPS were relatively stable around their equilibrium levels. In early 2004, the Fed started raising rates. Instead of its practice in 1994, when it raised rates to above equilibrium relatively quickly, the Fed embarked on a telegraphed, incremental program of raising rates.

The credit boom and real estate top, 2005-2007. It took a full year (until mid-2005) for short term rates to reach equilibrium. By this point the housing market was already going haywire and the credit markets were gaining a sense of false confidence due to the Fed's telegraphed game plan, even though it kept raising rates to above equilibrium levels. From this period until mid-2007 long term real interest rates also rose to an above-equilibrium level as investors felt that the investment wave was strong enough to withstand an extended period of above-equibilirium short term rates.

The bust and the aftermath, 2007-2009. Of course that is not what happened. Higher short term interest rates eventually made real estate investment less attractive. Construction peaked in 2006 and prices peaked shortly thereafter. More and more marginal loans were being made and the credit allocation system was far more fragile than investors realized. As the credit market started to unravel, the Fed started cutting rates and long term real rates started to fall, touching very low levels in early 2008. During the height of the credit crisis in late 2008 and early 2009, long term real rates reversed and spiked as the market feared uncontrolled deflation, but then quickly dropped again as they realized that the Fed was on top of things and willing to do what it took to keep inflation positive.

The "U" shaped recovery, 2009 – 2013. In the period since, private investment in general, and real estate investment in particular, has been very weak, so demand for cash for long term projects has also been weak. The Fed has been aggressive about keeping rates below inflation and about reducing the cost of capital of long term securities. Even though businesses have returned their levels of investment to more normal levels, real estate investment has remained at abnormally low levels while excess capacity from the boom was worked off. During this period, investors came to the conclusion that investment would be abnormally weak for a long time and that the Fed would thus have to hold rates below inflation for a long time. The 10-year TIPS yield has been negative, implying that we would be in this state of affairs for 10 years or more on average.

Private investment

As we can see in the chart below, private investment relative to GDP was actually pretty healthy in the early 2000s when the Fed was erring on the side of being too easy. That was the major mistake that fed the housing bubble (in addition to their failing to recognize the excesses in the shadow banking system). After the credit bubble, on the other hand, investment fell to its lowest level since World War II. Thus the Fed has been correct to err on the side of being easy during the lackluster recovery.

Chart 2

(Click to enlarge)

Slide2

Private investment, while improving, is only just above the level at which recessions usually bottom, so the Fed can be easy (i.e. keep rates below inflation) for a while longer without doing too much damage. The housing market has started to turn and housing has a long investment cycle. Investors can therefore see the economy returning to a relatively normal level over the intermediate term and not wallowing in the state of perpetual weakness that would necessesitate 10 years of negative real interest rates. It is the improving housing market, not the Fed's jawboning, that is causing long term real interest rates to rise.

Bringing it back to gold

OK, but real interest rates are still predicted to be negative over the next five years and the Fed's rate hikes are a year away at least. So why is gold falling now?

The market for gold, like the one for treasury securities, is focused on the future. For a long time the people focused on gold were very different than those involved with the more mainstream fixed income markets. In the early 2000s, gold had gone through a 20 year bear market and had been left for dead by all "respectable" market participants. During the high real interest rates of the technology investment boom of the late 1990s, gold had fallen to under $300 per ounce. The people that followed gold at that point were mainly ideological…people who hated paper currencies.

Gold bugs are contrarians that think an economy built on paper currency is a castle made of sand. I know, because as I was investing I gold during the early and mid 2000s, I used to traffic gold bug websites. Because there was no greater castle of sand than America riding the dot com bust, followed by the Iraq War, followed by the housing bubble, all on the back of a falling dollar and Chinese imports, the gold bug crowd was having a contrarian field day in the early 2000s.

The gold bull market had three phases that correlated with the the phases of the treasury market described above. The first phase lasted until about early 2006. As the Fed eased policy and the dollar declined from its lofty levels of 2000, the price of gold normalized to its old level of $350-$400 per ounce that held before the tech bubble. In late 2005 and early 2006, the gold market recognized the Fed's mistake of feeding the credit bubble with its telegraphed policy and that the housing market would eventually fall, necessitating a major Fed easing. It was during this period that the price first spiked to $600+, signalling a real bull market.

