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Why High P/E’s Matter

August 10th, 2016

Historic PEDouble click any image for a full sized view

I’ve written on the blog about the high Price to Earnings Ratio in the market right now – as you can see on the image above, from a historic viewpoint, we are at one of the highest levels in history other than during the dot.com crash and the subprime crash.  Its a funny thing, the peak reading during those crashes are after corporate earnings have fallen to minimal levels but prices hadn’t yet fallen to compensate for it.

We have had 18 months of earnings contractions while the prices for stocks have continued higher.  In other words, if you look at the P/E Ratio, you can easily see why it is climbing:  we have increasing prices (P) and falling earnings (E) so mathematically in a fraction, when the numerator is increasing and the denominator is decreasing your result is a larger number.

It dawned on my, though, that I haven’t really explained the math behind WHY high P/E ratios are a bad thing, and it all boils down to future expected returns.

As one of our clients like to say when he stops by the bank:  buy low, sell high.  The reason is that you make more profit when you for a price that is higher than where you bought, and the greater the spread between the buy price and the sell price is what yields you more profit.

Concepts like this seem simple but there is a real mathematical relationship between low and high, and you can predict what your returns will be using a formula developed several years ago by John Hussman.   I turned the formula into an excel spreadsheet so that I could project what future returns for the stock market will look like based upon today’s P/E ratio and one assumed to be in place at some point in the future.

Check out this image of my spreadsheet:
Hussman

If you look at the full sized view, you will see that this formula includes  the historic stock market growth rate using the S&P 500 Index to represent the market, the dividend yield for that index, an assumed 10 forward investment horizon, the current P/E ratio for the index and the forward P/E ratio for the index from today’s Wall Street Journal Online.

You can see that using the formula shown on the spreadsheet, with the P/E ratio at today’s elevated levels, we can expect an average annual total return on the S&P 500 of 4.02% including dividends, significantly less than the historic average of 8.69% (you can see the calculation of that return in the pale yellow box on the right side of the image.  You can see that buying at these elevated levels depresses future returns.

But what happens if we have a market correction and the forward P/E normalizes to its historic reading of 15?  Here is that calculation:

Hussman 2

All else being equal, a correction in the stock market that dropped prices so that they caught up with earnings (decreasing prices and decreasing earnings in this scenario), your forward expected average return for the next decade is 2.23% including dividends (which are estimated to be 2.01%).  Buying near historic high valuations has a big impact on your future returns.

However, just as you might expect, if you are brave and buy into a correction when the P/E has fallen to near-bear market lows of 7, and wait for it to grow back to the historic average of 15, your results are completely different:

Hussman 3In this scenario where you did in fact buy low and sell high, your average annual total return is 14.59%.

In this blog, when I talk about the risk/reward ratio (I know I have and I likely didn’t explain what I meant to an adequate degree) this calculation is a good example of it.  Buying now when the valuations are high mean you are assuming the risk that the P/E falls toward its historic average but your expected return is barely above inflation.

But by buying when the market has corrected at a low valuation (albeit when its very scary to put your money into the stock market) and waiting for the market to just normalize to historic average valuations, your risk is low but your expected return is exceptionally high.

For this reason, we are maintaining our cautious stance on the market, being opportunistic when we get short-term pull backs and putting cash into the market, but being prudent and taking cash back out of the market when it moves back higher.  When will we get the big correction?  No one knows but you have to be prepared and invest your money wisely, buying low and selling high, not the opposite.  Its better to be wise and smiling than greedy and crying.

For all you classic rock fans out there, I’ve been listening to Willies Roadhouse on XM Radio – so bear with me as I play some of my favorites from there before we return to Styx, GNR, and other popular choices here on the blog:)

Mark

 

 

When Growth Becomes Value

July 26th, 2016

When a growth stock with a high P/E Ratio drops in price yet their EPS growth is up significantly from just six years ago, you get a Growth Stock at a Value price!

GILDDouble click on any image for a full sized view

Gilead Sciences is a top notch Biotech company that has seen its stock price tumble more than 30% over the last year along with most of its competitors.  The biotech industry had the unfortunate luck to be painted with the same brush as the drug company that overnight raised the price on one of its drugs 5000% when a new owner took over.  The political establishment jumped on this and made statements about punishing the industry when it was really just one bad owner who needed to be corrected.

