My old friend Terry recently sent me this chart with a simple question: “Return to the mean?”.
This could be the most important chart of 2018.
- This is the third generational low in the commodities/equities relationship since the late 1960s. The previous 2 lows did mean revert and were eventually followed by generational highs.
- Every low occurred after a general collapse in commodity prices due to excess supplies, not to economic recessions, sharply rising equity prices and a period of strengthening dollar.
- Both reversions to the mean from the lows started with equities and commodities rising somewhat in synch, followed by sharply falling equity prices before commodities also eventually peaked out.
- After reaching the mean, commodities kept outperforming as equities completed their bear phase. In total, equities collapsed 46% in both 1973-74 and 2000-02 from peaks reached 11 and 8 months prior to the official start of a recession respectively.
- In 1973-74, corporate profits (S&P 500) rose until Q3’74, well into the recession and the market rout, while in 2000-02 profits peaked in August 2000, right at the market peak 8 months before the recession started.
- At its peak in December 1972, the S&P 500 Index was selling at 18.4 times trailing EPS (34% above the LT median) and 21.8 times on the Rule of 20 P/E (9% above “20”). In August 2000, the P/E was 26.9 and the Rule of 20 P/E 30.3.
- The big depressing factor in 1973-74 was the sharp acceleration in inflation which rose from 3.0% in mid-1972 to 3.6% in January 1973 (first S&P 500 decline), 9.0% in December 1973 and 12.0% in September 1974. The OPEC oil embargo began in October 1973, impacting U.S. prices from January 1974. The Fed had started raising interest rates in March 1972 from 3.3% to 6.0% in January 1973 and 13.0% in July 1974.
- In 2000-2002, core inflation also picked up, from 1.9% in December 1999 to 2.8% in February 2001. The Fed funds rate rose from 4.8% in June 1999 to 6.5% one year later.
From this admittedly limited sample of but 2 occurrences, we can say that there was, indeed, a reversion to the mean in both cases and that
- in both instances, the initial move back to the mean started with overvalued equities and depressed commodities rising somewhat in synch, followed by sharply falling equity prices while commodity prices kept rising;
- in both instances, inflation was up;
- in both instances, the Fed was tightening;
- in both instances, the yield curve inverted;
- in both instances, a recession followed before the mean was reached;
- in both instances, equity markets peaked 20 months after the commodity/equity ratio troughed.
Importantly, profit trends differed meaningfully:
- S&P 500 profits rose 42% throughout the 1973-74 bear market while the P/E collapsed from 18.4 to 7.0 under the pressure from rising inflation and interest rates.
- Profits tumbled 30% between the August 2000 market peak and the September 2002 trough.
When equities are overvalued, trends in inflation and interest rates matter more than profits.
Only considering the outperformance of commodities from the mean up, we can include the period between 1988 and 1990 although from a higher low reached just before the October 19, 1987 crash. We thus have 3 periods to analyse for this second phase, and they were all very different.
- The 1974 spike was just that, a spike when Iran shocked the world tripling the price of oil over 12 months causing a recession throughout that year. Commodity prices troughed at the end of 1977 but not before equities shot back up 67%.
- Commodities staged a strong rally in 1987-88 culminating with a doubling in oil prices in Q3’90 and a recession. This is when equities bottomed after a correction of only 15% thanks to the absence of strong overvaluation at the peak. The rest is history as equities quintupled to the dotcom bubble summit of 2000.
- The 2000-2008 period of commodity outperformance is explained by one word: China. All demand driven following 6 years of weak commodity prices which curtailed supplies. Even though equities almost doubled between 2002 and 2007, commodities outperformed 4 to 1! Let’s also not forget that oil prices doubled between January 2007 and June 2008.
Post each mean reversion process, the continued outperformance of commodities has either been very short lived and/or pretty chaotic and has always culminated with a sharp spike in oil prices and a recession. While equities underperformed, they nonetheless provided good absolute returns up to between 2 and 11 months prior to recessions.
It seems that the low of the commodity/equity ratio was reached in June 2017, seven months ago. Since then, the S&P GSCI is up 18.2% and the S&P 500 12.0%. The Fed hiked 5 times since December 2015 taking the effective Fed funds rate from 0.1% to 1.4%. The yield curve is only 2 hikes away from inverting. Only inflation is apparently MIA.