Chart 3

(click to enlarge)

Slide3

Gold had a hard time rallying in 2006 and 2007 as real interest rates were high, but it held its ground as it rightly anticipated that there would be a recession and real interest rates would fall again. Then by early 2008, gold investors realized that the credit bubble was even worse than they thought, and prices spiked to $1000 per ounce anticipating a massive Fed rescue.

In late 2008 and early 2009, however, the market feared that the Fed may be erring on the side of being too tight, and real interest rates spiked and gold fell to below $800 per ounce. Then the Fed and the Treasury Department rode to the rescue and the gold and TIPS bull market resumed. As can be seen in Chart 3 above, the gold market has done a pretty good job of anticipating the decline in long term TIPS yields (shown on an inverted scale).

In 2011 and 2012, these markets started topping out for fundamental reasons. The economy is improving, the Fed has not proven to be overly reckless, price inflation is quiescent and it has gotten pretty tough to justify buying long term TIPS at a yield of negative 1%. Gold bugs point to consipiracies and treasury investors can blame the Fed, but it was time for real rates to rise and the smart money started getting out of both gold and TIPS.

So what's the right price for gold?

In a bear market that follows a big bull market with three upwaves and two consolidation waves, you figure the bear market wipes out the last upleg or "extended fifth wave". That would take us down to the $800-1000 range.

The other old rule of thumb is that an ounce of gold over time is about equivalent to the price of a "decent man's suit". This follows the store of value or neutral currency notion. When I was gruaduating from college and starting work, a suit at Brooks Brothers cost about $350, about equal to an ounce of gold. The price of a Brooks Brothers suit today…$1000 (interestingly, currently marked down to $700). Sounds about right.

I am not your financial advisor. These posts and the observations therein are written purely for the author's pleasure. Please consult your own financial adviser before making any investment decsions.

5 Questions Every Private Equity Investor Needs to Ask

The following article originally appeared in Fortune.com on July 9, 1012. The original article can be found here.

Many institutional investors are convinced that the days of easy money are over in private equity. Managers need to distinguish themselves through their ability to add actual operating value to the underlying portfolio companies.

Private equity firms are generally active board members of their portfolio companies. Nearly every investment firm spends a great deal of time monitoring the tactical performance of their portfolio companies: Performance vs. budget, sales pipeline analysis, cash flow monitoring, margin assessment, capital structure optimization, valuation, etc. The tactical performance of a company is important, of course. Ultimately, however, as an investor and board member, a private equity investor's role should be more strategic than tactical. It is easy for investors to get lost in the tactical minutia and forget to ask themselves the big strategic questions.

The following are five key strategic questions private equity investors should ask themselves about each of their portfolio companies — or prospective portfolio companies — at least every 3 to 6 months.

1. What is the company's core strategic plan? Investors need to evaluate tactical performance within the context of strategic goals. The lifecycle of a company or operating division is basically a series of 3- to 5-year strategic plans. The plan may be to develop a prototype product and win some key first customers. It could be to expand internationally, scale revenues and cash flow or expand the product set into adjacent markets. It could be to manage the transition from a growth to a value orientation by rationalizing the cost structure, or to successfully transition a company from a corporate spinoff to a standalone entity. It could be to narrow the company's focus to a core set of products in a declining market. There are numerous core strategies that are potentially appropriate 3- to 5-year plans for a private equity or venture-backed company. Investors must also consistently evaluate whether the strategic plan remains appropriate if there have been changes in the portfolio company's operating and competitive environment. Companies that clearly identify their core strategic plan almost always execute better than those that do not.

2. Are we the right owners to execute on the strategic plan? This is perhaps the hardest question for investors to ask themselves, but it is fundamental. Private equity firms are generally pretty good at screening deals that don't fit their strategies at the time of acquisition but they don't always recognize when the strategic environment has shifted post-investment. A growth equity firm with a company that has shifted into slow-growth maturity; a company in a consolidating industry that would better off as a product or division of a larger company; a company embarking on a new 5-year product strategy with an investor near the end of their fund life…

These are all situations in which the right decision may be to seek a new owner. Sometimes answering this question requires admitting relative defeat on a certain investment but that is preferable to spending years working on a portfolio company that is outside a firm's investment strategy.

