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)

 

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)

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)

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)

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)

 

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. 

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)

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)

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)

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.

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.

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.

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.

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.

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.

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.

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.