At the current price, Gilead trades at a 6.75 P/E ratio when the stock market is trading at a 25 P/E ratio.  It projects that it will earn $30 Billion this year.

It has two bread and butter franchises:  one is an HIV franchise that has been revitalized with a new drug that is out performing expectations (according to analyst David Katz) and the other is a Hepatitis C cure (not just a treatment but an actual cure) that has been so successful for so long that the market for this drug is shrinking, albeit slowly.

This last issue, the shrinking market for its Hep C cure has the market up in arms and when earnings were released today investors sold off Gilead for a > 6% loss on the day because it lowered its revenue guidance from $30.5 Billion to $30 Billion.

I was one of the buyers today and made a bit under 1% for our clients in our growth strategy, doubling down on our current position – unfortunately, I was also a buyer when the stock was down a bit more than 25% but the fundamentals justify the purchase decision.

So I thought I’d give you some insight into the sort of analysis we do on a company like this that leads me to buy it.

1.  GILD has 61 products in Phase III trials per CMLviz (the last step before the FDA can approve a drug).  Investors should not be overly concerned about the Hep C market shrinking when somewhere in these 61 new drugs there could be one or more that will be block busters like the two principal franchise it currently has.  Having this number of drugs in Phase III trials is a catalyst for future earnings growth many company’s could only wish to have.

2.  We are buying this classic growth stock at a significant discount to the market (6.75 P/E ratio).  Normally, you only get to buy deep cyclicals at this sort of valuation, not a company earning $30 Billion this year with 61 potentially significant catalysts to earnings on the horizon.

3.  Investors get a > 2% dividend yield on a biotech stock.  In all the years I’ve been a growth stock investors, it has been tough to find companies that are growing their earnings faster than the market and the economy while paying a dividend yield  greater than the yield on the S&P 500 or the yield on fixed income investments.

4.  Check out this graph of productivity (Revenue per Employee):

GILD rev empGilead is off the charts compared to its competitors (graph courtesy of CMLviz)

5.  Check out this graph of efficiency (Revenue per $1 of Expense):

GILD rev expAgain, Gilead is off the charts compared to its competitors (graph courtesy of CMLviz)

6. Check out this graph of Revenue Growth (you can see why its a growth company):

GILD rev growthNormally, the earnings multiple valuation for a company like this is higher than the market multiple – because of the political impact, you are getting a growth stock for a value stock multiple.

7.  When I calculate the target price for GILD using our multi-factor valuation methodology, I come up with $148 or 80% potential upside.  Gilead is currently trading at the bottom of its 52 week price range.  The risk to reward ratio is clearly favorable.

8.  The Morningstar Fair Value price for GILD is $124 (making it 34% undervalued today) and their Sale Target is $168 (or 100%+ potential upside).  The risk to reward ratio is clearly favorable.

9.  When I perform our standard calculation for under-valued Vs over-valued, I come up with a fair value today of $126, making it currently 35% undervalued.  This is based upon an extrapolation of next year’s earnings estimates, book value, estimated sales, and estimated cash flow using a ten-year weighted-average of the Price to Earnings ratio, Price to Book Value Ratio, Price to Sales Ratio and Price to Cash Flow Ratio.

Given the superior operating performance of Gilead Sciences, Inc., its potential earnings growth catalysts, its above average dividend yield, its current undervaluation and the potential upside leading to a superior risk to reward scenario, Gilead is a buy in my estimation.

One thing to remember – even though a stock is cheap, it can always get cheaper.  If Gilead drops in price some more, I will be a buyer – investing is a long-term activity that cannot be constrained by a calendar.  Yes, I might not be a winner on this one stock by 12/31 when clients get their annual statements.  However, buying good companies with strong earnings power at cheap prices is the hallmark of how you make money investing in stocks.  You don’t always see the results tomorrow, but you will see the results with patience and conviction.

Mark

Brexit Bounce Back

June 29th, 2016

The common stocks that make up the S&P 500 Index have experienced their second day of recovery as investors now realize that the actual exit in Brexit will not occur for a long time into the future.

SPX 2016-06-29

Double Click on any Image for a Full Sized View

If you look at the graph above, you will see that I’ve drawn some Fibonacci Retracement lines that mark the high before Brexit was announced and the low two days ago.  As of close of market today, we have retraced 62% of the Brexit Breakdown.