3. Does the company have the right CEO to execute on the strategic plan? Most private equity investors are good at figuring out when a CEO is underperforming. It's more difficult to determine whether a good CEO is in the wrong role, particularly if the core strategy has changed. Sometimes a company needs an entrepreneurial visionary, other times it might need an operational "Mr. Fix-It." Sometimes a company may need a turnaround specialist, other times it may need a sales and marketing expert. A visionary's talents are not appropriate for a turnaround strategy, nor should a sales and marketing guy be focused primarily on operational efficiencies.

4. Is the company earning an appropriate return on invested capital? The key unit economics of the company's products must be earning more than a sufficient return on invested capital. The ROIC methodology varies by industry (a mature product manufacturer needs to monitor different metrics than a growth-stage online software company, for example), as does the cost of capital. No matter what the stage of business, however, at some point the core business must be able to profitably generate revenue. There is no point investing in revenue growth if the unit economics won't work.

5. Is the company gaining market share? If the unit economics are working, a company must assess its total addressable market and its share within that market. If the competition is growing more quickly (while also earning sufficient returns on invested capital), then the investor must figure out why and help look for solutions. It could be a sales and marketing execution problem, or a product problem. It may be a market power problem that can only be fixed by pivoting to a different or more specialized niche. If a company is having difficulty gaining market share in a certain market, then it has to question how long it should remain in that market.

Investors with the discipline to consistently ask these five strategic questions will have a framework to evaluate a company's tactical performance, which in turn will enable the investors to create more portfolio company value. After all, creating portfolio company value is what private equity investors are paid to do.

Q2 2012 Market Update: Have Corporate Profits Peaked?

This post is an installment in a continuing series supported by The Dynamist's Market Valuation Model. Please click the link to see past installments.

Interest Rates

As usual, we start by examining the current state of the interest rate complex, which gives us the market consensus of underlying economic policy. The breakdown of the yield curves of US treasury bonds, muni bonds and corporate bonds is shown below.

Slide4
If we look at the market's inflation expectations, it is generally assumed that the Federal Reserve will succeed at maintaining inflation right around its target range of 2%-2.25% over a variety of time horizons. Real interest rates (the inflation-adjusted rate on the Treasury Inflation Protected Securities or TIPS) are expexted to remain low for the forseeable future, averaging NEGATIVE -0.5% over the next ten years. This implies that the sluggish economy will force the Fed to maintain nominal interest rates below the rate of inflation for more than five years at least. This would be consistent with my view that we are in a long down cycle as the world economy struggles under its large debt load, resulting in weak demand relative to supply. (The phase known as the Kondriatev Winter to you cycle theory buffs.)

The combination of below equilibrium real interest rates and equilibrium inflation expectations results in nominal treasury yields well below equilibrium. And even though the spreads of municipal and corporate bonds relative to treasuries are currently attractive, their resultant nominal yields are relatively unattractive. While this would normally singal that fixed income in general is overvalued at this time, I believe the bond market is accurately reflecting the likely long term economic scenario, meaning that bond yields are unlikely to rise significantly in the intermediate term at least. Overall, I am overweighting cash and intermediate munis and corporates and underweighting treasuries (and I have sold all of my TIPS).

I'll discuss what this rate structure means for the dollar, gold and commodities in a future post.

Stocks

As long time readers of these columns are aware, I base my assessment of equity values on the S&P price relative to the long term trend in inflation-adjusted earnings. Using long term returns that fail to take into consideration the unnaturally large surge in inflation during the 1970s will overstate the long term earnings growth assumption. It was the great surge in prices (and thus nominal earnings), followed by the long decline in interest rates that underpinned the massive bull market since the 1980s. I tend to believe that it would be folly to expect a repeat of those extreme conditions.

The long term chart of inflation-adjusted S&P 500 earnings is shown below, along with the calculated trend line.