Inflation has remained below the Fed’s 2.0% target using core CPI or the PCE deflators although total CPI has accelerated from zero to 2.2%.
But the Fed is determined to do what’s necessary to get inflation to target (and somewhat beyond for good measure) and odds of coming success are increasing:
- Core PCE rose 1.8% annualized in the last 3 months from +1.4% during the previous 3 months.
- Total PCE rose 3.1% annualized in the last 3 months from +1.4% during the previous 3 months.
- Total CPI rose 4.2% annualized in the last 3 months from +2.0% during the previous 3 months.
- Core CPI rose 1.9% annualized in the last 3 months from +1.9% during the previous 3 months.
- The NY Fed’s Underlying Inflation Gauge measures currently estimate trend CPI inflation to be in the 2.2% to 2.95% range, with the prices-only measure close to the actual twelve-month change in the CPI.
- The S&P GSCI has risen 18% since June 2017
- Oil prices are up 15% YoY.
- CPI food prices deflated during 2016 and the first half of 2017 but are now up 0.6% YoY; the PPI-Finished Consumer Foods, in negative territory for most of 2015-16, is now +3.4% YoY.
- “Indicators currently suggest a 75% probability of a La Niña in the coming months, according to Stefan Vogel, head of Rabobank’s agricultural commodity markets research team. The weather pattern could inject volatility into markets like grains, soybeans and palm oil next year . (…) The last severe La Niña was in 2012 and caused a record-breaking heat wave and drought across the U.S. Midwest, Mr. Vogel said in a note. It eventually drove prices up to $18 a bushel for soybeans and $8 a bushel for corn, according to him. Soybeans’ average price over the past five years has been 38% below that level; corn’s has been 39% below its 2012 high. A return to those levels would constitute an 87% gain for soybeans and a 130% jump for corn.” (WSJ)
- Aluminum prices are +29% YoY, copper +26%, cotton +7%.
- Non-petroleum import prices in the U.S. declined in 2015-16. They were up 1.4% YoY last November and +2.0% annualized in the last 3 months.
- The U.S. dollar is down 7% in the past year.
- The producer-price index for final demand advanced 3.1% in November from a year earlier, the biggest jump in nearly six years. Producer prices rose 0.4% in November for the third consecutive month. Even when excluding food and energy and a volatile category known as trade services, prices businesses charged were up 0.4% in November from a month earlier.
- Core PPI-Final Demand is up at a nearly same monthly pace; 3-m SAAR: +4.0%.
- PPI-Core Goods has accelerated sharply in the last 3 months: +3.2% SAAR. Same with Services: +4.3% SAAR.
- The pipeline of intermediate goods and services is also showing sharply accelerating inflation.
- “The global economy ended 2017 on a buoyant note, according to PMI survey data. Current business activity growth gained momentum and rising inflows of new orders suggest that business will start 2018 on the front foot. The brighter outlook and signs of stretched capacity led to the largest rise in employment for a decade. Price pressures meanwhile remained elevated, reflecting improved pricing power amid robust demand.” (Markit)
- Wage growth remains subdued this late in the cycle and with such a low unemployment rate. But wages grew 0.34% MoM in December amid rising complaints about worker shortages while GDP growth shows signs of acceleration. Employers could well become more aggressive on compensation given the growing economic enthusiasm, their new found pricing power and the coming tax cuts.
So the case for higher inflation is strengthening and the Fed is totally behind it, literally and morally.
The S&P GSCI/S&P 500 Index ratio troughed at 0.89 last June and is now 0.95. A return to the mean of 4.1 would require the GSCI to multiply by 4.3 to 11,000 or the S&P 500 Index to crater 77% to 625 or a relative combination thereof. Recall that the GSCI peaked at 10560 in June 2008 and the S&P 500 bottomed at 666 in March 2009. Also, note that the GSCI can be highly volatile: it quintupled between 1970 and 1974 and more than doubled in 1999-2000 and 2007-2008.
Equities and commodities have been rising at similar paces since mid-2016 with the latter slightly outperforming the former since June 2017. Conditions are ripe for a good commodity rally after a 75% bear market over 9 years. Exploration budgets have been severely curbed and supplies have declined. Metal inventories are down 60% from their 2013 peak and stand below their 2002-2004 levels just before prices quadrupled. OPEC seems to have reached a better control of the demand/supply equation. And agricultural prices could feel the effect of La Nina in coming quarters.