Below is the action for today only:

spx today

You can see that the market topped out today about 45 minutes before close and the computers kicked in, sending it lower while the Stochastic was in overbought territory.  This indicates that we could open lower tomorrow as people take profits they’ve made on this short term swing.  It will not impact us because we intend to hold our beta plays until the market gets back to or above 2050 as fits with my stair step lower scenario for the market for the balance of the year.

As far as the purchases go that we have made during the recent drop, the strategy was two pronged:  continue to move money into companies that are primarily domestic in keeping with the turmoil in the rest of the world or to move money into defensive or recession resistant companies that will have less volatility on the downside in keeping with my market scenario for the balance of the year.

The defensive or recession resistant investments did not move up as much as some of the higher beta domestic investments, but that is expected.  Here is a sample of the performance of some of the purchases the past few days:

AT&T up 1.50%

Nvidia up 2.50%

Southwest Airlines up 5.45%

Waste Management up 0.97%

Dominion Resources up 3.21%

United Kingdom ETF up 0.79%

This is on top of the 3.5% we made on the Long Term Treasury ETF we used to hedge against the correction and give us the freedom to capitalize upon the market moves.

I’ll be back with more as the market makes it moves – and I hope you enjoy this Pitbul remake of the classic Rolling Stones song.

Mark

Brexit Breaks the Banks

June 27th, 2016

The common stock of the European Banks is getting crushed in this post Brexit selloff.  Our own S&P 500 is holding up better on a relative basis.

SPX 2016-06-27

Double Click on any Image for Full Sized View

The graph above is the one you have seen here on the blog a few times before.  It shows the S&P 500 Index for the past 18-months and how it has primarily traded in a 4% range during that time.

There are two important points to note on this graph before we look at the banks:  (1) the index has dropped below the bottom of the trading range in a definitive way; and (2) the index is sitting right on two major support levels – (a) the market closed today with the index at 2,000.35, virtually sitting on the psychologically important 2,000 level; and (b) after an intraday low of 1991, the market recovered above the 1998 level of the lower support as defined by the previous month’s trading activity.

With the S&P 500 down about 2% year-to-date, our market is not in a free fall.  If you don’t know what a free fall looks like on a chart, look at Barclays Bank:

BCS

And, how about Lloyds of London:

LYG

And we can’t ignore Royal Bank of Scotland:

RBS

These banks are off double digit percentages each of the past two trading sessions.  They trade for roughly 30% of book value.  This is a BIG warning sign that there is something really wrong in the global banking system.  The British banks are being hit by investors, but if you look at any of the other big European banks you will see that they have also sold off in a significant way, maybe not as bad over the past two days, but over the past year many of the most leveraged ones are down 50%.

The US banking system is far healthier than its European counter-part.  The banks here have significantly more capital and significantly less leverage.  That’s not to say that if there is a European banking crisis and the governments there have to inject capital to keep the banks afloat that it won’t impact our banking system – it will, the world is way to interconnected and most of the big banks are involved in complicated derivative contracts in the Trillions of dollars which are off balance sheet but a contingent liability none the less.  If even one bank goes down and cannot make good on its counter party obligations, the impact will be felt globally (if you haven’t rented the movie The Big Short, you should to get a flavor for what this could potentially look like if not managed correctly by the banks and the European governments).

As always, I have an indicator that has served me well beginning with the 1987 stock market crash which was caused by a disruption in the global financial markets, the TED Spread.  This TED Spread graph plots the difference between US Treasury yields and Eurodollar deposit yields.  As the spread increases, it indicates that investors perceive there is increased risk in dollar denominated deposits in European banks and require a higher return.  Back in 1987, the spread got to over 200 basis points.  During  the 2008 crash, it approached 475 basis points.  Today, it is sitting around 39 basis points, but up from 11 basis point at its low in 2010.

TED

If we start to get a sustained move higher, that will be a sign that there is something seriously at risk in the global financial system – which will be a sign that its time to get very conservative in portfolio management.  For now, the steady trend higher, albeit still at low levels, causes us to keep track of this indicator as a prudent risk management practice.