Slide1
So while the earnings of the S&P500 were $86.95 in 2011 and are expected to be $97.98 in 2012 (according to S&P analysts, not Wall Street analysts) and $108.76 in 2013, the trend earnings were only $64.88 in 2011 are only $67.73 over the next twelve months.  In this view, the trend market PE is about 20, as opposed to 13 or so on projected forward earnings.

The chart below breaks down the components of the projected S&P return, which I calculate to be 7.6%. This return is below what I believe to be the equilibrium return of 8.3%, but is not wildly off.

Slide3
If you want to earn an 8.3% return, you would have to wait fot the S&P500 to drop to a PE of 16 on trend earnings. That level is currently 1104, about 19% below where it currently trades. That said, given today's interest rates, a 7.6% return sounds pretty good. In fact I calculate the current the equity risk premium (the spread of the expected equity returns over the risk free rate) to be 5.4%, above the proper premium of 4.0% (according to my read of the literature, at least).

Another way to look at PE is to reverse the ratio to earnings to price, or earnings yield. The chart below shows the earnings yield of trend earnings over time. The current yield of 5.2% is more in line with the late stage bull market of the 1960s than the bear market or early bull market valuations of the 1970s or 1980s.

Slide2
One potential flaw in my model is that my trend earnings could be too low, dragged down by artifically low earnings in the 1970s and 1980s and ignoring the structural changes like globalization that have permanently increased corporate earning power. There may be some validity to this view, but I could easily counter with the theory that recent earnings have been artificially inflated by financial earnings and the effect of the weak dollar on foreign income.

Have corporate profits peaked?

Let's see what the statistics say. If I take the level of corporate profits in the economic statistics and compare them with GDP, we can see that corporate profits are indeed at record levels.

Slide5
The trend for corporate profits has been on the way up for the past few decades, now exceeding the levels from the mid 1960s. If we break down corporate profits into domestic profits vs. financial and "rest of the world" profits, however, we come up with a different story.

Slide6
Domestic corporate earning power relative has remained in the same "trading range" since the early 1970s, oscillating between 4% of GDP at lows to around 7.5% at highs. The level is currently 7.3%, signalling that they may be near a cyclical peak. The big change over time has been the increase in financial and rest of the world profits. Financial profits have increased steadily with the long bull market in treasuries, which we can probably safely say has likely run its course. As interest rates flatten out and as Dodd-Frank and Basel III regulations are implemented, it is highly probable that financial profits as a percent of GDP will decline over the next decade.

Rest of world profits have recently caught up with financial profits (they are roughly equal now). Foreign profits could fall with a strengthening of the dollar or any sort of rollback of globalization, either of which are possible or even likely in this environment. 

Teed up for disaster?

While not necessarily likely, the outlines of a potential meltdown scenario for earnings is becoming more clear: the quagmire in Europe, leading to banking problems, leading to a crash in Chinese real estate, leading to a rising dollar, leading to a crash in commodities, leading to a bout of deflation, leading terrible earnings, leading to a stock market swoon.

The alternative scenario is that we are headed for a weaker version of the late 1990s, where after a mid-cycle slowdown the US economy steams ahead on the back of a powerful investment cycle as real estate investment recovers and business investment picks up its pace. The US could be able to prosper even while Europe languishes, with US imports keeping Asia afloat. In my last post "Atlas Done: The US Can't Carry the World Economy" I argue why this scenario would be difficult to achieve, but I have been wrong before. In this event, we could see domestic profits continue to head higher and to reach the levels to the late 1960s relative to GDP, rendering my trend earnings too low and making stocks a screaming buy at these levels.

The other perhaps most likely scenario is that the US real estate market, Europe and China can all muddle through for the next year or two. In this case, the market would trade choppily for the next few years as time continues to heal the wounds of the credit bubble. Private sector debt levels would gradually decline until the point that the private sector is able take the growth baton back from the public sector. In this scenario, an investor would want to be modestly underweight equities and overweight fixed income. This is the "Rounded Bottom" scenario that I view as my base case.

I continue to believe that we are riding a cyclical bull within a secular bear market and that investors need to be careful here. The chance of a deflationary crash probably exceeds that of a powerful second leg to the bull market. The most likely scenario is more of the same. The good news is that we are likely nearer to the end of the long bear market than we are to its beginning. In the meantime, caution should rule the day.

