Month: December 2016

This recent headline caught my attention: Another Reason Wall Street Loves Trump, like if loving Trump was so universally widespread. Even more so because this particular reason to love the President-elect is not of the pie-in-the-sky sort like infra-spending and manufacturing revival. Banks are actually seeing renewed and profitable activity in their trading.

(…) Average daily bond trading volume rose by 22% from a year earlier in November, according to data from the Securities Industry and Financial Markets Association. Volumes have been rising since midyear, but the election put them in overdrive. (…)

The more important question now is how long the pickup can last. If the Federal Reserve signals more rate increases coming when it meets next week, that could keep trading elevated. (…)

J.P. Morgan Chase Chief Executive James Dimon, speaking this week, said fixed-income trading has fallen around 35% from its peak years ago. Of that, Mr. Dimon figures around half is “gone forever,” while the rest “may very well be cyclical and will come back eventually.” (…)

Three questions?

1. How much money will banks lose on their bond holdings because of the jump in rates? The Financial Times puts current global bond losses at $2.1 trillion and counting.
2. What would be the net effect on bank profits and capital ratios if tax rates are cut given that the deferred tax credits booked after the massive 2008-09 losses assumed a 35% tax rate?
3. Last but not least, are rising rates any good for equities?

I have no clue on #1 and #2 but here’s a hint on #3 (click on chart to enlarge).

In the 12 periods of rapidly rising long-term rates between 1965 and 1996 (I grouped a few short periods on the chart), not one was accompanied with any meaningful gains in equities while most saw equities perform a really deep dive (average –14.5%).

True, that was in the previous century. Since 1996, there were some instances when rising rates coincided with higher equity prices, like in 1998-2000, maybe 2005-06,  and 2010. The first two instances saw equity valuations truly explode as investors bought into “great stories”, only to totally deflate when the dreams turned into terrible nightmares.

Humans are sometimes very open to “great stories”, especially when they come with labels like “game changer”, “revolution”, “new paradigm” and the famous “this time is different”. Sometimes, humans can be in such a need for any “credible” stories, they show an amazing capacity to adapt to rapidly changing narratives.

Only two months ago, “lower for longer” was almost universally tagged on long-term interest rates and inflation. And that was good for equities. Now, we get sharply rising rates along with inflating inflation expectations and that is also good for equities. Nobody really cares to document why, other than claim that the Trump revolution will have such an impact on profits…yaddi, yaddi, yadda.

The bond market cares deeply about inflation and real returns, except when central bankers decide to take it over to achieve their own particular goals which recently were very foreign to positive real returns.

Mr. Trump’s magic is expected to do the job on growth and inflation, right when central bankers wish to return to the back pages and let the bond market be the bond market, that is a generally pretty good discounter of inflation. So rates will be let loose and finally normalize. But what does that mean practically? It means positive real long-term rates around 1.3% give or take 1.0%.

Current inflation is anywhere between 1.5% and 2.5% depending on the yardstick and is generally expected to be above 2.0% in 2017, meaning 10Yr rates in the 3.5% range from the current 2.4%. A tremendous jump from the July low of 1.5%. Will equity investors be able to cling to a good enough story, dismiss this new competition and overlook what that means to indebted corporate America and emerging markets already struggling with the mighty dollar?.

It happened before. In fact, there seems to be a pattern to investors’ “irrational exuberance”: almost once every decade investors totally overlook valuations when presented with a “game-changing” story. There was the brief Kennedy mania in the early 1960s, the nifty-fifties in the early 1970s, the brief Reagan mania in the early 1980s, the real-estate boom in the late 1980s, the internet revolution in the late 1990s and the housing mania in the late 2000s.

Now the Trump mania. Based on the Kennedy and Reagan exuberances, equities could run some more, possibly to the 22-23 levels on the Rule of 20 scale. That would mean 2350-2450 on the SPX or another 5-10%.

Long-term interest rates serve to discount future earnings. But real rates also fluctuate along with investors’ greed and fear. Using inflation as a discount factor provides a more stable valuation gauge than trying to value equities with rates that are themselves subject to fickle investor psychology, or central bankers manipulation. The latest period of central bank experiments is a prime example. The “lower for longer” mantra was a trap to keep P/Es at a high level.

The Rule of 20 continues to help investors objectively assess the risk/reward ratio for equities. After proving its effectiveness in early 2009, against most other popular tools, and all the way up through 2014, the Rule of 20 kept its usefulness during the 2015-16 dry spell, adequately measuring the lack of rational upside since early 2015 and protecting against three sudden and serious setbacks during the period: two near –15% corrections in August 2015 and early 2016 and a smaller –6.5% drop in June 2016.