But lets take a look at our top graph again, except this time I’ve added two short-term directional indicators to give us an idea of what might happen tomorrow:

SPX 2016-06-27 v2

The bottom two panels of the above image are the Relative Strength Indicator (RSI) and the Stochastics.  Both flash reversal signals when the indicator line drops below the bottom horizontal line.  You can see that the RSI (upper most of the two panels) is sitting right on the line and the Stochastics (bottom of the two panels) is still well above that line and falling.

If both were above the line and falling, it would indicate that we would likely have another down day in the market tomorrow.

If both were below the line it would indicate that the market is getting ready to turn higher – even if for just a short term bounce.

However, with neither one below the line but one sitting on it, you have a less than 50% chance that the market bounces higher tomorrow.

In spite of the odds, I have more than a feeling after having worked with this stuff for 35 years that we could bounce higher tomorrow, particularly since the index ran higher off the lows at the end of the day. The computers kicked in their buy programs when the market hit a triple bottom for the day which was a level that the index bounced higher from the previous two times (below is the chart of just today’s action on the index):

spx today

The overnight news will determine much of how we open tomorrow – it will be day three since the Brexit, so the media are getting tired of reporting on the same thing and will be looking for new news to make.  So absent another day of chicken little news casts, and if we get some stability in prices in Europe over night, our own markets should see some buying and bounce higher.  If there is more bad news, it will likely continue to fall.

Remember, invest what you see and not what you believe is our golden rule here on the blog.  We will see what tomorrow brings us and make investment decisions accordingly.

Mark

Brexit Investment Update

June 24th, 2016

Common stocks are under pressure today due to the Brexit vote to leave the European Union.

spx 2016-06-24Double click on any image for a full sized view

You saw this chart a couple of days ago when I was showing you the 4% sized trading range of the S&P 500 Index over the past 18 months.  Today, I am showing it to you again with the impact of today’s post-Brexit sell-off.

You can see that the index has move down toward the lower boundary of the range (the red bar on the far right of the chart), but that it is still well inside the two blue bars.

There is no reason to get overly aggressive based upon today’s move, but I have made a couple of trades in client accounts that would be classified as opportunistic:

1.  A couple of months ago, I told you that I was adding the Vanguard Long Bond ETF to client accounts as insurance against some unplanned for event.  When the market is near a top, any sort of negative surprise will send the market down and long bonds up.  Today, I sold it for a total return of just under 4% over the past 10 weeks.  This investment performed exactly as expected and gave us a premium performance over the stock market which is up 0.3% year-to-date.  Since this was added as insurance, today was the perfect day to cash it in.  We still have an allocation to intermediate term bonds, including treasury, corporate and mortgage, so there is still insurance in place – but those are more dividend plays until the market corrects more and we have additional need for cash to pick up targeted purchases at better prices.

2.  With the proceeds of the sale above, I added starter positions in two adated beta ETF’s (index ETF’s that mimic a portion of the S&P 500 that I view as being in the sweet spot investment-wise at the moment) just to take advantage of today’s sell-off.  I added the S&P 500 High Quality ETF and the Deep Value ETF to get some additional exposure to the stock market but with holdings that should outperform the broader market during the likely turbulent period ahead.  Both funds feature companies with solid balance sheets, strong dividends, and cash flow.

3.  And with the balance of the sale proceeds I added a short-term position in the ETF that mirrors the London stock market.  It was down more than 10% and we will either hold it for a short-term gain or hold it for an intermediate period depending upon the post-Brexit prospects for the British economy and its corporations.  The British Pound is at its lowest level in 30 years, so the companies headquartered in England should get a significant upward revision in earnings since they will be able to sell their exports significantly cheaper to buyers who have an immediately stronger currency (making the British goods cheaper by comparison).  Plus our buying the ETF at a 10% discount should make for a decent investment.

I have some other trades to make, but will probably sit tight and see what the market tells us before adding additional equity exposure. Over the weekend there could be scare stories hitting the news that will send the wolves to the gate and give us a lower purchase level next week.

Britain’s Brexit Breakdown

June 23rd, 2016

This Brexit schedule will guide you through the night of vote counting and reporting.  Credit goes to The Guardian for this guide:

0_map_britain_1987_enlarged

10pm (6pm CST)

Polls will close, and on election nights this is normally the moment broadcasters show their exit polls and make their projection for the night ahead.

However, that won’t happen this time as there’s no exit poll for this referendum. Some banks are said to have commissioned private exit poll, but they will be kept for their employees.

