Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: May 2018

THE RULE OF 20 VS “REY”

Barron’s interviewed John Apruzzese, chief investment officer of Evercore Wealth Management in its May 7 edition (Who Says This Market Is Overpriced?):

Inflation is absolutely crucial for long-term investors. It’s the most important macro factor. Oddly, the market is stuck on the P/E ratio. When people talk about Treasuries, they don’t say that if a bond yields 2%, it is selling for 50 times the coupon. It’s upside-down. The conventional way of saying inflation is important is the Rule of 20, which is that the P/E plus inflation should equal 20. Why is that? It makes much more sense to think about the earnings yield than to use a reciprocal. Once you do that, it falls into place. You can take the earnings yield and subtract inflation and that’s the real earnings yield. (…)

That’s significant because people are looking at the CAPE [cylically adjusted P/E] ratio, which looks really expensive using the average of the past 10 years. Of course it does, because it includes 2008 and 2009. As soon as that rolls forward, the P/E falls. On the other hand, people might say the P/E isn’t that expensive relative to low bond yields. Inflation is related to bond yields, but bond yields are artificially low. For example, the 10-year Treasury should nominally yield GDP [gross domestic product] and be at 4%. But it doesn’t because it has been manipulated by the central bank. When bond yields return to normal, people will have lost the justification for the current P/E.

Today, on the real earnings yield, the market is almost exactly at its long-term average. (…)

“John has always focused on the core issues in investing,” says Ed Yardeni, chief of Yardeni Associates, another market bull.

Yardeni says that Apruzzese’s study of the real earnings yield “neatly incorporates inflation into a stock-valuation model. It’s a simple model that is easy to construct and comprehend, and it has a good track record.”

Apruzzese explains why he is using the real earnings yield (REY) model [E/P – Inflation] and not the simpler Rule of 20:

At low inflation levels, each percentage point by which the CPI growth rate increases will reduce fair value for stocks by just five percent or so under the Rule of 20.

Say inflation has been running at two percent, much as it has been lately. An increase to four percent would take fair value on stocks from 18 times earnings to 16, but it’s difficult to imagine such a muted reaction to that great a jump in inflation. By contrast, fair value would drop by the same proportion, from nine to eight, if inflation rose from 11% to 12%, even though the markets probably would judge such a move as far less significant than a doubling of inflation in a low-inflation environment.

(…) a more conceptually and mathematically rigorous adjustment that takes full account of inflation would start with the earnings yield instead of the P/E ratio and subtract the inflation rate. (…)

REY provides a full adjustment for inflation, without the distortion that results from subtracting the same change in inflation from different starting rates and therefore different fair values. REY will rise or fall by one percentage point with each decline or increase, respectively, in the inflation rate, no matter what the starting levels of inflation or the nominal earnings yield may be, providing a more accurate assessment of potential returns. (…)

Mathematically sensible (although debatable) but less useful in the real world. Judge by yourself:

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The Rule of 20 is much more stable around its 20.0 average with a very useful symmetry around the average allowing for more dependable calculations of risk vs reward which is the ultimate objective.

FYI, here’s Apruzzese’s November 2017 paper A Reality Check for Stock Valuations.

Also FYI, LPL Research produced this chart in its April 30, 2018 Market Commentary. Notice how average P/E ratios plus inflation always total roughly 20.

image

THE DAILY EDGE (18 May 2018):

U.S. Leading Economic Indicators Post Another Firm Increase

The Conference Board’s Composite Index of Leading Economic Indicators increased 0.4% last month, the same as during March which was revised from 0.3%. The y/y change strengthened to 6.4% from 4.1% during all of last year. (…)

All but two of the component series contributed positively to the change in the leading index last month. (…)

The Index of Coincident Economic Indicators increased 0.3% (2.2% y/y) during April following two months of 0.2% gain. Each of the component series contributed positively to the total’s rise including personal income less transfer payments, business sales, payroll employment and industrial production.

The three-month gain in the index of 2.8% (AR) was the strongest since December.

The Index of Lagging Economic Indicators rose 0.3% last month (2.4% y/y) after a 0.1% March dip, revised from +0.1%. All but two of the seven component series contributed positively to the change in the index. (…)

From Advisor Perspectives, still no signs of recession from this indicator:

Smoothed LEI

But I am still worried about the U.S. consumer’s ability to keep supporting this economy amid slow wage growth, rising inflation, higher interest rates and very low savings.

From the NY Fed’s Q1 report on household credit via @spomboy:

@jessefelder

Government Bond Yields Wobble Near Multiyear High
Mortgage Rates Hit Seven-Year High as Ultracheap Era Ends Mortgage rates this week jumped to their highest level since 2011, signaling a shift to a higher-rate environment that could slow home price appreciation and squeeze first-time buyers.