Combined with Edge and Odds’ thorough and objective assessment of the economic, financial and media environment, the Rule of 20 keeps delivering what counts most for investors: a simple, dependable and objective measure of the risk/reward ratio in order to optimize the crucial asset allocation between equities and cash.

We are admittedly in a tough moment for investors faced with all these Trump stories boosting an already expensive equity market (“exploding profits will take care of this”) and simultaneously dismissing any notion of risk emanating from the fixed income world (“rising rates mean a better economy”), a potential inflation revival (“corporate pricing power is back”) and/or the vagaries of a rising dollar on emerging market economies (“exports are only 12% of GDP”).

Barry Ritholtz could be right: pricey equities can get pricier and new market highs can be considered bullish. Many investors will surely not want to leave money on the table, love Trump or not: Six Things to Consider as Stocks Break Records (with my comments):

1- Sentiment: Has gotten frothy as the market has run up. One of the more interesting ways to track sentiment is to use the Wall Street Journal as a reference guide. Stock-market researcher Laszlo Birinyi notes that when new market highs are consigned to page C4 or otherwise buried in the back pages, it is still early in the cycle. By the time it makes it to the front page, we might be getting ahead of ourselves.

After months of back-of-the-paper articles (see pages C4, C4, B12 and B1). Here is yesterday’s front-page Journal headline: “Postelection Rally Lifts Stocks to New Heights.”  The A1 coverage suggests that more investors are aware of — and participating in — the market rally. That might imply that a short-term retreat is due.

But also consider Bob Farrell’s rule #9: When all the experts and forecasts agree — something else is going to happen.

There is also the notion that there is lots of cash on the sidelines and that small investors have yet to enter the fray and push valuations to the extreme like they always do. Two problems here: one, small investors are already very well invested as Lance Roberts shows with this AAII chart. Their level of cash is also close to historical lows, which also holds for the institutional crowd.

Ned Davis Research confirms with this chart (via CMG’s Steve Blumenthal):

2- Valuations are elevated: Markets are overvalued relative to historical averages. This may be true, but it misstates an important fact. Markets are rarely fairly valued. When stocks are undervalued, people can be too nervous to put capital to work; when they are expensive, they are reluctant to overpay.

Here is the thing about equities: Pricey markets often become pricier, cheap markets often become cheaper. It is important to remember that markets are at fair value for only the briefest of moments. Then they quickly careen off course, staying cheap or overvalued for years at a time.

The Rule of 20 chart above partly supports this view. It also illustrates that extreme high valuations beget extreme “corrections”. Bob Farrell’s #4: Exponentially rising or falling markets usually go further than you think, but they do not correct by going sideways

3- Earnings: It may be counterintuitive, but consider this: markets are forward looking and valuations look elevated sometimes because the economy and corporate profits have to catch up with prices. That’s what the first three-quarters of this year were about: stocks prices were little changed as they waited for earnings to rise enough to justify valuations.

I am always amused when people talk about forward looking markets, like if “markets really knew”. They sure try to gaze into the future, but that does not mean they know. What did they know in 1962, 1968, 1972, 1980, 1987, 2000 and 2007? Bob Farrell’s #9 again.

4- Then there’s the CAPE ratio: This is Yale economist Robert Shiller’s measure of cyclically adjusted price-to-earnings ratio. My colleague Michael Batnick crunched the numbers on CAPE, and he found that “over the past 25 years, the CAPE ratio has been above its historical average 95% of the time. Stocks have been below their historical average just 16 out of the last 309 months. Since that time, the total return on the S&P 500 is over 925%.”

In other words, CAPE is a useful guide to give you some ideas about future expected returns, but as a market-timing tool, it is of little use.

Some ideas? Please, be more specific. I have been warning of the CAPE drawbacks since January 2009 when I was treated a “bloody fool” (e.g.: The Shiller P/E: Alas, A Useless Friend, “LEAVING CAPE TOWN”). Good to see other people are finally realizing its limitations. Nobody seems to care about The Rule of 20 which is perhaps too simplistic for guru-fiefdom. It certainly does not require any Nobel prize to understand and use it.

5- New market highs are bullish: We said this two years ago, but it remains true today. I am always astonished when I hear that new market highs are a reason to avoid equities. Of all of the many factors that have been demonstrated to generate returns, I believe momentum — and in particular, trend — is misunderstood by many investors.

Think of it this way — which is the better way to generate gains, investing in markets that reach new lows or new highs?