So if anyone tells you they know what’s going to happen at this stage, they’re a chancer, unless they are an eagle-eyed watcher of sterling derivative markets. Sky News has commissioned a survey from YouGov of people previously polled, asking how they voted on the day. This will be released at 10pm, but this is not, repeat not, an exit poll and shouldn’t be treated like one.

If you prefer moving pictures (tsk!) this is the line-up from the broadcasters.

BBC1: David Dimbleby will anchor BBC1’s coverage until the early hours. Emily Maitlis will be presenting as well and Jeremy Vine will have his snazzy graphics. The BBC’s political editor, Laura Kuenssberg, and economics editor, Kamal Ahmed, will do the bulk of the analysis. If you’re not in the UK, you can watch the coverage on BBC World News.

ITV1: Tom Bradby will host the broadcaster’s coverage with the political editor, Robert Peston, and national editor, Allegra Stratton, speaking to politicians and pundits. Julie Etchingham will also present, and there will be live reaction from Brussels with ITV’s Europe editor, James Mates.

Sky News: Adam Boulton hosts, alongside political editor Faisal Islam, boasting a team of 50 correspondents at counts across the country.

CNN International: For international viewers, Richard Quest and Hala Gorani will anchor from CNN’s London bureau, with a touring “Brexit campervan” providing outside coverage. Christiane Amanpour will be with guests and analysts outside the Houses of Parliament, with correspondents contributing from Berlin and Brussels.

12.30am (6:30pm CST)

The voting is done by 380 council areas, not by constituencies, so it will play out slightly differently from election night. Sunderland (always the first in a general election) and Wandsworth are expected to declare first, and we can learn a bit from their results, depending on whether either campaign does better or worse than expected.

Wandsworth should have a very strong remain showing, with Sunderland showing a narrower lead for Brexit, about 55-60%. Anything lower than that for Brexit will be a great start for remain campaigners.

The City of London is expected to be among the first as well, declaring around 12.45am and likely to show a substantial lead for remain. The remain vote is likely to look high in the early hours of the morning. If it doesn’t, that’s a big problem for in campaigners.

Gibraltar and the Isle of Scilly will have high remain votes, but the voter numbers aren’t exactly huge. More telling will be results from Salford and Stockport, which will start to give us a sense of whether Labour’s safe seats in northern England are as pro-leave as has been predicted. That conversation could dominate the punditry for an hour or so.

Another to watch is Swindon, where leave will hope for a win, but a chunk of middle-income voters in their early- to mid-30s in the area – natural David Cameron voters – might push it towards remain.

Hartlepool, a leave heartland, is expected to declare during the hour, as is Merthyr Tydfil, which should also show a lead for leave.

Northern Irish results should start coming in, which will be interesting as there’s been very limited polling in the area. Most areas in Belfast should declare during the hour and instinct would suggest a remain lead, over concerns about the border crossing.

1am (7pm CST)

Gibraltar and the Isle of Scilly will have high remain votes, but the voter numbers aren’t exactly huge. More telling will be results from Salford and Stockport, which will start to give us a sense of whether Labour’s safe seats in northern England are as pro-leave as has been predicted. That conversation could dominate the punditry for an hour or so.

Another to watch is Swindon, where leave will hope for a win, but a chunk of middle-income voters in their early- to mid-30s in the area – natural David Cameron voters – might push it towards remain.

Hartlepool, a leave heartland, is expected to declare during the hour, as is Merthyr Tydfil, which should also show a lead for leave.

Northern Irish results should start coming in, which will be interesting as there’s been very limited polling in the area. Most areas in Belfast should declare during the hour and instinct would suggest a remain lead, over concerns about the border crossing.

2am (8pm CST)

This hour is a good time to start concentrating, so put some coffee on.

Westminster, Wandsworth, Ealing and Oxford may give remain the lead here. These are likely to be very safe areas for a remain vote, with high numbers of graduates and younger voters.

We’ll also start to see a number of Scottish results rolling in, from Shetland, East Ayrshire and Angus. If these show only a weak lead for remain, it might be time for Cameron to worry.

Key Welsh boroughs to watch are Blaenau Gwent and Neath Port Talbot, where the opposite is true: Vote Leave will want a good win here, especially in the area troubled by the steel crisis, which Brexit campaigners have linked to the EU.