This just as world economies appear to be in synchrony. Rising demand meeting limited supplies, once again.
There is another mean reversion process likely to get underway in the near future. The Rule of 20 simply states that the median (fair) P/E for equities is 20 minus inflation. The chart below illustrates the stability of this gauge over all types of cycles. It also shows that mean reversion is an ongoing process for this ratio which almost almost always completes the full cycle from undervaluation to overvaluation.
At 22.6, the Rule of 20 P/E is but 6% below its “24” upper boundary. It is 11.5% above its “20” mean and 29% above its “16” lower boundary. These assume static inflation but any rise of inflation from its current 1.8% level would boost all downside calculations. Note that the Rule of 20 P/E, a dependable measure of investors ebbing enthusiasm, always returns to its mean.
The circles indicate the last two GSCI/S&P 500 generational lows and the arrows point to the level of the Rule of 20 P/E after the bear market, coincidentally –46% in both instances. The combination of rising inflation and declining profits can hugely amplify the effects of the “return to the mean” process. So the Rule of 20 currently “only” 11.5% above its mean does not limit the downside risk to –11.5%. This actually is the minimum downside that a return to the mean would entail if inflation and/or profits are held constant, two highly improbable assumptions.
In summary, the current rare combination of overvalued equities and a generational low in the commodity/equity ratio should seriously worry investors. The long commodity bear market has done its usual effect on commodity supplies which, coupled with synchronized world economies, low interest rates, excess liquidity, rising profits and declining U.S. tax rates could really boost commodity prices and refuel inflation. Not only would P/E ratios decline, profits could also be materially impacted by dropping margins (another mean reversion?).
The soon to be renewed Fed, possibly the least experienced ever, could well find itself overwhelmed by the rapidly changing conditions, find itself well behind a “curve” it did not anticipate and be forced to really hike interest rates.
Mean reversion has been a key theme for many cautious or bearish investors and strategists during this long bull market. Just as some are frustratingly giving up, possibly uplifted by the expected impact of synchronized growth and the U.S. tax reform (remember 1973-74’s profit growth), mean reversions could well be just around the corner.
That would be really mean.
Is there a silver lining here?
- We may not be at the GSCI/S&P 500 low just yet or the ratio could remain weak for a while longer if commodities remain depressed and/or equities “melt up” (see Jeremy Grantham’s Bracing Yourself for a Possible Near-Term Melt-Up). But synchronized world growth ought to impact commodity prices given current low inventories.
- Equities could nonetheless keep outpacing inflating commodities given profit trends and tax reform. But that needs to assume that companies can pass on their cost increases, which should feed inflation and incite the Fed to raise rates further and/or more aggressively.
- Inflation could remain “mysteriously” low in any event. Possible, it has been the case so far this cycle. But improbable; this is more akin to magical thinking than normal economic supply/demand. And the Fed, the BOE and the BOJ all aim at boosting their economy and reach 2% inflation. Shooting for 2% will likely mean that it must overshoot for a while. Unable to bring it up for years, can we reasonably expect the Fed to hold inflation down if it starts rising, especially if commodity prices react to severe supply issues and La Nina plays havoc with Ag prices. The Fed has no control there.
- Finally, we could all be the lucky first ever witnesses of equity markets slowly and calmly absorbing rising profits and restore valuations in a nirvana environment where world economies grow at a pace that maintain a stable equilibrium between commodities, inflation and wages and central banks keep interventions to a minimum.
Yet, inflation or not, the Fed is determined to “normalize” interest rates in the U.S. and several more hikes are expected this year. In 2014, I wrote a post about equity markets when the Fed is hiking (EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954) analysing the 15 tightening cycles since 1954.
(…) I found that in 6 of the 8 years when the S&P 500 rose during the initial rate hike, inflation was actually diminishing or stable (2004). This did not verify in 1987, although the market eventually avenged itself and in 1999 when internet speculation blinded everybody.
Maybe we got ourselves a bit of a rule here: rate hike cycles are not damaging to equities in as much as inflation is not rising at the time.
Here we are again: watch inflation!