I am not your financial advisor and I write these articles purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations or views made in this article.

 

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.

 

Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: Bloomberg.com (for treasury prices), economy.com (for historical inflation), calculations by tylernewton.com

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors, economy.com, calculations by tylernewton.com

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.

Conclusion

Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in www.tylernewton.com are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

Get Ready for a Dollar Bull Market

Get ready for a multi-year bull market in the U.S. dollar.

Yes, you heard that right.

No statement about investing right now could feel more wrong. And this is why it's probably time to start swimming against the tide.

First, I'll make a mundane case based on timing. Consider the following chart:

Since the Bretton Woods monetary system started breaking down under the strains of the Vietnam War and Great Society spending, there have been three dollar bear markets, each lasting roughly 10 years: 1968 to 1978, 1985 to 1995 and the current dollar bear market, which started in February of 2002. Currently the dollar is right against the lower bound of its long term trading channel.

You might say that the major currency index is no longer relevant due to the rise of emerging markets. Here is the broad dollar index (which incorporates all currencies on a trade-weighted basis) in real terms (adjusting for differences in inflation):

Not much difference in the timing of the bull and bear markets. Against the broad basket, the dollar has punched below the lower bound of its long term trading range, which means it might just be ready for a snap-back.

But things are so much worse now, aren't they?

In the mid-to-late 1970s, we experienced the loss of a major war and the resignation of a president, soaring inflation and commodity prices, union militancy, provocations by tin pot despots in the Middle East, years of bear markets in both stocks and bonds, weak leadership at the Fed and a general sense of American decline. Plus you had polyester leisure suits and disco.

In the early-to-mid 1990s, we were experiencing the "hollowing out" of American manufacturing and "downsizing" of white collar jobs, years of a brutal bear market in real estate, Japan was eating our lunch, years of large fiscal deficits, the aftermath of a major banking crisis and credit crunch that had followed a boom in high yield and real estate debt, a divided government with Congress controlled by firebrand conservatives that had forced a shut down of the Federal government and a general sense of American decline. At least we had flannel shirts and grunge rock…better than the late 1970s.

Hmm…for the most part these periods of time sound pretty similar to today.

There are major differences, of course. For example the transition to the dollar bull market involved a horrible recession in the early 1980s, while in the mid-1990s the transition was relatively smooth (in the U.S. anyway).

So what happens in a dollar bull market?

  • Real interest rates rise. This might come from a rise in short term interest rates or a shift to falling prices or very low inflation (or both).
  • US technology is hot. Leading edge technology attracts a lot of investment. The great venture capital bull markets coincided with the dollar bull markets of the early 1980s and late 1990s.
  • US business investment rises. Higher real interest rates attract investment capital back into the US, which flows into software and business equipment.
  • Emerging markets crash. It is no coincidence that the great emerging markets crises occurred in the early 1980s and late 1990s. The strong dollar draws investment dollars away from emerging markets and back to the US. This occurs after 10 years of an emerging market bull market during which untold unbalances build up. Would you really be surprised to find out that much of China's growth has been built on a mirage of cheap credit and wasteful infrastructure spending?
  • Commodities and farm prices crash. A rising dollar is a net negative for commodity prices (which are priced in dollars). Plus, it usually turns out that much of a commodity bull market is built on financial speculation, which flees once it becomes clear that momentum has shifted.
  • Large cap outperforms small cap. The long-awaited rotation from small cap to large cap and from value to growth might finally occur.

I am assuming that the transition to a dollar bull market will take a year or more. My plan is to gradually start moving to underweight in commodities, emerging market stocks and foreign bonds. As the Fed transitions from accommodating to neutral or restrictive, or if there is an inflation or financial crisis in emerging markets like China, there could easily be a major bear market US equities. I will wait to see how the market handles the transition in monetary policy before moving to overweight in large cap US stocks. There is also a dollar bull ETF, the Powershares DB USD Bull ETF (ticker: UUP), for those that want to get more aggressive.

I remember people yelling at me for being an idiot when I was buying gold and silver back in 2002. People argue vehemently against me now. I must be on to something.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here.