Castle Point, a key Eurosceptic area in south Essex, will declare around 2.30am. About 70% of voters are in favour of leaving the EU.

Crawley in West Sussex, a bellwether seat in the general election and also likely to be pretty evenly split at the referendum, is also due to declare, as is South Norfolk, where the split should also be telling.

According to JPMorgan’s analysis, commissioned for investors, even if leave ultimately ends up victorious, the remain camp is likely to be in the lead until about 3am. If leave has a total vote share of about 40-45% at this stage, Stronger In will be celebrating.

But if that percentage for leave is more like 45-50%, it will be a very close run thing. Anything higher than that is an indication of a good night to come for Boris Johnson and Nigel Farage. Still, pundits are unlikely to call the race this early.

3am (9pm CST)

Boston in Lincolnshire, where 68% of voters are predicted to be in favour of Brexit, is likely to declare now. Cambridge, one of the strongest remain cities in the country, will declare here, though surrounding Cambridgeshire is very much out-land. Jeremy Corbyn’s distinctly Europhile constituency, Islington, will also declare during the hour.

Look out here for West Oxfordshire, home to David Cameron’s Witney constituency, so the result will be symbolic of something or other.

4am (10pm CST)

Time to hear from Tendring – home of Ukip’s only MP, Douglas Carswell, who represents Clacton – which is unsurprisingly one of the most Euroskecptic areas of the country. Great Yarmouth and Blackpool, both Brexit heartlands, could also bump up the leave share of the vote during the hour.

Harrogate, one of the most affluent areas of North Yorkshire, will be an interesting result to watch, especially if the leave campaign does better than expected.

Once South Staffordshire, Havering and Gravesham, all strong leave areas, are counted, the running tally should give a pretty fair idea of how the overall result will look, percentage-wise. Broadcasters may start officially calling the result from now.

5am (11pm CST)

Manchester will declare by 5am, almost certainly for remain. However, by this time, about 80% of authorities are expected to have made a declaration, and it would be a huge surprise indeed if the final percentages differed greatly from the running tally at this hour.

Bristol, one of remain’s strongest areas and also the country’s slowest counter, will declare by about 6am, but it’s unlikely to make a massive difference.

7am (1am CST)

The official result should be in by now – unless there are substantial recounts needed and it is close – and Jenny Watson, who chairs the Electoral Commission, will announce the final tallies in Manchester.

Mark

Stock Market Trading Range

June 21st, 2016

Today’s chart shows the S&P 50o Index in a Trading Range with the RSI indicator and Volume by Price overlays for the common stock in the indices.

SPX 2016-06-21Double click on any image for a full sized view

The graph above shows the action in the S&P 500 Index over the past 18 months.

You can see that we have a really well defined trading range with the upper boundary being the all-time high of roughly 2,135 and 2,040 (roughly 4.5% below the high).

There are two very obvious corrections out of the trading range that dropped to a level of 10% below the 200-day moving average (for those of you who are long-time readers of the blog, you know how important the range of 10% above and below the 200-day moving average is for the S&P 500 – 10% above acts as a solid resistance and 10% below is a solid support level – or in other words, when index is trading 10% above the 200-day moving average you consider selling and when its 10% below the 200-day moving average you consider buying).

But our case today is not that cut and dried.  This trading range has become a significant obstacle to investing.  It is clear that investors do not have the confidence in the economy to push the index to new highs.  Who can blame them?  Corporate earnings have been falling for the past 18-months – check out the same graph above except I’ve added GAAP Earnings (the green line) which drops each quarter over the 18-month time frame:

 SPX 2016-06-21 EPS

If a company’s stock price is just the present value of its future earnings, and the index is made up of individual companies, the only way for stock prices to go up at a time when earnings are falling is for investors to place an ever-higher valuation on those earnings.  That can be justified to a certain extent by the low interest rates we have, but given they have been stuck at current levels for seven years that justification eventually runs its course at a certain level of valuation.

Without some catalyst to drive the market higher, like a change in governmental fiscal policy, a change in the tax code, or some macro event that jump starts production, an ever-growing valuation is not likely.  The market will have to correct sometime to fix the over-valued levels we are currently experiencing.  However, this sideways trading within the range can go on for a long time – a lot longer than anyone believes – before the index breaks out of the range.