Hmmm…Hopefully we will all get Barry’s wise word when the time comes. Because it will come. Bob Farrell’s #5: The public buys the most at the top and the least at the bottom and #1: Markets tend to return to the mean over time. Ben Graham also had a view on that: You don’t have to trade with Mr. Market when he wants to, but only when you want to. Warren Buffett has more:

• I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.
• Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.
• Risk comes from not knowing what you’re doing.

And these crucial ones from Peter Bernstein:

• We can never know the future — least of all at the very moments when it seems most certain.
• You must weigh not only the alluring probabilities of being right, but the dire consequences of being wrong.

6- The election is over: The chief executive officer of Southwest Airlines noted that bookings have risen since the election. Maybe this is because everyone is so enthusiastic about Donald Trump’s victory and his plans to cut taxes and roll back regulations. My guess is that this election — the most insane, bizarre, surprising, reality-show-of-a-car wreck of our lifetimes — left many people too exhausted to think of doing anything other than watching the spectacle unfold.

Regardless of who you supported, and whether or not America is or was or will be great again, many people are relieved that the race is over. People are returning to their regular lives, and that means working, traveling, spending and investing in the equity markets.  

But wasn’t this election supposed to be a slam dunk?

Back in 2009, people were so disgusted of equities, however cheap they were, that no positive view or interpretation was acceptable. Everything was gloomy and bleak. Now, however expensive equities can be, there is always a positive spin to just about everything. Michael Lewitt quoted Daniel Kahneman last week:

An unbiased appreciation of uncertainty is a cornerstone of rationality – but it is not what people and organizations want. Extreme uncertainty is paralyzing under dangerous circumstances, and the admission that one is merely guessing is especially unacceptable when the stakes are high. Acting on pretended knowledge is often the preferred solution.

Here’s the reality as I see it:

• Equities are overvalued by most measures.
• The Fed clearly wants to raise short-term rates, not necessarily bad for equities but a potential headwind nonetheless. More on this? EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954
• Higher U.S. interest rates would likely push the USD up. More economic headwind, more earnings headwind.
• USA Inc. is very, very leveraged.
• Rising long-term rates could prove a strong headwind for the economy and equities. They generally do. A crude estimate by Peter Boockvar (via David Rosenberg) is that, given current leverage in America, a 100 basis points increase in market rates causes interest charges to soar $470 billion or 2.5% of GDP.
• Buybacks and dividend growth are slowing as companies must address their debt ratio amid slower cashflow growth and rising rates.
• World politics are getting complicated (USA, Brexit, Italy, France, China).
• Central banks are getting complicated. What else can they really do?

Rather than being fearful of leaving money on the table, why not consider leaving risk on the table? Not only is there Bob Farrell’s rule # 9 and Warren Buffett’s rules #1 and #2, there is also the forgotten fact that expensive equities are fertile ground for black swans and ground hogs, especially when accompanied with rapidly rising interest rates.

I am thus leaving my equity rating at 2 stars, meaning a below neutral stance. Not an outright negative for 2 reasons:

1. A recession is not in sight (will we really see it coming?) 
2. Importantly, the “120 yield spread” remains very positive. As shown in A Powerful Combo: the Rule of 20 and the “120 Yield Spread”, the Rule of 20 barometer, being a valuation gauge, has occasionally had timing issues that the 120 Yield Spread alleviated:

• The S&P 500 Index gained 43% between August 1970 and December 1972 while the Rule of 20 P/E ranged between 20.3 and 24. The yield spread was well above 120 for most of this period. Earnings were generally flat throughout the period but inflation dropped from 6% to 3%.
• The S&P 500 Index jumped 50% between November 1990 and January 1994 even though the Rule of 20 P/E was well above 20 and often above 22. The yield spread stayed well above 120 (reaching 360 in January 1993). Earnings declined during the first 12 months (recession) but recovered 40% thereafter. Inflation declined from 6.3% to 2.5%.
• Same thing between September 2002 and May 2005 when the S&P 500 Index advanced 46% while the Rule of 20 P/E was above 20. The yield spread stayed well above 120 (reaching 370 in May 2004). Earnings exploded 60% post recession more than offsetting a rise in inflation from 1.5% to 3.5%.

A caveat to the caveat: in all three instances, the equity rallies started at the end of a recession-induced bear market…Furthermore, the current spread of 198 could be seen as artificial given the artificially low short term rates…which the Fed clearly wants to normalize. Three more hikes and we’re below 120. Maybe Mr. Market will see that coming.