In the third quarter of 2009, we have seen some pretty significant market shifts relative to the second quarter. To refresh yourself on how my market valuation model works, please refer to this page.
Inflation and the Treasury Yield Curve
As I outlined in my May 25th post "Inflation is not a threat (yet)", I look at the treasury curve, the dollar and gold to take the market's pulse on inflation.
The TIPS spread, which is the difference between the nominal yield on bonds less the yield on the Treasury Inflation Protected Security (TIPS) has seen some interesting shifts. While the 10-year inflation rate has remained right around 1.7%, the 5-year inflation rate rose from 0.8% on May 25 to 1.7% at the end of Q2, to 2.2% at the end of Q3. The 30-year inflation rate, on the other hand, has fallen from 2.2% on May 25 to 2.0% at the end of Q3.
Embedded in these numbers is the assumption that inflation surges from zero today to average 2.2% per year over the next 5 years. Inflation is then expected to slow to 1.3% per year from 2015 to 2019, before averaging 2.1% per year for the 20 years after that. This scenario is plausible. It implies a surge in economic activity after all the stimulus currently in the pipeline, before re-succumbing to the disinflationary undertow as the economic cycle turns down several years from now.
My other near-term inflation signals are also flashing yellow. Gold has traded to slightly higher than $1000 per ounce, and the dollar is very close to the bottom of its long term trading range. They aren't yet past the point where I'll start screaming that the Fed needs to hit the brakes, but they are right at the edge.
What does a flattening of the real yield curve mean?
In my May 25th post I discussed how the proper rate for overnight money is around 2.75% if inflation is averaging 2% per year. This would deliver a zero percent after-tax, after inflation rate of return, which is what you should earn for taking no risk. That would imply an equilibrium overnight TIPS spread of 0.75%. In my equilibrium model, I have assumed an upward-sloping real yield curve of 1% for the 2-year, 1.5% for the 5-year, 2% for the 10-year and 2.5% for the 30-year. The current TIPS real yield curve is 0.5% below my "equilibrium" along the curve from the 5-year on. The difference between the 0.75% overnight real yield and the higher yields further out is driven by uncertainty regarding future inflation volatility, which increases as the time horizon gets longer. If the TIPS curve has flattened, that implies that future inflation volatility assumptions have come down.
Much of the flattening move came in the last week after Fed Governor Kevin Warsh wrote an Opinion piece in the Wall Street Journal declaring that the Fed would be vigilant about removing stimulus if inflation became a threat. In other words, they wouldn't make the mistake they made earlier this decade, when they let inflation run and were too slow to remove monetary accommodation. If a flatter TIPS curve becomes a permanent feature of the financial markets, then asset yields would come down permanently and asset values would rise permanently.
What happens to my market equilibrium assumptions?
(As a reminder, I use the yield of various Vanguard bond mutual funds for my market rates of non-treasury bonds, my treasury yield curve information is from the PIMCO web site and my S&P 500 earnings estimates come from Standard and Poors)
The rally in TIPS is catching up to the rally in the bond market generally and allowing the intermediate and long ends of the treasury, muni and corporate bond markets to be in proximity to fair value, while the short end of the curve is still overvalued.
The equity market (S&P 500) is about 22% overvalued if you feel the proper return is 7% per year. 7.1% per year would imply a 5% equity risk premium in after-tax terms to the 30-year treasury bond. The market is currently pricing in an equity risk premium of about 4.5%, which is low by historical standards, but in line with the drop in TIPS term risk premiums.
What level of S&P 500 earnings am I using?
As a reminder, I am using the long-term trend for inflation-adjusted AS REPORTED earnings. The next twelve month trend earnings number I am using is $56.56, and assume it grows at its historical inflation-adjusted rate of 1.64% plus the market long-term inflation rate of 2%. In the press you often hear a higher number for earnings, which is the operating earnings number for the next twelve months. Operating earnings allows for companies to exclude the effects of all of the poor acquisitions and perma-restructurings they conduct. The long term trend in as reported earnings gives a much more accurate view of accrual of value to the equity holders. With the S&P at 1030, the price to trend forward earnings ratio is 18, well above the long term average of about 14. The actual top-down, as-reported earnings number projected by S&P analysts for 2009 is only $39.35.
Conclusion
It's tough to have conviction about this market. It's good that the embedded volatility premium in the market has declined, but if it rises again (which it very well could) valuations of bonds and stocks could fall a great deal. Rising tax rates could hit the valuations of stocks and bonds pretty well, too. With inflation signals flashing yellow, the Fed could very well start pulling back stimulation soon. I have made a series of adjustments to my investment model to justify the shifts occurring in the markets. Either we've entered into a permanently low-return world, in which case these markets make sense, or we're rationalizing the effects of cheap liquidity and are in for a rude awakening sometime in the not-too-distant future.
Given a lot of unexciting choices, I like muni bonds, hedged with cash, a bit of gold and crossed fingers.
Disclosure: I am not a financial advisor. Seek investment advice from your own financial advisor.
The Dynamist 