I am sticking with our defensive asset mix for the present time.  If the market were to fall and correct some of the over-valuation or if something were to cause it to move to a new high and remain above that level for at least three trading days, then I would get more aggressive and put some of the money to work we have reserved for that purpose.  But until we break out of the trading range and the index gives us a buy signal, right here, right now, the current strategy of defensive holdings, cash and fixed income is the right place to be.

Mark

Yield Curve Ball

May 26th, 2016

Inverted Yield Curve 2000Double click on any image for a full sized view

One of the things that I find really troublesome is the Yield Curve, or more specifically, what the Federal Reserve will do to stimulate the economy when we get to the next recession and stock market correction.

The Yield Curve is a line graph that plots the span of interest rates from overnight rates to 30-year bond rates on a single day.  In a normal situation, short-term rates are lower than long-term rates and the line graph has an upward slope to it.  But there are times, in particular when you are at a recession, that short-term rates are higher than long-term rates – this is called an inverted yield curve.  This situation comes from investors fleeing the stock market due to the risk of corporate earnings falling in the recession. The investors are reinvesting their money in the safety of bonds, driving the longer term rates down since there is so much demand.  The inversion can also be aided by a Federal Reserve that doesn’t cut interest rates fast enough to avoid the recession.

In the graph above from the peak of the stock market in 2000 (the red vertical line) you can see the yield curve on that specific day (the red downward sloping line) was inverted.  The recession was upon us and the stock market started its long journey down as corporate earnings were less than expected.

Normal Yield Curve 2003Fast forward to the bottom of the stock market in 2003 (again the red vertical line) and you can see that the Federal Reserve had cut short-term interest rates from roughly 6% to 1% in order stimulate the economy.  The yield curve resumed its normal shape and companies started to experience increased earnings coming out of the recession, those earnings increases translated into a bull market for stocks.

Inverted Yield Curve 2007Fast forward to the top of the market in 2007 and you can see that we again have an inverted yield curve.  Shortly after this date, the recession takes hold and corporate earnings begin to fall sending the stock market down decisively (this was a lack-of-liquidity driven market crash as much as falling corporate earnings).  To combat the recession and to add liquidity to the financial system, the Federal Reserve cut interest rates again.

Normal Yield Curve 2009You can see that at the bottom of the market in 2009, we again have a normal yield curve with short-term rates cut by the Federal Reserve from just under 5% to just above 0%.  Those near 0% rates fueled a rally in the stock market that ran to last May’s highs.  Unfortunately, corporate earnings have started to fall again and there is talk of another recession coming our way.

Flattening Yield Curve 2016This is the yield curve today.  You can see that it is still a normal yield curve, but that it is noticeably flatter than the one above (this could possibly presage an inverted yield curve – but it would be difficult to get long-term rates near zero, but anything can happen in this economy where we have no past history to learn from).  You can also see that the Federal Reserve has kept short-term rates at the near 0% level.  The question we should all want an answer to is what will the Fed do when we get to the next recession if it cannot lower interest rates since they never raised them as would be normal during an economic cycle.

There is a lot of speculation that our Federal Reserve will follow the European Central Bank in two ways:  negative interest rates and purchasing corporate bonds in a new round of quantitative easing.

We haven’t talked about QE in a while here on the blog because the Fed ended that practice a couple years ago – QE is where the Federal Reserve prints money to flood the economy with liquidity by buying government bonds.

Both of these actions, if the Fed were to follow the ECB’s lead, would be unprecedented.  Much of the economic stagnation we currently have comes from the 0% rates – consumers and businesses have loaded up on debt to record levels given the low rates.

Consumers have incomes that have not kept up with their debt fueled spending and they are not the catalyst for economic activity that they once were.

Corporations have used the debt to buy back their outstanding shares of stock, a financial trick that makes their earnings per share appear to go up simply because there are fewer shares to spread the earnings over.  The side effect of borrowing to buy back shares is that reinvestment into property, plant and equipment as well as research and development has been curtailed, adding to our economic stagnation.

What unintended harm can negative rates or QE for corporate bonds have?  I don’t know but it will likely continue to provide the wrong incentives for consumers and corporations while not doing anything to stimulate the economy.  This is our yield curve curve ball, or with a nod to Wheel of Fortune, our yield curve ball.

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