The average rate for a 30-year fixed-rate mortgage rose to 4.61% this week from 4.55% last week, according to data released Thursday by mortgage-finance giant Freddie Mac. (…)

The concern among economists is that higher rates will prompt homeowners to keep their low-rate mortgages rather than trade up for better properties. As rates approach 5%, the risk of the phenomenon known as rate lock grows, economists said. (…)

A 4% rate on a $250,000 loan translates to a monthly payment of $1,194, according to LendingTree Inc., an online loan information site. At 5%, the monthly payment would go up to $1,342, excluding taxes and insurance.

The monthly increase is more pronounced on higher-priced homes. According to LendingTree, a 4% rate on a $500,000 loan would create a monthly payment of $2,387. At 5%, the monthly payment would swell to $2,684. (…)

BTW, one of the reasons why new house prices are rising. Can you guess when the U.S. imposed countervailing duties on Canadian lumber:

BTW #2: steel studs prices will likely also spike:

The central bank’s Beige Book, a collection of anecdotal reports from businesses,  said there were “widespread reports” in March and early April “that steel prices rose, sometimes dramatically, due to the new tariff.”

Emerging-Market Currencies Fall Against Dollar Worries percolate that U.S. bond yields will keep rising

China sees rise in companies defaulting on bonds Value of defaults marks a 32% increase year on year, says Standard Chartered

(…) Moody’s has warned that there is “a considerable amount” of refinancing due in the next two years, with some Rmb3tn of onshore corporate debt due for repayment next year. (…)

Other issuers outside of the corporate sector are coming under pressure. A local government financing vehicle owned by the megacity of Tianjin failed to repay half of a Rmb500m ($78m) trust loan late last month. (…)

(…) Ten onshore bond issuers have defaulted on 17 bonds with a total principal amount of CNY14.6 billion in 2018 (as of 7 May 2018), compared with 18 defaults on 46 bond issues with a total principal amount of CNY39.3 billion in the whole of 2017. These 10 issuers operate in sectors including ports, coal mining, machinery, shoe retailing, environmental service/EPC, biomass energy, and security surveillance equipment. Trust loan defaults have increased, including a provincial state-owned construction company. Credit events have also risen. For example, DunAn, a large private manufacturer based in Zhejiang with CNY45 billion in outstanding debt, asked the provincial government to intervene with banks to resolve a liquidity crisis, citing systemic risk. (…)

The shift in the credit cycle is coinciding with a peak in corporates’ domestic bond refinancing needs, which stems from an issuance boom in 2015 and 2016, when credit conditions were loose and the domestic exchange bond market lowered entry barriers for corporates, especially private companies. Many bonds issued in those years become due or puttable by investors in 2018 and 2019, which will result in bond maturities totalling more than CNY4 trillion per year. (…)

Trump Trade Chief Says ‘Nowhere Near’ a Deal on Nafta President Donald Trump’s trade chief said the U.S. is “nowhere near” a deal on Nafta, effectively brushing aside an offer from House Speaker Paul Ryan for more time to conclude a deal.

Japan Considers Retaliation Against U.S. Steel Tariffs Japan is looking into retaliating against the U.S. over steel tariffs, a break from the more conciliatory approach Tokyo initially adopted toward its closest ally.

Deal or No Deal: Can China Shrink U.S. Deficit by $200 Billion?

(…) “I find that difficult to contemplate,” said Victor Shih, a professor at the University of California in San Diego who studies China’s politics and finance. “Even with a drastic reallocation of Chinese imports of energy, raw materials and airplanes in favor of the U.S., the bilateral trade deficit may reduce by $100 billion. A $200 billion reduction would mean a drastic reduction in Chinese exports to the U.S. and a dramatic restructuring of the supply chain.” (…)

(…) Even if the two sides could agree on items to target—they don’t—and even if China cooperated by lowering import barriers, trade experts say the U.S. simply doesn’t have the capacity to ramp up production enough to make the $200 billion goal.

“The U.S. is operating at full employment. There isn’t a tremendous amount of underutilized U.S. capacity,” says Chad Bown, a trade economist at the Peterson Institute for International Economics. (…)

House Republicans are brawling over immigration again, and it could scuttle their farm bill. Most of the public debate focuses on the so-called Dreamers. But another big problem receiving less media attention is that the immigration restrictionists are detached from the reality of the American farm economy and a worker shortage that’s driving food production overseas. (…)

A Wall Street Journal analysis of 1,450 cryptocurrency offerings reveals rampant plagiarism, identity theft and promises of improbable returns.

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